Is Plan B for Cyprus an Exit from the Euro?

Key Points

  • A deal for Cyprus is still likely, but there is an increased risk the country could exit the euro.
  • We believe that, whether the country opts for an exit from the euro or a deal that taxes depositors, contagion will be contained.
  • Should Cyprus exit the euro, we expect some resulting market volatility—but it's likely to be short term.

Cyprus' parliament recently voted down the proposed European Union bailout package that threatened a levy, or tax, on all bank deposits as a condition of continued emergency funding. Now, like many borrowers in a tight situation, Cyprus must consider other options that are just as unpalatable.

Patience is wearing thin, both inside and outside of Cyprus, with negotiations ongoing, and banks closures expected to last through next Tuesday. Perhaps to give negotiators an incentive to find a solution, the European Central Bank (ECB) has said emergency lending assistance (ELA) for Cypriot banks beyond Monday "could only be considered if an EU/IMF (bailout) program is in place that would ensure the solvency of the concerned banks."

As a result, the risk of Cyprus leaving the euro has increased. If banks don't have funding, they could fold, and depositors could lose much more than the up-to-10% levy initially considered. Accounts holding more than 100,000 euros could be reduced by 30% or more. Widespread bank failures would likely result in an eventual collapse of the economy, a surge in unemployment and the need to slash the value of the currency—impossible as a member of the euro, hence the risk of an exit.

What does this mean for the broader eurozone? Will there be contagion to other peripheral countries? Thus far, we've seen little in the way of contagion, either in the form of depositors pulling money from Spanish or Italian banks, or in rising government bond yields. In fact, Spain conducted a fairly bullish government bond auction today.

We believe that Cyprus is indeed a unique case, and not a template for bailouts in other nations. The ECB has had since last spring to weigh the consequences of a country's exit from the euro, when questions about Greece arose. Should Cyprus eventually exit, the ECB would probably take exceptional measures to prevent contagion. That said, there is no precedent for an event like this, and an exit would likely result in increased volatility in markets, although we believe it will be short term in nature.

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© Charles Schwab

© Charles Schwab

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