The Economic Knock-on Effects of the Cyprus Bailout

From Thoughts of Cyprus and Malta:

First memorandum deal makes a second memorandum almost a certainty for Cyprus.

It took a while to get around the news this morning. The main issue is the immediate haircutting of all deposits of all Cypriot banks (although oddly Greek depositors are excluded!). What does that mean for the economy of Cyprus:

A) Macroeconomic Instability

The news this morning initiated what looked like a bank run: the Eurogroup must not have known that the Co-op societies are open on Saturday, and people patiently waited in queue to remove their deposits only to be turned away. This made everything worse: we seem to have a bank run, which I think the government promise of this being a “one-off” raid on personal deposits will not stem.

How bad is the bank run? According to government sources, the last two months saw 11 billion euros was removed from the Cypriot deposit system within the last few weeks. This week is not going to be any better. I am assuming that at best there will just be an additional 11 billion loss of deposits for the banking system this following months. This means that banks will need liquidity assistance; as a result the Emergency Liquidity Assistance (ELA) of the ECB is bound to continue.  

What is the effect of this loss of deposits? Let remember the Axiom of economics that links the monetary economy with the real economy:

Ms*V= P*Q

or Money supply times velocity equals price times quantity (P*Q is also called nominal GDP).

The removal of deposits led to a reduction of the money supply. As a result there is a brutal negative shock to the money supply, coupled with reduction of velocity as companies and individuals with loans that are attached to deposits battle it out with the banks. As prices in Cyprus are relatively stable then it means that quantity (output) will decline. This makes the scenario for a recession of -2.4% very unlikely (my prediction is -5% GDP). As the recession will be worse than predicted, then neither the government revenue/expenditure stream we agreed on the troika, nor the PIMCO report on the banks’ capitalisation needs, will be accurate. As a result we need a larger bailout à A second bailout is coming...MORE