April 3, 2013
How much money is needed to maintain the normal economic flow of a country? For example, it is a common view in European Union countries that the total capital in banks should be 3.3 times as much as their economy. Only then is it possible for enough capital exchange needed for economic development. This shall be achieved through the constant flow of money. Metaphorically speaking, it resembles a full bottle, one third of which consists of solid substance and the rest is water. The water allows the solid substances to move freely.
This ratio reached one to eight in Cyprus, a small European Union country. The most serious problem is that it had bought Greek government bonds and lent a huge amount of money to its private sector. Following the Greek debt crisis, the European Union made a decision to give a haircut of 50 percent on Greek bonds, and those who bought Greek government bonds had to discard half of the money they were supposed to be paid back. Therefore, Cyprus’ receivables were reduced by half and its banks lost their liquidity.
Cyprus commercial banks closed on March 15 for an indefinite amount of time, which disrupted the normal flow of its economy and, eventually instigated a broad civil protest. In order to rescue its economy from bankruptcy, the Cyprus government requested a bailout from the European Union.
CAUSE OF CRISIS
Cyprus, an island in the Mediterranean Sea, was a tax haven and an international financial center for the last 20 years. The Financial Times wrote that one third of all bank deposits in Cyprus were being made by Russians. It is said that most of this Russian money stems from the 1990s when the communist system collapsed. Cyprus granted citizenship to almost 80 oligarchs and Germany was not happy about it, claiming that it allowed entrance and circulation of hot money into the European Union.
Cyprus had a GDP of EUR 18 billion, a discount rate of 4.2 percent, which was 2.2 percent higher than the European Union average, and a lending rate of 5 percent, which was also 2 percent higher than the European Union average. Its economic growth was also weakened failing to reach its 2009 levels and the biggest two banks of Cyprus (the Cyprus Popular Bank, also called Laiki, and the Bank of Cyprus – 38 percent of total loans and 42 percent of total savings belong to them) had bought Greek bonds and lent 22 billion EUR to the private sector of Greece. That is why the Cyprus banking sector faces a catastrophic problem and is about to suffer from bankruptcy.
BAILOUT WITH GREAT AUSTERITY MEASURES
Eurozone finance ministers agreed a 10 billion EUR deal with Cyprus on March 25, 2013. As a part of the deal, it was decided to shut down Laiki, the second largest bank in Cyprus, and move its deposits to the Bank of Cyprus. It was also agreed to preserve all insured deposits of 100,000 EUR or less without a levy and impose a 40 percent levy on those deposits of more than 100,000 EUR (860,000 deposits) to have them share the burden of the crisis.
Dmitry Medvedev, the Prime Minister of Russia, condemned this deal by saying that it was an act of theft – not a “levy.” Vladimir Putin, the President of Russia, gave its government a task to resolve the issue of the 3.2 billion USD loan that was lent to Cyprus banks in 2011.
Although banks and loan institutions in Cyprus were reopened on March 28, there were strict controls on transactions in order to prevent money from draining out of the economy by the owners of deposits. There were no restrictions imposed on the domestic use of credit cards. However, cash withdrawals from banks were limited to 300 EUR a day and people could spend up to 5,000 EUR overseas. Also, nobody was allowed to cash bank checks.
The economy of Cyprus – 80 percent of which consists of the service sector-is experiencing sudden changes. Half of the people who lost their money totaling 6 billion EUR were Russians and the other half were Cypriots. Foreign businessmen have ceased to visit the island. Therefore, hundreds of service sector workers such as lawyers, brokers and bankers are becoming unemployed and the hotel, banking, and restaurant industries are facing a disastrous crisis.
LESSONS
Money is needed for the development of a country. The entire world is now wondering what would happen if Malta or Luxembourg, which has 23 times as much money as its economy, went into recession just like Cyprus did despite having as much money as eight times its economy. Some experts say that they are in a completely different situation because all bank loans in Malta are in its own economy and most banks in Luxembourg are large foreign banks.
Paul Krugman, a Nobel Prize winner in economics, said that the best way to avoid a banking crisis is to prevent the inflow of a huge amount of money and to control the free flow of capital. Hot money laundering is trending internationally after the Cyprus crisis.
Today when foreign direct investment is decreasing in Mongolia, we need to use our past experience to deeply analyze how much money or capital from foreign markets needs to come into our market, in what ways, and for how long to produce the biggest profits and have the best possible outcome. Also, we need to investigate what situations have an impact on exchange rates and inflation levels.
Our economy has the same capacity as the money we have. In other words, our economy to money ratio is one to one. Therefore, we need at least three times as much money as our economy in order to stop lacking money and have one-digit lending rates. When we start having more than enough money, we will also need to improve our control and oversight.
We need to identify how much money our economy can absorb. In order to have higher yields on loans that allocate money capital, there should be a stable macroeconomic environment, increased labor productivity and anexpanded market.
A huge amount of money can disappear as suddenly as it appears. Therefore, banks should improve their risk management and ensure a good interconnection between savings and loan terms.
The Cyprus crisis reminds us that any economy should not be too dependent on another’s money, especially the money that belongs to governments. It also shows us that deposit owners and other clients end up sharing the burden of the crisis if monetary policy does not support economic growth, is not long-term enough, and does not align with capital market policy. It also shows us that the operational risks of banks are not insured by their own money.
Translated by B.AMAR