Is Cyprus Too Small To Fail?

“Just when you think they’ve hit bottom, they keep digging.”

These were the words of the U.S. ambassador to Bulgaria spoken to us during the country’s staccato political ejaculations which eventually drove the country into hyperinflation in the late 1990′s. It was on the same trip to Sophia that a senior central bank official looked us in the eye and said they would not let the government default. The government had lost the confidence of the markets to meet its debt obligations even though it had an independent central bank.

Bulgaria faced a choice to either default or monetize its bond maturities. Unlike Russia who chose default over hyperinflation in 1998, Bulgaria monetized the debt payments causing one of the worst hyperinflations in post-war history. The economic chaos eventually resulted in a currency board FX/monetary regime. This is a lesson to the modern monetary theorists who believe governments with independent central banks can’t default.

History shows when governments get into trouble with their local currency debt they have to make a political choice on who will take the pain. The Russians chose to inflict the pain on David Tepper, his hedge fund buddies, and rest of the creditors, many of whom were foreigners. Bulgaria chose the domestic population through hyperinflation.

Fast forward to Cyprus 2013 who today rejected the depositor bail-in scheme as part of its EU bail-out. This is a game changer. Just when we thought Cyprus may have hit bottom, they keep digging.

We hope the government has a Plan B — i.e., Russian bail-out, etc. — as the 6-10 deposit tax will look golden to depositors if Cyprus decides to/is forced out of the Eurozone. The EU could also cave and soften up the terms of the bailout, but wouldn’t this increase the political contagion to other countries?

If Greece, for example, sees Cyprus voting down unpalatable measures forcing a Troika retreat and softening of terms, wouldn’t they try and do the same?

The Cyprus rejection of the bail-out deal really complicates matters and significantly increases uncertainty.

How and when will they get the banks back open? Could this be the tipping point where Germany and the rest of northern Europe’s commitment to the Euro experiment begins to falter?

Will a Plan B resemble that of Argentina’s forced conversion of confiscated bank deposits into BONEX during 1980′s?

BONEX– Government bonds issued in the 1980’s and early 1990’s. The 1989 issue was used to compensate for confiscated bank deposits. Although BONEX bonds traded as low as 20-25% of par value, they generally enjoyed a good reputation and were all paid off. Many were purchased by foreign investors at discounted value, and then used (at full value) to acquire privatized public companies – Argentina U.S. Embassy

The financial resources needed to solve Cyprus are so small one would think the powers that be will not let the country fall into the abyss and increase the risk of taking much of Europe with it. In other words, Cyprus is too small to fail.

This does raise the question, however, is Cyprus, like Lehman, the problem or just the symptom of larger issues? If not Lehman, who? If not now, when?

Tough to currently see the path to a decent outcome now and have no idea where this is going. Does feel like more turbulence coming. We’ve buckled up.

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