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Rolling the Dice in Cyprus

PRINCETON – The task was never going to be an easy one: impose losses worth about €5.8 billion ($7.5 billion) on lenders to the Cypriot government and depositors with the country’s banks. And now that effort has led Europe to its latest impasse.

In marathon negotiations, the Cypriot government, under the supervision of the troika (the European Commission, the European Central Bank, and the International Monetary Fund), agreed to a one-time “tax” on bank deposits. But, despite an amendment to exempt accounts containing less than €20,000, the Cypriot parliament overwhelmingly rejected the plan, leaving Cyprus – and Europe – in limbo.

In fact, large depositors are not unlike senior bondholders, and the proposed haircut was a small but welcome step forward. But, because it did not go far enough, a hole remained. There were other options. Lee Buchheit, the veteran sovereign-debt attorney who should have been in the negotiating room, and Mitu Gulati of Duke University have proposed an elegant “reprofiling” of Cyprus’s €15 billion sovereign debt that would instantly reduce the financing pressure on the country. But such considerations were off the table well before the deliberations began.

Instead, the initial decision was to confiscate just under €3 billion from accounts containing less than €100,000 – the cutoff for deposit insurance. Make no mistake: this would have been the greatest policy error since the start of the financial crisis five years ago. Indeed, the proposal amounted to a rupture with the near-universal agreement that small depositors should be considered sacrosanct. After all, televised news footage of panicked depositors in long lines outside banks and at ATMs can cause immeasurable financial damage far beyond a country’s borders.