If the bailout flops, the options quickly get messy. I don’t see the EU backing down this time and watering down the deal, nor do I see the European Central Bank continuing to provide emergency liquidity. This means that without the bailout, the Cypriot banking system will collapse, and given that the banking system is eight times larger than the economy, there is no way that Cyprus will be able to make its depositors whole. Barring some sort of last-minute emergency loan from Russia (which would presumably come with some pretty wicked strings attached), Cyprus either accepts the EU bailout and goes about its business or it drops the euro, issues a new currency, and then falls into hyperinflationary oblivion.
What does this mean for the Eurozone?
The fear was that seizing bank deposits would set a terrible precedent and lead to bank runs in Spain, Italy and other indebted countries and plunge us back into crisis mode. Once bank depositors are seen as a viable target, you create a slippery slope.
But judging by the market’s reaction, this is a non-event. European stocks took a small hit on the news, though it caused nothing like the turmoil over Greece, Spain and Italy last year. Bond yields in these problem countries spiked up but hardly to levels that would cause alarm.There are a couple reasons why the bank run didn’t happen…or at least hasn’t happened yet. To start, Spain and Italy already effectively had bank runs last year. Funds have been leaking out of both since the onset of the crisis, and their respective banking systems have been kept solvent by the ECB. But more basically, it’s an open secret that Cyprus is a haven for dirty money (wink wink), and investors see clear differences between their own banking systems and that of Cyprus.