Lesson from the rouble crash: Don’t put all your eggs in one basket

Eastereggs_ostereier

Vivek Kaul

The Russian rouble has been crashing over the last few days. On December 10, 2014, one dollar was worth 55 roubles. After this, the rouble started crashing against the dollar and it even touched 73 to a dollar on December 16, 2014. This happened despite the Russian central bank raising interest rates to 17%.
Interestingly, as I write this in the late evening on December 17, the rouble has recovered to 62 to a dollar, after the Russian central bank promised to sell close to $7 billion to buy roubles, in a bid to push up the value of the currency.
The Russian government is totally dependent on revenue from oil. With the price of Brent Crude Oil falling below $60 per barrel, the Russian economy is expected to contract majorly next year. This has led to foreign investors exiting Russia.
When foreign investors exit Russia they sell the roubles they have and buy dollars. This leads to an excess supply of roubles in the market and a demand for dollars. This led to the rouble crashing against the dollar. The Russian central bank is now selling dollars and buying roubles being sold and in the process has managed to stop the crash for the time being.
But that’s the simple bit. The first question that arises here is how did the Russian economy become so heavily dependent on money coming in from selling oil. Currently, nearly 50% of government’s income comes from oil. Oil also makes up for two-thirds of Russian exports.
The answer to this question is provided by Yegor Gaidar in an excellent research paper titled
The Soviet Collapse: Grain and Oil. Between 1991 and 1994, Gaidar was acting prime minister of Russia, minister of economy and the first deputy prime minister.
The story starts with Joseph Stalin who was the leader of the Soviet Union from 1922 till his death in 1952. Stalin essentially forced collectivization and expropriation of agriculture. “The result of the disastrous agriculture policy implemented between the late 1920s and the early 1950s was the sharpest fall of productivity experienced by a major country in the twentieth century,” writes Gaidar.
In the 1960s, this “state production of grain stabilized” and remained fixed at around 65 million tonnes per year, until the late 1980s. The trouble was that the urban population was increasing and more grain was needed. This led to Russia becoming a major importer of food grains.
As Gaidar points out: “The cities, however, continued to grow. What policy could succeed if a country had no increase in grain production and an 80 million–person increase in its urban population? The picture was bleak. Russia, which before World War I was the biggest grain exporter—significantly larger than the United States and Canada—started to be the biggest world importer of grain, more so than Japan and China combined.”
So, the harebrained agricultural policies of Stalin turned the world’s biggest exporter of grains into the world’s biggest importer, in a matter of a few decades. The trouble was that the imports had to be paid for in hard currency (largely dollars). Nations like Japan were also importing food grains, but then they also were exporting a lot of goods using “their machine-building and processing industries” as well. This helped Japan earn the foreign exchange it needed to pay for its imports.
The Soviet Union did not have this ability simply because it had followed a policy of “socialist industrialization” which had resulted in “in the Soviet industry being unable to sell any processed (value-added) products”.
Since no one would buy machine products manufactured in the Soviet Union, it became a big exporter of raw materials which included oil and gas. As Gaidar writes: “The Soviet economy thus hinged on its ability to produce and export raw commodities—namely, oil and gas. The Soviet leadership was extremely fortunate: at almost exactly the time when serious problems with the import of grain emerged, rich oil fields were discovered in the Tyumen region of Western Siberia.”
So, oil and gas helped the Soviet Union earn enough dollars to pay for the food grains that it needed to feed its citizens. The country was totally dependent on the revenue from oil and gas.
In fact, its leaders had to get the Tyumenneftegaz (the  production association of the oil and gas industry in the Tyumen region) to produce more than what had been initially planned for. “The Soviet premier, Aleksey Kosygin, used to call the chief of the Tyumenneftegaz, Viktor Muravlenko, and explain the desperation of the situation: “
Dai tri milliona ton sverkh plana. S khlebushkom sovsem plokho” [Please give three million tons above the planning level. The situation with the bread is awful],” writes Gaidar.
After the breakup of the Soviet Union in 1991, this model has been followed by Russia as well. The trouble is that over the years Russia started to assume that high oil prices would stay forever. As Gaidar puts it: “ the idea that “high oil revenues are forever” has gained an even wider acceptance.”
Interestingly,
The Financial Times reports that around two weeks back, the current Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” As I write this Brent Crude Oil is selling at around $59.3 per barrel, inflation is about to cross 10% and the economy is expected to contract in 2015. Hence, the assumptions are going all wrong.
The Russian government’s budget becomes balanced at a price of close to $100 per barrel, which is nearly 66% higher than the current price of oil. Interestingly, Russia is not the only country which has worked out its government finances assuming a high price of oil.
As Ambrose Evans-Prtichard
recently wrote in The Daily Telegraph: “ The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.”
This applies to the Organization of Petroleum Exporting Countries as well.
As Javed Mian writes in an investment letter titled Stray Reflections and dated November 2014: “Once all the costs of subsidies and social programs are factored-in, most OPEC countries require oil above $100 to balance their budgets. This raises longer-run issues on the sustainability of the fiscal stance in a low-oil price environment.”
Moral of the story: Countries cannot be dependent on revenue from just one major source like oil sales. It is like the old investment wisdom which the financial planners never get tired repeating: “Don’t put all your eggs in one basket”.
What applies to long-term investing applies to countries as well. The basic lesson is the same.

