The New Rules of the Game – Five Ways Cyprus Changed the Course of the Eurozone Crisis

1.  Capital controls are back – Typically associated with emerging markets crises and Bretton Woods, the eurozone is developing its first set of capital controls. Capital controls will create a defacto new euro currency in Cyprus, where the local currency will not be able to buy the same goods and services as it would in the rest of the eurozone. Cyrpus imports everything, but money can’t leave to buy imports. When money can’t leave the country, it creates scarcity which drives inflation and an internal devaluation of the currency.

2.  Insured deposits are no longer untouchable – Even if deposits are insured, the Troika, comprised of the ECB, EU and IMF, made it clear that deposit insurance, and national law, is subordinate its demands. The appropriation of Cypriot deposits will make depositors across the eurozone think carefully about pulling cash out of banks if there is an indication of further banking sector trouble.

3.  National champion banks are in play – Spain, Italy, France and Greece have all protected their national champion banks regardless of the banks’ sustainability. In Cyprus, the Troika is breaking the two national champion banks into a good-bank/bad-bank structure that effectively kills off the second-largest bank and neuters the largest bank. Now that national champion banks are in play, creditors may pull back bank financing if the Troika indicates it is not satisfied with banks’ health.

Price-to-book ratio

4.  Senior bondholders suffer losses – While far less aggressive than the raid on deposits, punishing bondholders does impact the way banks capitalize themselves. If bondholders perceive risks to have increased across the eurozone after the Cypriot banks’ bondholders were wiped out, they may demand higher interest rates to refinance banks limiting the ability of banks to lend to customers.

5.  Germany makes the rules now – Eurozone decision making is now clearly in the hands of Germany which has contentious elections coming up this fall. German demands about the structure of the bailout look good at home but undermine the ECB commitment to do “anything it takes” and the broader European vision of cooperation.


What this means for your business: Expect any eurozone recovery to be pushed out further into the horizon as banks will be cautious about recapitalization, and as a result, lending. If lending can’t restart, the economic cycle will remain stalled. Also expect interest rates to increase in the short term outside of Germany while the probability of a eurozone default increases. For a more detailed analysis of the crisis and what it means for emerging markets, FSG clients may download the EMEA Regional Overview released today.


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