THE financial crisis in Cyprus has again shown that over-dependence on the financial sector and an unregulated and liberalised financial system can cause havoc to an economy.
The particular manner in which a financial crisis manifests itself may be different from country to country, depending on the ways the country became financially over-reliant or over-liberalised, and also on how ever-changing external conditions affect the country.
For the past two weeks, Cyprus hit the headlines because of the rapid twists and turns of its crisis, the terms of the bailout it negotiated with its European and IMF creditors, the hit that bank depositors are forced to take, and finally the “capital controls” that the government has imposed to prevent bank runs and capital flight out of the country.
Depositors with more than 100,000 (RM396,000) could lose more than half their savings.
Bank customers can only withdraw 300 (RM1,189) daily; cashing of cheques is prohibited; transfers of funds to accounts held abroad or in other credit institutions are prohibited; transfers due to trade transactions above 5,000 (RM19,832) a day require central bank permission; the use of credit cards overseas is restricted to 5,000 (RM19,832) per account a month; and travellers can only take out 1,000 (RM3,960) or equivalent in foreign currency per trip.
These capital controls, announced on March 28, were highlighted in the media as the first to be imposed by a country belonging to the European Union.
It was like the slaying of a “sacred cow”, because the freedom to move funds out of and into the European countries had been treated almost like a human right.
But it is this total freedom for the flow of funds that has contributed or even been ultimately responsible for so many financial crises in so many countries in the past few decades.
This liberalised system of capital flows enables residents to place their funds abroad or to purchase foreign assets like bonds and shares.
It also enables foreigners to bring in funds either for short-term speculation and investment or longer-term investment and savings.
After the Second World War, capital controls were the rule: flows of funds to and from abroad were mainly restricted to activities linked to the real economy of trade, direct investments and travel.
From the mid-1970s, the liberalisation of capital flows took place in the rich economies and gradually spread to many developing countries.
The finance ministers of Brazil and of other developing countries have been protesting against the easy-money policies in rich countries that have had adverse effects on emerging economies.
When the internal or external situation changes and investor perception changes with it, the inflow of funds turns into its opposite.
The sudden outflow of funds, and depreciation of the currency, can then cause an even more devastating effect on the economy.
In the 1997-99 crisis, East Asian countries that had over-liberalised their financial system found that local banks and companies had borrowed heavily in US dollars.
When their currencies depreciated, many of the borrowers could not service their loans.
The countries’ foreign reserves dropped to danger levels, forcing them to go to the IMF for bailout loans.
Malaysia fortunately had some control over the amount local companies could borrow from abroad, which prevented it from falling into an external debt crisis.
The imposition of capital controls over outflows in September 1998 enabled Malaysia to avoid a financial crisis requiring an IMF bailout.
The immediate response from the IMF and the Western establishment was that the capital controls would destroy the Malaysian economy.
Today, the economic orthodoxy has changed, and most analysts including at the IMF give credit to Malaysia for the capital controls.
The Malaysian controls included a temporary ban on foreigners transferring their ringgit denominated funds (for example in the stock market) abroad, a limit to the funds local travellers could take out of the country, and limits to overseas investments by local companies and individuals.
Today, the IMF itself has changed its position, saying that capital controls in certain situations are not only legitimate but may also be necessary.
It has partially recognised that unregulated capital flows can cause financial instability and economic damage.
In the case of Cyprus, analysts now conclude that its growth model was flawed because it was too reliant on a bloated financial sector, having become a haven for foreign savers, especially from Russia.
But a major factor in its recent crisis was that the country’s biggest banks invested in Greek government bonds.
In October 2011, a bailout package was arranged for Greece by the European Union and the IMF.
Part of the bailout terms was that holders of Greek government bonds would take a “haircut” or loss of about 50%.
This Greek debt restructuring meant a loss of 4bil (RM15.9bil) for banks in Cyprus, a huge amount in a country whose GNP is only 18bil (RM71.4bil).
Now, it is Cyprus’ turn to be reconfigured and re-created as part of a 10bil (RM39.7bil) bailout scheme. The two biggest banks, Bank of Cyprus and Laiki Bank are to be drastically restructured, with the latter to be closed.
The biggest innovation designed by the European Union and IMF creditors is that the bank depositors will have to take losses. Deposits less than 100,000 (RM396,000) are to be spared, after an original plan to also “tax” them by 6.75% was cancelled after a huge outcry and the fear of contagion, with bank runs in many European countries.
The final plan is for deposits over 100,000 (RM396,000) in the two banks to take losses not by the originally planned 9.9% but by much more.
The new European policy of getting bank depositors to take a big hit in bailouts of banks will have big ramifications for public confidence in banks.
The new perception is that money put as savings in banks is no longer safe.
The question remains: will the policymakers learn the real lessons from these crises?
GLOBALTRENDS BY MARTIN KHOR
- Financial crises a result of governance failures (rightways.wordpress.com)
- Bank of Cyprus major depositors could lose 60% of savings (panarmenian.net)
- Bank of Cyprus head Kypri ‘sacked’ (bbc.co.uk)
- Cyprus Has Finally Killed Myth That EMU Is Benign (ritholtz.com)
- You: Bank of Cyprus depositors could lose up to 60% of their savings (guardian.co.uk)
- Cyprus: Big depositors could lose up to 60 percent (wireupdate.com)
- Cyprus bail-out: banks reopen as it happened, March 28, 2013 (ninthfact.wordpress.com)
- Cyprus told: take bank levy or leave euro (guardian.co.uk)
- Cyprus cash curbs ‘may last a month’ (bbc.co.uk)