Postscript: Yesterday I had written about why the government should not be bailing out SpiceJet. But what has happened is exactly the opposite. In fact, the ministry of civil aviation said in a statement: “Indian banks may be requested to give some working capital loan based on the assurances of the promoter. Banks or financial institutions to lend up to Rs 600 crore backed by a personal guarantee of the chairman, SpiceJet.”
The question is if the promoters of SpiceJet are not willing to sink in any more money into the airline why are banks being
“requested” to lend? This in a scenario where the stressed assets of public sector banks is already greater than 10% of their total advances. Beats me totally.

The article originally appeared on The Daily Reckoning, on Dec 18, 2014 

 

Foreign investors exit Russia lock, stock and barrel: Rouble crisis has lessons for India

Pmr-money-rouble-10-obvVivek Kaul

The Russian rouble has been in trouble of late. The value of the currency crashed from 55 roubles to a dollar as on December 11, 2014, to nearly 73 roubles to a dollar as on December 16, 2014. Since then the currency has recovered a little and as I write this around 67 roubles are worth a dollar.
What caused this? A major reason for this has been the fall in the price of oil by 50% in the last six months. As I write this the Brent Crude Oil quotes at slightly less than $60 to a barrel. The Brent Crude price dropped below $60 per barrel only this week.
The Russian government is majorly dependant on revenues from oil to meet its expenditure. The money that comes in from oil contributes around half of the revenues of the government and makes up for two-thirds of the exports.
As The Economist points out: “The state owns big stakes in many energy firms, as well as indirect links via the state-supported banks that fund them.” Given this excessive dependence on oil, Russia needs the price of oil to be in excess of $100 per barrel, for the government expenditure and income to be balanced.
As Javed Mian writes in the
Stray Reflections newsletter dated November 2014: “Today, Russia needs an oil price in excess of $100 a barrel to support the state and preserve its national security.” The Citigroup in a report puts the break-even cost of the Russian government budget at an oil price of $105 per barrel. The oil price, as we know, is nowhere near that level.
The rouble lost 10% against the dollar on December 15 and another 11% on December 16. Why did this happen? Foreign investors are exiting Russia lock, stock and barrel. The Russian central bank recently estimated that capital flight
could touch $130 billion this year.
The foreign investors are selling their investments in roubles and buying dollars, leading to an increase in demand for dollars vis a vis roubles. This has led to the value of the rouble crashing against the dollar.
The Russian central bank has tried to stem this flow by buying the “excess” roubles being dumped on to the foreign exchange market and selling dollars. It is estimated that on December 15, 2014, it sold around $2 billion to buy roubles.
But even this did not help prevent the worse rouble crash since 1998. This forced the Russian central bank to raise the interest rate by 650 basis points (one basis point is one hundredth of a percentage) to 17%. Despite this overnight manoeuvre, the rouble continued to crash against the dollar and fell by 11% on December 16.
The Russian central bank has spent more than $80 billion in trying to defend the rouble against the dollar this year and is now left with reserves of around $416 billion. The question is will these reserves turn out to be enough?
Russian companies and banks have an external debt of close to $700 billion. Of this around $30 billion is due this month and
another $100 billion over the course of next year, writes Ambrose Evans-Pritchard in The Telegraph.
He also quotes Lubomir Mitov, from the Institute of International Finance, as saying that any fall in reserves below $330bn could prove dangerous, given the scale of foreign debt and a confluence of pressures. “It is a perfect storm. Each $10 fall in the price of oil reduces export revenues by some 2 percent of GDP. A decline of this magnitude could shift the current account to a 3.5 deficit,” Mitov told Evans-Pritchard.
