3 Reasons a Potential Cypriot Default is Concerning

Just a few days ago, the Troika and a few Cypriot leaders drafted a bailout deal for Cyprus, whose debt swelled to 127% of its GDP in 2012. The proposal, which included a one-time tax on all bank deposits, was intended to help the country secure enough liquidity to save its troubled banks.

However, the Cypriot parliament quickly rejected the proposed bailout faster than you can say “bank run” as 36 lawmakers voted against the deposit levy. The rest of the members of parliament abstained from voting as absolutely no one voted in favor of the proposal.

This puts Cyprus back at risk of default, as the nation needs roughly 17 billion EUR in extra funding to avoid declaring bankruptcy. Here are three reasons why this scenario is particularly concerning:

1. Talks of a euro zone breakup could resurface.

Almost a year ago, concerns about a “Grexit” or a Greek exit from the euro zone haunted the markets as Greece faced political and financial pressure to comply with the EU and Troika’s bailout deal. This eventually escalated to fears of a euro zone breakup as other member nations, such as Portugal and Ireland, also had trouble conforming to the EU’s fiscal requirements.

A potential default for Cyprus could once again threaten the stability of the 17-nation currency bloc as speculations about a euro zone exit could resurface. The euro’s existence as a shared currency could be questioned once more, reviving fears of a region-wide breakup.

2. It’s another blow to European credibility.

Since Greece started showing signs of economic weakness back in 2009, the euro zone has been haunted by the words “debt crisis.” Heck, mentioning the two under the same breath comes almost naturally these days. Not surprisingly, this has led investors to question the region’s credibility.

A Cyprus default, however, could make things much worse for the euro zone as it could further discourage creditors from lending funds to the cash-strapped region. After all, private holders of Greek government bonds were forced to stomach huge losses when Greece was bailed out, and it’s looking more and more like Cyprus is headed in the same direction.

Should the poop hit the fan for Cyprus, we could see capital flow out of the country into neighboring countries or even outside the euro zone. This would be a sad sight considering the amount of progress the European Central Bank has made in restoring confidence in the region through economic reforms.

3. The ECB could lose its focus on growth.

The ECB has only recently shifted its efforts from achieving financial stability to promoting growth, but it seems as though it may have to battle its debt demons once again.

Investors dumped euro zone bank shares earlier this week, but the real danger is if they start demanding higher risk premiums, as it would raise these banks’ funding costs.

Of course, when it comes to saving the day, who do the markets usually turn to? That’s right, Mario Draghi! The problem is that pressure on the central bank could lead ECB policymakers to devote their time and energy to stabilize Cyprus’ banks instead of promoting growth in the region.

Currently, Cypriot officials are working double time to come up with a new plan to raise the 5.8 billion EUR it needs to unlock emergency loans.

Rumor has it that Cyprus might look for support from Russia, its strong ally and largest source of foreign deposits. Moscow has helped Cyprus and loaned out 2.5 billion EUR when it was strapped for cash before, so there’s still a chance that the small country could make it out of this debt mess before things get uglier.