Here’s a scenario for you.
You wake up one morning. Over the radio, you hear that the government has said that all the banks are bust. Everyone is going to have to sacrifice 10% of their savings to bail the system out. It’s the only solution.
Now, you’ve only got £20,000 in the bank. You know up to £85,000 is insured under the nation’s deposit protection scheme. So you think you’re covered.
Not so. Turns out the 10% fee is a tax. A ‘wealth’ tax, if you like.
So you lose £2,000 of your savings anyway, even although you thought you were playing by the rules.
Sound unfair? I’m sure the residents of Cyprus would agree with you. Because that’s exactly what happened to them this weekend.
And the ramifications will spread well beyond their little island…
How Cyprus ended up robbing its savers
The banking system in Cyprus is about eight times the size of the country’s economy.
And, as Hugo Dixon of Reuters points out, due to its exposure to Greece and its “own burst property bubble,” it is bust.
Meanwhile, the European Central Bank was threatening to cut off emergency funding to the banking system if some sort of bail-out deal couldn’t be sorted out.
In all, Cyprus needed around €17bn – 100% of GDP – to save the banking system and pay its own bills.
It’s not much money by euro standards. Trouble is, any bail-out loan would just have boosted the nation’s debt-to-GDP to ridiculous levels. They’d never have been able to repay it. Eventually, its government debt would have needed to be restructured.
The northern ‘creditor’ countries (Germany and Finland in particular) have already been caught out on that front by Greece. They’re not keen to let it happen again. Not in a German election year.
It doesn’t help that Cyprus is a tax haven. More than half of the savings in the Cypriot banking system come from overseas. And while I’m no expert on the topic, it’s a reasonable assumption that a fair bit of that is there to be laundered.
Bail-outs are unpopular at the best of times. Bailing out organised criminals is even less of a vote-winner.
So Germany and Finland said that Cyprus had to find more money from somewhere to reduce the loan needed, from €17bn to €10bn.
Making government bondholders take a ‘haircut’ would have scared every other bond holder in the eurozone. It also wouldn’t have helped much, because banks hold a lot of the debt.
So it had to be the savers. That’s drastic enough – so far depositors have been protected in this crisis.
But even more radically, the tax applies to everyone. So the €100,000 eurozone protection scheme counts for nothing. The argument is it’s a tax. It’s not that the bank has gone bust. So the protection isn’t relevant. But I’d agree with Dixon, who goes so far as to describe it as “a type of legalised robbery”.
If you hold less than €100,000, you’ll be charged 6.75%. If you’re over that limit, it’ll be 9.9%.
Now, the deal isn’t done yet. The Cypriot government has postponed a vote on the topic. It looks as though they might try to punish small savers a bit less by changing the split from 6.75% and 9.9%, to 3.5% and 12.5%, suggests the FT.
And they’re also talking about giving people who keep their money in the banks some form of potential future compensation, in the form of bank shares, or future revenues from natural gas production.
But the point is: a precedent has been set. Depositors are fair game, regardless of how often the rest of Europe insists this is a ‘one-off’. And that’s a major worry.
The lessons from Cyprus
Assuming you don’t have any money in Cyprus, you won’t be directly affected by this. But there are two key lessons to take away.
Firstly, when you deposit money in a bank, you are making a loan to that bank. ‘Savers’ are a much-derided group of people at the moment, more often painted as degenerate selfish ‘hoarders’ than as the vital sources of capital they actually are. And banks often act as if they’re doing you a favour by deigning to look after your money.
But the fact is, you are providing funds for the bank. And just as you would with any other person who asks you to borrow money, you need to consider both the terms on offer (such as the interest rate available), and the borrower’s creditworthiness.
The second point is that governments can do what they like. They will lie point blank. They will make stupid decisions. You cannot expect them to look after your best interests if this conflicts with their own.
As my colleague Merryn Somerset Webb notes on her blog this morning, don’t think this ‘wealth repression’ can’t happen here. It is already happening. By keeping interest rates low and tolerating above-target inflation and currency devaluation, the average British saver has already lost a substantial amount of money in ‘real’ terms over the last few years.
What does this mean for investors?
This is frightening for anyone with savings in a fragile economy, and the ‘peripheral’ eurozone countries in particular. As The Economist puts it: “People who don’t trust banks, and keep their money under the proverbial mattress, will not be touched by this levy; in the past, such people have been regarded as eccentrics. Not any more.” The same goes for gold, the paper adds.
That said, I’m not convinced that the biggest immediate worry is a bank run in Greece or Spain or Italy, say, although it’s worth monitoring. The real worry is that this undermines any sort of trust in the eurozone in the longer run.
It’s one thing to put up with austerity measures. It’s quite another to start having to worry that your savings might just be confiscated. Your average Cypriot is being asked to pay nearly 7% of their savings as the price of staying in the euro.
That might still seem a price worth paying compared to the scale of devaluation they’d see if they quit the euro. But it starts to provide a benchmark for other countries. It can only add to the evidence for anti-euro political parties.
And given that the euro is a political construct, that’s what you really have to watch out for. If a group of voters finally wake up to the fact that this is the fault of the euro, not just the Germans, then the disintegration will have begun.
In the meantime, Bill Gross at Pimco noted at the weekend that the “risk-on” trade is likely to falter. And it has. Japanese stocks tumbled this morning, stocks in Europe have been sliding too, and US Treasuries are higher.
We’ll need to wait and see if this will result in the correction that everyone’s been expecting. A lot hangs on how the Cyprus vote goes. But reading US market writers on Twitter over the weekend, I get the impression that they’re basically bored of Europe, and still in ‘buy the dips’ mode.
In any case, I’d still stick to the plan. A sell-off in Japan is a buying opportunity. I still like Italy, for all the reasons I’ve written about before, although I can see it falling a fair bit further. And all of this panic in Europe can only be good for the dollar – if the euro is no longer the surprise strong man in the currency wars, there aren’t many options left outside the US.
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
Follow John on Twitter || Google+ John Stepek
Our recommended articles for today
MoneyWeek TV: Where to put your Isa money
In this week’s edition of MoneyWeek TV, Merryn Somerset Webb and John Stepek talk about where they’re putting this year’s Isa allocation; Tim Bennett explains why you might want to look at preference shares; and Tim Price talks gold.
My love/hate relationship with gold miners
Gold miners have proven to be something of a disappointment to shareholders. But you’d be mistaken to turn your back on them just yet, says Bengt Saelensminde. Here, he explains why.