This has implications for Russia on multiple fronts. With oil revenues falling, the Russian economy will contract in 2015. Before raising the interest rates to 17%, the Russian central bank had said that the economy could contract by 4.7% because of oil prices falling to $60 per barrel.
Also, inflation which before this week’s currency crisis was at 9.1%, could go up further. As The Economist points out: “Russian shopkeepers have started to re-price their goods daily. Less than two weeks ago one dollar could be bought with 52 roubles; on December 16th between 70 and 80 were needed. Shops defending their dollar income need a price rise of 50% to offset this.”
Further, so much money leaving Russia in such quick time, the country may also have to think of implementing capital controls.
The revenue projections of the Russian government have gone totally out of whack.
The Financial Times reports that two weeks back, the Russian president Vladmir Putin, “ signed the federal budget for 2015-17 — which is still based on forecasts of 2.5 per cent annual gross domestic product growth, 5.5 per cent inflation and oil at $96 a barrel.” These assumptions will have to junked.
Putin might also might have to go slow on the aggressive military strategy that he has been following for a while now As Mian points out: “Russia is the world’s 8th-largest economy, but its military spending trails only the US and China. Putin increased the military budget 31% from 2008 to 2013, overtaking UK and Saudi Arabia, as reported by the International Institute of Strategic Studies.”
Whether this happens remains to be seen. Nevertheless, the Russian crisis has led to financial markets falling in large parts of the world. As I write this the BSE Sensex is quoting at around 26,700 points having fallen by around 1800 points over the last two weeks.
So, what are the lessons in this for India? The first and foremost is that foreign investors can exit an economy at any point of time, once they finally start feeling that the economy is in trouble. They may not exit the equity market all at once but they can exit the debt market very quickly.
This is something that India needs to keep in mind. From December 2013 up to December 15, 2014, the foreign institutional investors have invested Rs 1,63,523.08 crore (around $25.7 billion assuming$1=Rs63.6) in the Indian debt market. This is Rs 44,443 crore more than what they have invested in the stock market.
Even if a part of the money invested the debt market starts to leave the country, the rupee will crash against the dollar. This is precisely what happened between June and November 2013 when foreign institutional investors sold debt worth Rs 78,382.2 crore.
When they converted these rupees into dollars, the demand for dollars went up, leading to the rupee crashing and touching almost 70 to a dollar. It was at this point of time that Raghuram Rajan in various capacities, first as officer on special duty at the Reserve Bank of India (RBI) and later as RBI governor, helped stop the crash.
This is a point that the finance minister Arun Jaitley needs to keep in mind and drop the habit of asking Rajan to cut interest rates, almost every time that he speaks in public. Rajan knows his job and its best to allow him and the RBI to do things as they deems fit. Further, Rajan and RBI are more cued into what is happening internationally than perhaps any of the politicians can ever be.
Also, one reason that foreign institutional investors have invested so much money in the Indian debt market is because the returns on government debt are on the higher side vis a vis other countries. If the RBI were to cut the repo rate (or the rate at which it lends to banks) these returns will come down and this could possibly lead to the exit of some money invested by foreign investors in India’s debt market. And that would not be good news on the rupee front.

The article originally appeared on www.FirstBiz.com on Dec 17, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Eight things you need to know about falling oil prices

oil

Vivek Kaul

The price of oil has been falling for a while now. As I write this the brent crude oil is selling at around $80.4 per barrel. There are several reasons behind the fall and several repercussions from it as well. Let’s look at them one by one.

