Deal will keep Cyprus in the EuroZone but does yet more damage to the euro

03/25/2013 12:01 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

There’s a deal on Cyprus that will prevent the immediate collapse of the country’s banking system and an exit from the euro.

Reaction to the Sunday night deal was briskly positive in Asia with the Nikkei 225 climbing 1.7%. (A rally in the euro will help the Abe government weaken the yen, which will, in turn, help Japanese exporters and financials.)

So far in European trading the reaction has been much more restrained. The French CAC 40 index is up 0.5% as of 10:40 a.m. New York time. The German DAX index is up 0.6%. But Spain’s IBEX 35 index is off 0.3% and the FTSE MIB index in Milan is down 1.2%. And, of course, there’s no joy in Cyprus.

Asian stocks—and U.S. market so far this morning—may be up because to far-away investors the story is that euro chaos has been prevented for another day. For Europeans and Cypriots, however, the deal isn’t so much relief as it is an invitation to future pain and another step toward an eventual end to the euro as it is now constituted.

The pain first. The deal will shut down the country’s second largest bank. Small depositors—below 100,000 euros—will see their accounts transferred to the Bank of Cyprus in a move that essentially sets up a good bank/bad bank division. Amounts above 100,000 euros will remain in the bad Laiki bank, along with bad loans. The best estimate now is that account balances above 100,000 euros will be wiped out as Laiki is wound down. It’s not exactly clear what will happen to accounts with more than 100,000 at the Bank of Cyprus, but they will take some kind of haircut. To prevent wholesale transfers of bank funds the deal includes capital controls. The deal makes no distinction between overseas hot money and domestic balances needed to run businesses or to fund education or retirement plans.

It’s hard to see how this doesn’t result in a quick and brutal decline in the Cypriot economy. Early projections say a 10% drop in economic activity is likely this year. But that won’t be the end of the pain. The deal essentially destroys the bank-haven model for the country’s economy but puts nothing in it place. (It’s hard to imagine how this deal would make any company want to do business in Cyprus. Who wants to worry that account balances will vanish or that capital controls will make it impossible to pay bills or get paid for sales?) You can cheer the end of Cyprus as one of the global centers for money laundering but I’d argue that destroying the country’s economy is a rather extreme method for achieving that end. What we’re seeing today is the average Cypriot in the street paying the price for a lack of adequate banking regulation—at the country and the EuroZone levels--to crack down on money laundering activity.

Second, the deal does yet more damage to the euro. The single currency zone is supposed to allow for the free flow of capital—capital controls are a big hit to that goal. The attack in the earlier iterations of the deal on accounts with less thn 100,000 euros is going to make negotiating a deal on EuroZone wide uniform deposit insurance later this year even harder in my opinion.

The deal has also got to raise real fears among the EuroZone’s smaller members—Malta, Luxembourg, Slovenia, for example—that some day they too might be told that their economies don’t match up with some template at the European Central Bank or at the German finance ministry. Think Luxembourg, a small country with an economy centered on finance, isn’t wondering about the future today? Today rather than a democratic club, the EuroZone looks like a version of Orwell’s Animal Farm where all countries are equal but some are more equal than others.

And finally, the cost of staying in the euro over the next months and years is going to be so extreme that I’d expect that the Cyprus deal will become a huge test case for other countries that have to decide between the pain of leaving the euro and the pain of keeping membership in the common currency. It’s hard for me to see how in year anyone will be able to look at Cyprus and say, This was worth it.

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