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Can banking become any more confusing? In a week that has seen yet another Eurozone country foraging for cash to pay off its debts, people are wondering how, why, and when will it end? The buck is going to land with the banking system; more precisely, with the creditor-borrower relationship. The growing creation of debt – on both and individual and a government level –  is creating instability, and countries cannot rely on guarantees or bailouts (or bail-ins) to resolve the situation. It is a recipe for disaster.

Let us take Cyprus as an example and break down the situation. Before the 2008 credit crisis, Cyprus  “enjoyed a long period of high growth, low unemployment, and sound public finances.”  There was rapid wage growth attracting foreign migration and foreign investment, largely due to low tax rates. However, there were cracks, particularly forming following accession into the EU. Private savings decreased, effectively converting into investment (mainly into Greece) and credit growth (into real estate). After the credit crisis, Cyprus crumbled.  The manufacturing and service sectors experienced contraction causing increases in unemployment and reduced government revenue. A stimulus package was arranged, worth 4% of the country’s GDP, which led to fiscal deficits (when once it was surplus). Credit downgrades soon followed, and by 2010 Cyprus was effectively phased out of the long-term debt markets. Thus, the country could no longer rely on debt to prop up its economy.

However, while GDP of goods and services was lowering, Cyprus had a quite robust financial sector. In fact, Cyprus was a tax haven, a parking area for foreign individuals and companies, particularly Russian, to place their money. The Cypriot banking system was estimated to be 700 – 800 % of GDP, a quite bewildering figure. But parked funds were not providing a flow of income to address their debt burdens. Thus the levy, or haircut on deposits, even those guaranteed by the government was proposed: take a one of fee of 9.9% off deposits over $100,000 and 6.75% of deposits below that figure. This one off “wealth tax” would have generated government income to stimulate the economy or to go to the ECB for a bailout.

But the levy was rejected by the Cypriots (obviously), but even more interestingly, though not surprisingly, the Russians (and probably the British too). Russian residents comprise the biggest foreign depositor group in Cypriot banks, with USD19bn in holdings at end-2012, according to Moody’s. With the levy, Russian depositors, particularly corporations, would have lost $2bn. Thus, Vladamir Putin’s wallows that that levy would be “unjust, unprofessional, and dangerous” relate to the damage that could be caused to his own people, not the Cypriots. At the end of the day, funds can be transferred to another destination, say Latvia or Luxembourg.

And what about the average Cypriot? The people are now under the power of the IMF and the ECB. As the government rushes to generate enough funds to request a bailout (another debt), the Cypriots are facing banking collapse, and more gravely, a loss of savings. People are rushing to withdraw their cash, in fear that their savings will be wiped out. Businesses are not accepting credit cards, preferring to deal with cash. A sense of panic is growing in the country. It appears the only way to lessen the panic is for the government to go into more debt, to help stimulate the economy. But a country in debt, going into more debt, does not appear to be a long term solution.

In fear of this cycle, David Cameron has repeatedly defended the UK government’s austerity measures. However, with growth sluggish, austerity (less government borrowing, spending cuts and maybe tax increases) is having a multiplier effect, and not entirely solving the problem.  It is universally agreed that stimulus is needed to kick start an economy. It is the form of a stimulus that becomes the central question: should the country opt for debt finance or equity finance?

By and large, during the crisis, countries who have suffered have opted for debt finance. Bailouts and quantitative easing fall under this one umbrella; regardless of how complex a deal seeking to recapitalise an economy is, the underlying effect is that there will be one creditor and one borrower: one with power, and one without. Multiply these relationships, and we have a world economy that creates nations in authority, and nations in servitude. The problem is that the nations in authority aggrandize this relationship further. One must wonder why, with a country in debt, more time cannot be given to allow the country to fulfil its debt obligations? The argument will be about cashflows and liquidity, although rich nations and corporations must have the enough income to wait for a few years?  Perhaps they do not, or perhaps this growing debt cycle is what rich nations want.  Just do not tell that to the Cypriot wondering why his hard earned money could fade away tomorrow.

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