1) The Chinese demand for oil has not been growing at the same rate as it was in the past, as Chinese economic growth has been falling. As Ruchir Sharma, head of Emerging Markets and Global Macro at Morgan Stanley Investment Management wrote in a recent column in The Wall Street Journal “The growth rate in Chinese demand for oil has plummeted to nearly zero this year, down from 12% in 2010. This is arguably the main reason why oil prices are down.”
2) In the past when oil prices fell, the Organization of Petroleum Exporting Countries (OPEC) led by Saudi Arabia used to cut production to ensure that supply fell and that ensured that prices did not continue to fall. This hasn’t happened this time around. As the Saudi oil minister Ali Naimi told Reuters on November 12, “Saudi oil policy has been constant for the last few decades and it has not changed today.” He added that: “We do not seek to politicise oil…for us, it’s a question of supply and demand, it’s purely business.”
And what is this pure business Al Naimi is talking about? The United States and other western nations like Canada have had a boom in shale oil production. This boom has led to the United States and Canada producing much more oil than they were a few years back. Data from the U.S. Energy Information Administration shows that United States in 2013 produced 12.35 million barrels per day. This is a massive increase of 35% since 2009. In case of Canada the production has gone up by 22.8% to 4.07 million barrels per day between 2009 to 2013.
Shale oil is very expensive to produce and depending on which estimate one believes it is viable only if oil prices range between $50 and $75 per barrel. Hence, by ensuring low oil prices the Saudis want to squeeze out the shale oil producing companies in Canada and United States.
3) So is the Saudi policy working? The US Energy Information Administration in its latest Drilling Productivity Report said that the seven largest shale oil companies will produce 125,000 barrels more per day in December 2014 in comparison to November 2014.
Hence, the Saudi strategy of driving down oil prices to ensure that the production of oil by shale oil companies is no longer viable, hasn’t seemed to have had an impact yet. Nevertheless that doesn’t mean that a fall in oil prices will have no impact on shale oil production.
The
International Energy Agency (IEA) has said that the investment in shale oil fields will fall by 10% next year, if oil prices continue to remain at $80 per barrel. Faith Bristol, chief economist of IEA recently said “there could be a 10 per cent decline in US light tight oil, or shale, investment in 2015 [from full-year 2014 levels]”…I wouldn’t be surprised to see statements from different companies in the weeks and months to come [outlining a change in] their investment plans and reducing budgets for investments in North America . . . especially the United States.” And this will have an impact on the production of shale oil in the medium term, if Saudis continue to sustain low oil prices.
4) Nonetheless, the interesting thing that the United States and other Western nations may never have to increase production of shale oil, just the threat of doing that will act as an insurance policy. As Niels C. Jensen writes in the Absolute Return Letter for November 2014 “There is nothing easier to get used to in this world than higher living standards, and the populations of most oil producing nations have seen plenty of that in recent years. Shale [oil] is a threat against those living standards, and falling oil prices are the best assurance they can hope for that shale [oil] will never become the major production factor that we are all being told that it could become. It is very expensive to produce and thus requires high oil and gas prices to be economical.”
But even with that shale oil can act as an insurance policy against high oil prices, feels Jensen. As he writes “In a rather bizarre way, shale [oil] has thus become an insurance policy, as the western world never have to ramp up shale production to levels that have been discussed. The sheer threat of doing so should keep the oil price at acceptable levels.”
5) Also, low oil prices are going to benefit nations which import oil. “A $20-per-barrel drop in oil prices transfers $6-700 billion from oil producing nations to consumers worldwide or nearly 1% of world GDP. Assuming consumers will spend about half of that on consumption, which historically has been a fair assumption, the positive effect on GDP in consumer countries is 0.5%,” writes Hunt. And this is clearly good news for oil importing nations like India. Falling oil prices are also benefiting airlines and shipping companies given that oil is their single biggest expense.
6) News reports suggest that China is using this opportunity to buy a lot of oil. As a recent report on Bloomberg points out “The number of supertankers sailing toward China’s ports matched a record on Oct. 17 and is still close to that level now.”
7) The countries that are likely to get into trouble if oil prices continue to remain low are primarily Russia and Iran. Russia relies heavily on exports of oil and gas. As a recent article on cnbc.com points out “In 2013, for example, Russia’s energy exports constituted more than two-thirds of total exports amounting to $372 billion of a total $526 billion.” Further, the Russian government’s budget gets balanced (i.e. its income is equal to its expenditure) at an oil price of anywhere between $100-110 per barrel. Iran’s case is similar. Hence, both these countries need higher oil prices.
As a recent Oped in the Los Angeles Times points out “Russia and Iran compete with Saudi Arabia in the international oil market, and both need oil prices to be at roughly $110 a barrel in order to balance their budgets. If oil prices remain at $80 a barrel, the strategic ambitions of Tehran and Moscow could be severely undermined.”
8) Saudi Arabia also gets hit by a lower oil prices. “Saudi produces close to 10m barrels per day, similar to Russian output. A $20 fall in the oil price, costs Saudi Arabia about $200m per day,” a recent article in The Independent points out.
But Saudi Arabia has more staying power than the others. The fact that
Aramco (officially known as Saudi Arabian Oil Company) has deep pockets is a point worth remembering. As Vijay Bhambwani, CEO of BSPLIndia.com recently told me “Saudis can produce low cost arab light sweet crude very cost efficiently and only the recent state welfare schemes implemented after the arab spring, have raised the marginal costs. Even a slight rollback / delayed released of the additional welfare payments (US $ 36 billion) can add sizeable cash flow into the Saudi national balance sheet and give it additional staying power.”
To conclude, there are many different dimensions to falling oil prices and the way each one of them evolves, will have some impact on oil prices in the days to come .

