What Cyprus Means for your Investments
What could happen next in this ever unfolding drama?

The country: Whoever thought the EU crisis was over was wrong. It just went to the backburner for a bit. But it's now front and center once more – thanks to a tiny country called Cyprus. To put Cyprus into an investor's perspective, this tiny state of 9,250 km2 has a population of around 800,000, with a per-capita GDP of roughly $21,200. However, with banking assets over 7 times its GDP, and bank deposits that are 4 times GDP, for a tiny nation Cyprus has a significantly overweight banking system. To add to this complexity, over 37% of those deposits come from non-residents from mostly non-Euro zone depositors (primarily Russia).

The challenge: Like many care-free pre-2009 era Western world money managers, bankers in Cyprus "played loose" in their investments, and are now faced with urgent need for 10-12B EUR of recapitalization. Either that, or they go bust! The country's public debt is nearing 90% of its GDP, and the recapitalization represents an additional amount nearing 60% of GDP. If the government-of-the-day attempts any bailout on its own, the math is simple: public debt will soar to 150% of GDP which will inevitably trigger a need for restructuring its sovereign debts.


The deal: Given this backdrop, the IMF and EU prepared a recipe for salvation. They would serve the starving Cyprus government a $10B gourmet meal of international relief, if the country cooked up a EUR 5.8B dessert of its own. For the Cyprus government, the choice was simple. The banks created this mess, so the banking system should shoulder a bigger burden of its cleanup. If not, then the general population would end up paying for the sins of the 37% non-residents who are at the center of the banking system malaise.  

So, how to make the banking system pay its due? Because of their relatively small size, taxing junior bonds or unsecured senior ones would be of no consequence.  The answer they came up with was this: disregard the EU deposit insurance agreement, insuring EUR 100,000 in banking accounts, and tax everyone with EUR 100,000 or more in their accounts. Up to EUR 100,000 would pay a one-time tax of 6.75%, and above that would pay 9.9%.

The fallout: Even before the tax plan was announced, there was a run on banks and banking machines. Ordinary depositors were desperate to withdraw as much money as they could. That forced the bankers to close down the banks for a few days.

Over the weekend, Cyprus parliamentarians unanimously rejected the deal as being too unfair to Cyprus nationals. It was clear to them that, since a sizable portion of the deposits were from non-Cypriots (37% non-residents and 30% from non-Eurozone), Cyprus shouldn't have to pay to clean up the mess. Urgent consultations, and diplomatic shuttles, are happening between Cyprus, Russia (which is Cyprus's largest financial backer) and the EU countries. This now means both Russia and the EU have been scorned and feel they are being "dared" to react to parliament's defeat of the banking-tax legislation.  

The future: The consultations are likely to yield some type of compromise, where the tax rates and the ceiling for taxable accounts will be re-jigged. Perhaps the compromise might include lowering of tax rates for smaller depositors while increasing them for larger ones. Or it might include extending the threshold for tax-exempt accounts.  However, the EU is not likely to entirely withdraw its insistence that bank depositors pay their due share for the bailout fund. Either way, it is extremely unlikely that, as some doomsday analysts predict, this is the beginning of Cyprus's exit from the EU. It is more likely that the EU will do all it can to prevent further contagion and retain Cyprus within its folds.

The impact for global investors: If you are an investor who has significant exposure to the international financial sector, then you need to pause a while and assess what your geographic asset mix in these assets is. If you hold a Mutual Fund or an ETF, check the underlying securities to ensure that they don't contain an overabundance of Cyprus exposure. And if you are directly invested in Cypriot, Greek or other European banking institutions, then you may want to lighten up your positions somewhat to preempt any adverse fallout from possible contagion.

At minimum, investors in such classes of assets should continue to monitor this fluid situation carefully, especially over the weekend. You should be prepared with an exit strategy that can be put into action quickly, if the situation warrants it. Monday is the deadline for the Cypriot government to avoid a financial meltdown by coming up with some creative legislation to deal with the challenges that lie ahead.

(By: Monty R. – MarketConsensus News Contributor)