Euro Area ruins its progress with Cyprus deal

THERE'S nothing like having part of your savings account confiscated overnight to make you feel that your money isn't safe. That's what depositors in Cypriot banks awoke to on March 16, when they found their accounts frozen for at least five days to avoid panicked withdrawals. As part of a bailout package for Cyprus, euro-area leaders agreed to impose a one-time tax of 9.9 percent on uninsured deposits in Cypriot banks of 100,000 euros or more ($129,570) and 6.75 percent on insured deposits of less than 100,000 euros. The exact size and scope of the levies may yet change, but regardless a line has been crossed: Forcing depositors to participate in bailouts is now on the table in troubled euro- area countries.

The move would not only ensure that Cyprus's economy will contract sharply, necessitating more bailout money or a debt restructuring in the future, but it may also reverse most of the progress euro-area policy makers have made toward ending the euro crisis.

The one-off deposit levy was agreed to as part of the Cyprus bailout for two reasons. First, Germany's main opposition party, the Social Democrats, demanded that depositors participate in the bailout so that German funds wouldn't be used to bail out Russian oligarchs with money of questionable origin in Cypriot banks. The German government can't pass the Cyprus bailout in the Bundestag without the Social Democrats' support, so it had to cater to this demand. Second, the International Monetary Fund insisted that Cyprus's debt burden would be unsustainable if the country received all of the 17 billion euros that it needs in the form of bailout loans. To reduce the size of the bailout, policy makers had three options: write down sovereign debt, write down bank debt or raid deposits. Most Cypriot sovereign debt is under English law and can't be restructured. Cypriot banks have very little debt and are heavily reliant on deposits for funding.

Raiding deposits seemed the most expedient way to shrink the size of the bailout, but in reality this just ensures that additional money will have to be stumped up for Cyprus, or that Cyprus will have to restructure its debt, or both. Cyprus's banks are already a mess. Cypriots reacted to the deposit levy over the weekend by lining up at disabled ATMs in the hopes of withdrawing money. If there is a run, the banks will need far more than the estimated 10 billion euros estimated to be recapitalized. The European Central Bank could plug the gap with emergency liquidity assistance, but bank lending would continue to contract sharply. Private consumption would also fall as unemployment continued to rise and Cypriots worried that they may be subject to future tax increases -- on bank deposits among other things.

Furthermore, the new government burned through almost all of its political capital with this bailout package. Implementing the bailout agreement's unpopular structural reforms would become difficult, if not impossible. Cyprus couldn't expect to benefit from competitiveness gains any time soon. The economy would almost certainly contract more sharply than previously assumed, causing Cyprus to miss its government deficit targets and sending Cyprus's debt-to-grossdomestic-product ratio soaring. As was the case in Greece, the only way to plug the funding gap for Cyprus would be a second bailout, a debt restructuring or both.

Whatever the implications of the depositor levy for Cyprus, they're minor compared with the potential impact on the rest of the region. The tail risk of a meltdown of the euro area is significantly lower now than it was a year ago. This is down to two developments: the ECB's announcement of a bond-buying program -- the Outright Monetary Transactions -- and the tentative steps that policy makers have taken toward constructing a banking union. The Cyprus bailout agreement could significantly undermine these developments. Policy makers have stressed that Cyprus is a unique case given its tax-haven status and its supersized banking sector (about 800 percent of GDP). Depositors in other weak euro-area countries may believe this for now. The second a country comes under stress, however, depositors will know that their participation in a potential solution is now part of the bailout tool kit. As a result, they may rush to withdraw their savings. So far the ECB's promise to do whatever it takes has gone untested, but the mere existence of the OMT program has calmed markets significantly.