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HindustanTimes Fri,28 Nov 2014

Island of discontent

Gaurav Choudhury, Hindustan Times  New Delhi, March 26, 2013
First Published: 22:30 IST(26/3/2013) | Last Updated: 01:17 IST(27/3/2013)

EU leaders reached an agreement with Cyprus on Monday that closes down it's second-largest bank and inflicts huge losses on wealthy savers. HT takes a look.

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How did the Cyprus crisis come about?
Cyprus, the smallest of the euro zone economies, was a robust economy till about two years ago, characterised by relatively high economic growth, low levels of unemployment and healthy state of government finances.  Cyprus accounts for a very small fraction of the euro zone economy-about 0.2%. But its banking sector is strongly linked to Greece, which itself has been hit by sovereign debt worries. Cypriot banks had given out loans top Greek borrowers that had accounted for nearly 160% of Cyprus's GDP. As the Greek economy ran into a crisis in 2010, it was the Cypriot banks that were among the hardest hit. A slowing economy also meant that the government did not have the adequate finances to bail out its banks.

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How does the Cyprus banking system affect Russia?
Russia has close financial relationship with Cyprus. Estimates suggest about 33% of all bank deposits in Cyprus originate from Russia. According to one estimate Russians (banks, businesses and individuals) have deposited about $31 billion in Cypriot banks.  In addition, Cypriot banks are estimated to have loaned $40 billion to Russian companies based in the island nation. The collapse of the Soviet Union reportedly led to a rush of funds to Cyprus by rich Russian oligarchs who were scouting for a place to park their surplus cash.

Why was a deal necessary for the euro zone economy?
Without a deal, Cyprus's banking system would have collapsed raising the risk of the country becoming the first one to crash out of the euro zone.

Why was a deal necessary for the domestic economy of Cyprus?
The consequences of the banking crisis for the Cyprus economy can be grave. It is of paramount importance to keep banks afloat in Cyprus. The recaplitalisation of these banks can happen only through special funding that can come from multiple sources such as multilateral agencies, bilateral sovereign funding or from the Cypriot central bank aided by the European Central Bank. The banks, left to them can't borrow on their own because of inadequate capital and perceived lack of ability to repay. Without a deal pushed through a special funding mechanism, the banks would have shuttered down triggering a range of problems. Salaries, utility bill payment and cash withdrawal from banks would have been the worst hit, setting in motion multiple effects across the broader economy. A breakdown in the economy raises the risk of social problems such as unemployment and related troubles, eventually affecting citizens' ability to afford necessities.

What are the features of the deal that was agreed upon?
The Cyprus government agreed to  a €10 billion ($13 billion) deal with international lenders to rescue its banking system, hours before deadline to avert a collapse of its core financial system. Under the deal agreed upon by the Cyprus government, the heads of European Union, the European Central Bank (ECB) and the International Monetary Fund, Cyprus will shut down its second largest bank. It will wind down the Popular Bank of Cyprus, also known as the Laiki, and move deposits below €100,000 to the Bank of Cyprus to create a "good bank."

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What will happen to deposits above €100,000?
Deposits of more than €100,000 are not guaranteed under EU law and will be frozen. The funds so raised will be used to address Laiki's debts and inject capital in Bank of Cyprus. The banks are reported to be holding deposits worth €68 billion of which about €30 billion in accounts of more than €100,000. In the original EU-IMF deal that was discussed a week ago, all customers would have been forced to pay a one-off tax of a minimum of 6.75% on their deposits aimed at raising close to €6 billion to inject capital into the banks.  Cyprus's Parliament, however, voted down this deal in wake of a public outcry.

Is the crisis over?
The deal has averted, at least temporarily, a collapse of the Cypriot banking system. On Sunday, Bank of Cyprus capped cash withdrawals to €120 day, while Laiki had put a daily ceiling on withdrawals to €100, from the earlier one of €260 to avert a run on banks. The deal can potentially shrink the size of Cyprus's financial sector by a sizeable margin, currently at about 18% of the country's national income or GDP. It will hit Cyprus's credibility as an offshore financial centre and the government faces the task of turning around the economy by adopting tough austerity measures.

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