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What Lessons Does Cyprus Teach Us?

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Last Saturday, Cyprus finally reached an agreement on the terms of its bailout with a group of international lenders, consisting of the IMF, ECB and EU. The original set of terms was a bitter pill to swallow.

Particularly unpalatable was the proposal to tax insured deposits at 6.75%. The final agreement eliminates this clause altogether.

Ultimately, uninsured depositors will have to bear the entire burden of rescuing Cyprus’s two beleaguered banks – Cyprus Popular Bank and Bank of Cyprus. In order to receive the euro 10 billion ($13 billion) bailout package, Cyprus will have to itself put up a substantial amount. The Popular Bank of Cyprus, also known as Laiki Bank, will be closed. Its good assets and insured deposits will be transferred to Bank of Cyprus.

Deposits above euro 1,00,000 will be utilized to fund the amount to be paid by Cyprus. These frozen deposits are expected to amount to euro 4.2 billion ($5.5 billion) and depositors could lose up to 30%-40%. This is substantially higher than the originally proposed rate of 9.9% on these deposits.

Incidentally, most of these deposits are from Russia. Weak financial regulation and low corporate taxes have turned Cyprus into a destination for funds from affluent individuals and businesses from all over the world. This is why the country is hugely dependent on its financial sector. In fact, Russian funds amount to $31 billion in bank deposits. This figure is particularly relevant when compared to Cyprus’ GDP of $25 billion.

However, all this has come to an end thanks to the terms of the bailout. The fact that foreign depositors will be paying for the country’s bailout has effectively ended Cyprus’ lucrative offshore banking sector. This will lead to a huge loss of income, a rise in unemployment and a reduction in GDP. Brokerage agency Exotix has forecast a 10% decline in GDP this year itself.

Further action would mean going against the very spirit of the European Union. This would mean more trouble for Cyprus’ economy, already facing a downgrade from rating agency Fitch. It would also send a negative signal to those parking funds in other troubled euro zone countries like Spain, Italy and Greece.

What the Cyprus deal illustrates is that the Eurozone still has economic issues which remain a long-term concern. In any case, the rest of the region is anything but in the pink of economic health. This is particularly relevant to U.S. companies with large exposure to the Eurozone. According to Citi Research, a division of Citigroup Inc. (C - Free Report) ,as of 2010 several large U.S. companies drew significant revenues from the region.

These include the likes of General Electric Company (GE - Free Report) , The Coca-Cola Company (KO - Free Report) , Philip Morris International, Inc. (PM - Free Report) , McDonald’s Corp. (MCD - Free Report) , Abbott Laboratories (ABT - Free Report) , News Corp. (NWSA - Free Report) and Ford Motor Co. (F - Free Report) . Earlier this month, FedEx Corporation (FDX - Free Report) lowered its earnings forecast, saying that it had been affected by the global economic situation. Meanwhile, Caterpillar, Inc. (CAT - Free Report) , a significant indicator of the health of the world’s economy, said monthly sales had declined significantly.

According to Goldman Sachs (GS - Free Report) , around 50% of international sales of US companies can be attributed to Europe. Until now, share prices have been unaffected by the precarious European situation combined with such heavy exposure. However, markets have been sensitive on occasion. Indices had declined after Jeroen Dijsselbloem, head of the Eurogroup of Eurozone finance ministers, said that the approach used in Cyprus would be used in other countries facing similar problems.    

Of course, stocks recovered when he said: “Cyprus is a specific case with exceptional challenges,” but such concerns linger in the background. And capital controls cannot be one of them. This would go against the very spirit of the currency union and lead to a further loss of confidence. The Cyprus pact has put the brakes on a greater crisis for now. But, surely, the Eurozone will have to find a more permanent solution to its economic malaise.

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