The recent financial crisis in Cyprus has instantly brought back the memories having to do with the Israeli financial crisis back at the 80′s. When a country faces such an enormous deficit, which endangers its ability to pay back the debts to both internal and external debt creditors, it must take dramatic measures in order to avoid bankruptcy.
Insolvency damages the investor’s confidence
Unfortunately, the global financial history has its share of national bankruptcies. Argentina, for example, even had to declare bankruptcy more than once. It ought to be noted that insolvency is in fact a big deal because when a country admits it cannot pay its own debts, investors become skeptical as to any future investments in that same country.
Getting back to the Argentinean example, the last time they had to declare bankruptcy was back at the beginning of the new Millennium. At the time prominent world economists predicted that Argentina will have a tough time going out from this crisis mainly because the investors had little confidence in the Argentinean government.
However, reality had different plans for Argentina because the dramatic rise we all witnessed in the global prices of agricultural commodities helped Argentina immensely. The rise began a few years after bankruptcy was declared and the fact that Argentinean economic sector heavily relies on agricultural products based on wheat, soybeans and cattle allowed the country to end the crisis swiftly and defy the apocalyptic predictions.
A country wishing to avoid insolvency can take a number of specific and concrete steps aimed to rescue its economy: One of these possible steps is the one similar to the Stabilization Program implemented in Israel back in 1985. During this tough period, the employees sector had to give up nearly 20% of his real income whereas the “rich” paid the price via a rather inevitable sharp devaluation. The Stabilization Program has helped the government to stop the rising inflation and drastically reduce the deficit.
Israel has also considered the Cypriot Solution
People might not remember this but it is worth mentioning that during the times of raging inflation and constant instability, Israeli decision makers also considered imposing a tax on bank deposits and eventually decided not to do so because they realized such a measure would deliver a critical blow to public confidence in the Israeli banking system, which in turn, would obviously impede economic recovery. It turned out to be the right decision.
Cyprus, however, has decided to take this step, and one of the main reasons behind this decision is the fact that most of the deposits on the island simply don’t belong to local residents but rather to Russian citizens and corporations for whom Cyprus served as a safe haven.
The Cypriot government had concluded that harming this sector will not impede the local economic recovery and only time will tell whether they were right or not. Every country should consider taking these steps only when push comes to shove and it doesn’t have any significant alternatives. Make no mistake about it, the crisis does not concern the local banking system but rather a national financial crisis – and the banks were used in order to solve it.
After the Cypriot move has been completed, there is no doubt that in countries where the budget deficit is out of control – mainly in South-European countries such as Greece, Italy and Spain – the fear of similar measures is certainly present. This solution will bother both investors and depositors that might want to take out their money. This is not a step that can be taken lightly and I believe that the way in which European markets will behave in those upcoming weeks will further validate this claim.