Why small countries are systemic

At the peak of the Cypriot crisis the German finance minister, Wolfgang Schaüble, was reported as saying in Eurogroup discussions that Cyprus was not systemic. That was code for the idea that Cyprus could be forced out of the euro area without any significant consequences for other countries. Schaüble was not bluffing. He behaved in a similar fashion in July 2015, when Greece came even closer to leaving the euro. He publicly stated that Greece was better off exiting the euro “temporarily” and returning when it was ready.

On both occasions Schaüble was in a small minority, with support from only a handful of finance ministers. In the case of Cyprus, it was pointed out to him that a disorderly sovereign default in Cyprus would send financial shock waves through to Greece, as Cypriot banks owned 11 per cent of Greek bank assets and liabilities. More generally, if any country left the euro, no matter how small, it would create an important precedent. If the euro is not an irrevocable monetary union, markets would constantly be looking for the next weak link. The monetary union is, in effect, as strong as its weakest link at any point in time. It would unravel very quickly if the political commitment to keep it irrevocable was seen as waning.

In fact, the Cypriot and Greek crises were intimately linked. Cypriot banks’ exposure to Greece was massive. The banks’ loan portfolio in Greece represented an amount equivalent to 140 per cent of Cyprus’s GDP. In addition, the two largest Cypriot banks – Bank of Cyprus and Laiki Bank – had very large investments in Greek government bonds. When the Greek debt restructuring – widely known as Private Sector Involvement (PSI) – was agreed in 2011, the two largest Cypriot banks made losses amounting to 25 per cent of Cyprus GDP. These losses meant that they had to raise fresh capital in order to pass the subsequent stress tests conducted by the European Banking Authority. Their failure to do so by June 2012 was what triggered the Cyprus crisis and forced the Cypriot government to apply for financial assistance from Europe and the IMF.