The article originally appeared on www.FirstBiz.com on Nov 13, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Why there is no alternative to the dollar, the Russian threat notwithstanding

 3D chrome Dollar symbolVivek Kaul 

Sergei Glazyev, a close advisor to the Russian President Vladmir Putin, recently threatened that if the United States imposed sanctions on Russia, over what is happening in Ukraine, then Russia might be forced drop the dollar as a reserve currency. He also said that if the United States froze the bank accounts of Russian businesses, then Russia will recommend that all investors of US government bonds start selling them.
How credible is this threat? Is Russia really in a position to drop dollar as a reserve currency? Or is any country in that position for that matter?
There are a host of factors which seem to suggest that the dollar will continue to be at the heart of the international financial system. As Barry Eichengreen writes in 
Exorbitant Privilege – The Rise and Fall of the Dollar, “The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores. South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers. Fully 70 percent of Australia’s exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States…A recent study for Canada, a county with especially detailed data, shows that nearly 75 percent of all imports fromcountries other than United States continue to be invoiced and settled in U.S. dollars”
So, most international transactions are priced in dollars. Most commodities including oil and gold are priced in dollars. Over and above this dollar remains the main currency in the foreign exchange market. 
As Jermey Warner writes in The Telegraph “For instance, if you were looking to buy Singapore dollars with Russian roubles, you would typically first buy US dollars with your roubles and then swap them into Singapore dollars.” 
Hence, a major part of the foreign exchange transactions happens in dollars. 
As the most recent Triennial Central Bank Survey of the Bank for International Settlements points out “The US dollar remained the dominant vehicle currency; it was on one side of 87% of all trades in April 2013. The euro was the second most traded currency, but its share fell to 33% in April 2013 from 39% in April 2010.” 
Over and above this, another good data point to look at is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund complies this data. 
The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence, the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves. 
We can take a look at the allocated reserves over a period of time and figure whether the composition of the foreign exchange reserves of countries around the world is changing. Are countries moving more and more of their reserves out of the dollar and into other currencies?Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. 
In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as of the first quarter of of 2013, dollars formed 62.4% of the total allocable foreign exchange reserves.
Euro, which was seen as a challenger to the dollar has fizzled out because Europe is in a bigger financial and economic mess than the United States is in. Given this, there is no alternative to the dollar and hence, dollar continues to be at the heart of the international financial system. 
So where does that leave the Russian rouble and the recent threat that has made against the dollar? Here is the basic point. When the entire world has their reserves in dollars, they are going to continue to buy and sell things in dollars. So, when Russia exports stuff it will get paid in dollars, and when its imports stuff it will have to pay in dollars. And unless it earns dollars through exports, it won’t be able to pay for its imports. 
Any country looking to get away from the dollar is virtually destined for economic suicide. Russia can throw some weight around in its neighbourhood and look to move some of its international trade away from the dollar. The Russian company Gazprom, in which the Russian government has a controlling stake, is the largest extractor of natural gas in the world, being responsible for nearly 20% of the world’s supply. 
The gas that Gazprom sells in Russia is sold at a loss, a legacy of the communist days. But the company also provides gas to 25 European nations and this makes it very important in the scheme of global energy security. The company backed by the Russian state has been known to act whimsically in the past and shut down gas supplies during the peak of winter, which has led to major factory shutdowns in Eastern Europe. 
This is Russia’s way of trying to reassert the dominance the erstwhile Soviet Union used to have over the world, before it broke up. But even when Soviet Union was a superpower it could not trade internationally in dollars, all the time, because nobody wanted Russian roubles, everyone wanted the US dollar. 
The next step in the process is likely
to be an effort to price the natural gas which Russia sells through Gazprom in Europe in terms of its own currency, the rouble. Vladamir Putin has spoken out against the dollar in the past, calling for dropping the dollar as an international reserve currency. 
This makes it highly likely that Russia might start selling its gas in terms of roubles. Countries which buy gas from Russia would need to start accumulating roubles as a part of their international reserves. Hence, there is a high chance of the rouble emerging as a regional reserve currency in Europe and thus undermine the importance of the dollar to some extent. Whether that happens remains to be seen. 
The most likely currency to displace the dollar as the international reserve currency is the Chinese yuan. But that process, if it happens, will take a long time. As Warner writes in The Telegraph “
this process is on a very long fuse and basically depends on China eventually displacing the US as the world’s largest economy.” 
While the future of the Chinese yuan as an international reserve currency is very optimistic, it is highly unlikely that the yuan will replace the dollar as an international reserve in a hurry. For that to happen the Chinese government will have set the yuan free and allow the market forces to determine its value, which is not the case currently. 
The People’s Bank of China, the Chinese central bank, intervenes in the market regularly to ensure that the yuan does not appreciate in value against the dollar, which would mean a huge inconvenience for the exporters. An appreciating yuan will make Chinese exports uncompetitive and that is something that the Chinese government cannot afford to do. 
These are things that China is not yet ready for. Hence, even though yuan has a good chance of becoming an international reserve currency it is not going to happen anytime soon. Economist Andy Xie believes that “
There is no alternative to the dollar as a trading currency in Asia.” He feels that the yuan will replace the dollar in Asia but it will take at least thirty to forty years. 
Meanwhile, the Russians can go and take a walk.

