Cyprus Bailout: A Really Bad Deal

03/17/2013 04:16 pm ET | Updated May 17, 2013

The big euro news this weekend is playing out in Cyprus where the newly-elected government agreed to a 10 billion euro bailout with the so-called Troika (the European Commission, the European Central Bank and the International Monetary Fund) early on Saturday. One of the conditions of the bailout that made newspaper headlines worldwide is a controversial one-off tax of 9.9 percent on all bank deposits of more than 100,000 euros, and a tax of 6.75 percent on smaller deposits. This news was met with disbelief.

Not only did the news make Cypriots nervous, it sent them running in panic to their nearest bank where ATMs are running out of cash as I'm writing this article. I am afraid this behavior may be observed in other countries such as Greece.

What is the foreseeable outcome of the Troika decision and the timeline of actions for the condition along with the package to be implemented?

The loan package must be ratified by the Cypriot parliament, but the government may not reach the majority votes it needs. This is one reason the government asked banks to remain closed until Wednesday (Monday is a holiday).

Also, the European Central Bank has sent a special envoy to make sure the loan package passes through parliament. As a result, the date of the vote is not known with certainty yet, but the official date is Monday 2 p.m. London time. A negative vote will be a shock with implications beyond Cyprus.

According to media reports in Cyprus, the government was given a take-it-or-leave it offer from Germany.

Germany, the IMF, Finland and the Netherlands argued there are no contagion risks from a scenario of a disorderly default and euro exit in Cyprus. According to some reports, the European Central Bank even threatened to stop supporting Cypriot banks next week.

With the exception of Greece, no other Eurozone member supported Cyprus. Given the IMF's strong views on debt sustainability, it came down to either a promise of an official sector haircut or a tax on bank deposits. Although they gave the former to Greece in the last deal in November, this proved politically impossible for Cyprus given the very high share of foreign deposits and perceptions of money laundering.

The Troika, however, believes that the deposit tax is small enough to address risks of deposit runs.

The immediate risk is the parliamentary vote in Cyprus to approve the deal. It is not clear whether the government has the votes. Their coalition has only 29 out of the 56 parliamentarians, but one has already stated that he would vote against. In the past, the parliament has voted unanimously on bills of national interest. But this may not be the case now.

The opposition parties have been very critical of the bailout deal and the deposit haircut. The newly elected President Nicos Anastasiades had promised there would be no deposit haircut during his pre-election campaign just few weeks ago.

Anastasiades is now trying to determine whether he has enough votes before going to parliament. The vote was supposed to take place Sunday night, then Monday, and the latest is that it may take longer. Officially (for now), the vote has been scheduled for 2pm London time on Monday. Media reports suggest that if the President does not have the votes, he may go back to the Troika in a last effort to persuade them against deposit haircuts.

A negative vote or inability of Anastasiades to renegotiate with the Troika, in a desperate last ditch effort, could be a severe market shock. Unless the Europeans blink and offer a new deal to Cyprus, the country is likely to be threatened by a bank run, disorderly default, and eventually euro exit.

I am more concerned about the message that is being sent to the depositors in the Eurozone. This sudden turn of events has shaken their confidence and trust in the banking system of other Eurozone countries (including Greece and Spain) and see parallel forces shaking the Eurozone more than anyone expected.

We will have to wait and see how the markets will react Monday morning.

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