Cypriot bailout terms may reduce investor confidence
Fortunately for the European and world economies, the Cyprus banking system will now be bailed out under the terms of a harsh agreement finalised this week. This time round, the big losers were the large depositors in the Cyprus banks.
In the Greek bailout, it was the bondholders owning government debt who lost out. That arrangement did not affect confidence in the Greek banks, though it discouraged both domestic and foreign residents from investing in Greek assets.
Inflicting losses on large bank depositors, as has now been done in Cyprus, could well have a more serious impact by reducing confidence to invest in weaker eurozone countries. Bank depositors can no longer be certain that part of their assets will not be confiscated in any future European Central Bank bailout.
At this stage, it looks likely that small depositors will continue to be protected by government guarantees. But when the governments themselves are facing serious debt problems, there are obvious limits to their ability to guarantee deposits.
Uncertainty about the future safety of European bank deposits could well contribute to further problems with eurozone membership. Cyprus attracted large overseas deposits in relation to the small size of its economy because it was in the eurozone. If Cyprus had maintained a separate currency as Britain does, the inflow of foreign deposits would have been discouraged by an appreciation in the exchange rate.
The attraction of investing in Cyprus was access to euro currency deposits in a tax haven. Without being able to offer euro-denominated investments, Cyprus would never have been able to attract these large-scale deposits. Worse still, because devaluation was not an option available to Cyprus to deal with its banking problem, it had no alternative to a levy confiscating part of all large deposits.
Recent reports suggest Britain now faces the risk of a triple-dip recession. Nevertheless, the adjustment process for the banking system and economy has been much less painful than in other weak euro-currency members. This is the result of the depreciation of the British pound to such an extent that the Australian dollar is now buying nearly 2.5 times more pounds than it did several years ago.
The falling value of the pound has discouraged imports, encouraged exports and assisted the restructuring of the economy. Currency devaluation is not an option available to weaker eurozone members unless they opt to leave the eurozone. If eurozone bailouts continue to be as tough as the Cyprus one, there could be an even greater incentive for weaker countries to exit the eurozone.