The article originally appeared on www.FirstBiz.com on March 7, 2014

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Question after Cyprus: Will govts loot depositors again?

A woman walks out of a branch of Laiki Bank in Nicosia
Vivek Kaul 
So why is the world worried about the Cyprus? A country of less than a million people, which accounts for just 0.2% of the euro zone economy. Euro Zone is a term used in reference to the seventeen countries that have adopted the euro as their currency.
The answer lies in the fact that what is happening in Cyprus might just play itself out in other parts of continental Europe, sooner rather than later. Allow me to explain.
Cyprus has been given a bailout amounting to € 10 billion (or around $13billion) by the International Monetary Fund and the European Union. As The New York Times reports “The money is supposed to help the country cope with the severe recession by financing government programs and refinancing debt held by private investors.”
Hence, a part of the bailout money will be used to repay government debt that is maturing. Governments all over the world typically spend more than they earn. The difference is made up for by borrowing. The Cyprian government has been no different on this account. An estimate made by Satyajit Das, a derivatives expert and the author of 
Extreme Money, in a note titled The Cyprus File suggests that the country might require around €7-8billion “for general government operations including debt servicing”.
But there is a twist in this tale. In return for the bailout IMF and the European Union want Cyprus to make its share of sacrifice as well. The Popular Bank of Cyprus (better known as the Laiki Bank), the second largest bank in the country, will shut down operations. Deposits of up to € 100,000 will be protected. These deposits will be shifted to the Bank of Cyprus, the largest bank in the country.
Deposits greater than € 100,000 will be frozen, seized by the government and used to partly pay for the deal. This move is expected to generate €4.2 billion. The remaining money is expected to come from privatisation and tax increases.
As The Huffington Post writes “The country of about 800,000 people has a banking sector eight times larger than its gross domestic product, with nearly a third of the roughly 68 billion euros in the country’s banks believed to be held by Russians.” Hence, it is widely believed that most deposits of greater than € 100,000 in Cyprian banks are held by Russians. And the move to seize these deposits thus cannot impact the local population.
This move is line with the German belief that any bailout money shouldn’t be rescuing the Russians, who are not a part of the European Union. “Germany wants to prevent any bailout fund flowing to Russian depositors, such as oligarchs or organised criminals who have used Cypriot banks to launder money. Carsten Schneider, a SPD politician, spoke gleefully about burning “
Russian black money,”” writes Das.
It need not be said that this move will have a big impact on the Cyprian economy given that the country has evolved into an offshore banking centre over the years. The move to seize deposits will keep foreign money way from Cyprus and thus impact incomes as well as jobs.
The New York Times DealBook writes “Exotix, the brokerage firm, is predicting a 10 percent slump in gross domestic product this year followed by 8 percent next year and a total 23 percent decline before nadir is reached. Using Okun’s Law, which translates every one percentage point fall in G.D.P. (gross domestic product) to half a percentage point increase in unemployment, such a depression would push the unemployment rate up 11.5 percentage points, taking it to about 26 percent.”
But then that is not something that the world at large is worried about. The world at large is worried about the fact “what if”what has happened in Cyprus starts to happen in other parts of Europe?
The modus operandi being resorted to in Cyprus can be termed as an extreme form of financial repression. Russell Napier, a consultant with CLSA, defines this term as “
There is a thing called financial repression which is effectively forcing people to lend money to the…government.” In case of Cyprus the government has simply decided to seize the money from the depositors in order to fund itself, albeit under outside pressure. 
The question is will this become a model for other parts of the European Union where banks and governments are in trouble. Take the case of Spain, a country which forms 12% of the total GDP of the European Union. L
