What happens if Cyprus collapses?

[March 23, 2013]  PARIS (AP) -- What happens if Cyprus' banks collapse? If its government goes broke? If it leaves the euro?

The European Union, the International Monetary Fund, the European Central Bank and the country's leaders are trying to find a deal to secure a 10 billion euro ($13 billion) loan for Cyprus and stave off a failure of its banking system. The Cypriot parliament has already rejected one deal, which would have taxed all bank deposits in the country. The ECB has now put a ticking timer on this drama by declaring it would cut off emergency support to Cyprus' banks on Monday if no deal is found.

That's the worst case.

Even if a deal is found, the messy decision-making over the past week will have shaken confidence in Cyprus and the euro currency union itself. Here's what's at stake.

CYPRUS

The consequences for Cyprus itself could be so rough that many analysts think some kind of deal will be struck. If not:

The only thing keeping Cyprus' banks afloat right now are short-term loans from the Cypriot central bank with the blessing of the ECB. The banks need this special funding because they can't borrow normally. They don't have good enough collateral to receive normal loans from the ECB, and others are reluctant to lend to them for fear of not getting their money back. The emergency lending program isn't publicly declared, but analysts say the Cypriot central bank has already handed out around 9 billion euros ($11.6 billion).

If the ECB pulls the plug, the Cypriot banks would probably not be able to open their doors, or would very quickly collapse because they wouldn't be able to satisfy the likely rush of customers pulling their money out. Then the banking system enters a sort of twilight zone -- with the banks closed, there can be no real run on the banks, but salaries won't be paid, mortgage payments won't go through, electricity bills will linger.

After the banks, the next logical step is that the government goes bankrupt, either as it tries to shore up the banking system or because it is on the hook for insuring all deposits under 100,000 euros ($130,000).

The resulting disaster cannot be predicted clearly -- and shouldn't be underestimated. The road could lead to an utter breakdown not just of the economy, but of the country's social fabric. Some economists say that as euros become scarce, Cyprus may have to issue some sort of IOUs for people to buy basic necessities. That could lead to hyperinflation, in which the prices of goods double and triple regularly. The country might have to prevent cash from leaving its borders. People may turn to barter. Commerce will slow or grind to a halt.

The country could leave the euro, and no one really knows what happens then. It's such a terrifying possibility for Cyprus and Europe that some analysts think the EU will step in at some point to prevent it from happening, even if most of the damage to Cyprus is already done.

"The euro area doesn't want a failed state in Cyprus," said Jacob Kirkegaard, senior fellow at the Peterson Institute for International Economics in Washington. "Once the disaster happens, I would actually imagine that the euro area would be relatively lenient with respect to engaging in a new program."

Even if Cyprus avoids the nightmare scenario, it is facing a long road back. The measures it ends up enacting to secure the loan could hurt growth -- especially as it may have to raise taxes, doing away with one of the most attractive things for businesses setting up in Cyprus. And the mere threat of confiscating a part of bank deposits could ruin faith in Cyprus as a center of international banking -- destroying its largest industry.

Some argue that investors who put their money in Cyprus have been paid for this kind of risk -- through high interest rates and low tax rates. Even if they aren't scared away, any deal with international lenders will demand that the country severely shrink its banking sector anyway.

EUROZONE

Cyprus' economy is a tiny fraction of the eurozone's -- just 0.2 percent -- but its banking sector is heavily connected to Greece and any collapse could have a disastrous effect on that already stricken nation. European officials would have to move quickly to insulate Greece. How well Greece is protected will largely determine how much impact a Cypriot banking system collapse will affect the eurozone.

That's if Cyprus manages to stay in the euro. If it leaves, the consequences are hard to predict. Some think it could raise fears other countries, such as Greece, might leave. That would cause those countries' borrowing costs on the bond markets to rise, making it harder for them to finance deficits and potentially requiring them to seek bailouts. If fears worsened, investors and savers could pull their money out of these countries, threatening their banking sectors.

For now, the Cyprus crisis is not spreading market panic to other indebted countries such as Italy or Spain. That's because the ECB has pledged to do "whatever it takes" to save the euro, including buying the government bonds of troubled countries to keep their borrowing rates down. The backstop has done much to contain the eurozone crisis since last summer.

But even if Cyprus finds a deal by Monday, the impact of its crisis may be felt across Europe for a while to come. The mere fact that Cyprus considered confiscating bank deposits below the insured limit of 100,000 euros may have unsettled account holders in other financially troubled eurozone countries. The question is, whether depositors will be quicker to run for the ATM in a future crisis now that the insurance promise has been revealed as less than sacrosanct.

RUSSIA

The possibility that bank deposits might be taxed has particularly angered Russia, whose citizens hold as much as 20 billion euros ($26 billion) in Cypriot banks. Russian President Vladimir Putin called it "unjust, unprofessional and dangerous." Still, middle-class Russians don't have their money in Cyprus, so the effects will be limited to a class that can largely afford to shoulder the burden. They may move their money elsewhere, but Russian officials do not expect them to bring the money back home.

On the other hand, Russian banks, which have about $40 billion worth of loans to Cyprus-based companies on their books, stand to lose significant amounts if Cyprus' banking system breaks down and money isn't allowed to leave the country. The cost could rise to almost 2 percent of Russia's gross domestic product.

GLOBAL MARKETS

For the moment, global markets appear largely unconcerned about Cyprus.

This could be because Cyprus is tiny. It could be because they are confident an 11th-hour deal is assured. Or that there's so much cash floating around markets after several rounds of monetary easing by the U.S. Federal Reserve and other central banks that investors are impervious to a potential banking collapse in just one small country.

Since Cyprus has a highly connected, international banking system, if it collapses, companies around the world will suffer. They will lose their savings and fail to be paid on outstanding contracts. But the entire banking sector is relatively small, so the direct effects from a collapse in Cyprus shouldn't be dramatic around the world.

The global impact depends largely on how the eurozone is affected. If European leaders contain the damage to Cyprus, the world probably shrugs. If Cyprus exits the euro or its banking collapse roils Greece or Spanish savers start demanding their money back, then the world will sit up and take notice. Taken as a whole, the EU is the world's largest economy. When it falters, everyone does.

[Associated Press; By SARAH DiLORENZO and DAVID McHUGH]

McHugh contributed from Frankfurt, Germany. Associated Press writer Nataliya Vasilyeva contributed from Moscow.

DiLorenzo can be reached at http://twitter.com/sdilorenzo.

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