oans given to real estate developers and construction companies by Spanish banks amount to nearly $700 billion, or nearly 50 percent of the Spain’s current GDP of nearly $1.4 trillion. With homes lying unsold developers are in no position to repay. Spain built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
And Spain’s biggest three banks have assets worth $2.7trillion, which is two times Spain’s GDP. Estimates suggest that troubled Spanish banks are supposed to require anywhere between €75 billion and €100 billion to continue operating. This is many times the size of the crisis in Cyprus which is currently being dealt with.
The fear is “what if” a Cyprus like plan is implemented in Spain, or other countries in Europe, like Greece, Portugal, Ireland or Italy, for that matter, where both governments as well as banks are in trouble. “For Spain, Italy and other troubled euro zone countries, Cyprus is an unnerving example. Individuals and businesses in those countries will probably split up their savings into smaller accounts or move some of their money to another country. If a lot of depositors withdraw cash from the weakest banks in those countries, Europe could have another crisis on its hands,” 
The New York Times points out.
Given this there can be several repercussions in the future. “The Cyprus package highlights the increasing reluctance of countries like Germany, Finland and the Netherlands to support weaker Euro-Zone members,” writes Das. The German public has never been in great favour of bailing out the weaker countries. But their politicians have been going against this till now simply because they did not want to be seen responsible for the failure of the euro as a currency. Hence, they have cleared bailout packages for countries like Ireland, Greece etc in the past. Nevertheless that may not continue to happen given that Parliamentary elections are due in September later this year. So deposit holders in other countries which are likely to get bailout packages in the future maybe asked to share a part of the burden or even fully finance themselves.
This becomes clear with the statement made by Jeroen Dijsselbloem, the Dutch finance minister who heads the Eurogroup of euro-zone finance ministers “when failing banks need rescuing, euro-zone officials would turn to the bank’s shareholders, bondholders and uninsured depositors to contribute to their recapitalization.”
“He also said that Cyprus was a template for handling the region’s other debt-strapped countries,” reports 
Reuters. In the Euro Zone deposits above €100,000 are uninsured.
Given this likely possibility, even a hint of financial trouble will lead to people withdrawing their deposits. As Steve Forbes writes in The Forbes “After this, all it will take is just a hint of a financial crisis to send Spaniards, Italians, the French and others scurrying to ATMs and banks to pull out their cash.” Even the most well capitalised bank cannot hold onto a sustained bank run beyond a point.
It could also mean that people would look at parking their money outside the banking system.
“Even in the absence of a disaster individuals and companies will be looking to park at least a portion of their money outside the banking system,” writes Forbes. Does that imply more money flowing into gold, or simply more money under the pillow? That time will tell.
Also this could lead to more rescues and further bailouts in the days to come. As Das writes “If depositors withdraw funds in significant size and capital flight accelerates, then the European Central Bank, national central banks and governments will have intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.” And this can’t be a good sign for the world economy.
The question being asked in Cyprus as The Forbes magazine puts it is “
if something goes wrong again, what’s stopping the government from dipping back into their deposits?” To deal with this government has closed the banks until Thursday morning, in order to stop people from withdrawing money. Also the two largest banks in the country, the Bank of Cyprus and the Laiki Bank have imposed a daily withdrawal limit of €100 (or $130).
It will be interesting to see how the situation plays out once the banks open. Will depositors make a run for their deposits? Or will they continue to keep their money in banks? That might very well decide how the rest of the Europe behaves in the days to come.

Watch this space.
This article originally appeared on www.firstpost.com on March 26, 2013.

(Vivek Kaul is a writer. He tweets @kaul_vivek)