Info Service on Finance and Development (Apr13/01)
5 April 2013
Third World Network
Financial crisis deepens - will the lessons be learnt?
Published in SUNS #7557 dated 3 April 2013
Geneva, 2 Apr (Martin Khor*) -- This time it is Cyprus' turn to face
bitter financial crisis as bank depositors get hit and capital controls
are imposed. Will the lessons about these crises ever be learnt?
The Cyprus crisis has again shown that over-dependence on the financial
sector and an unregulated and liberalised financial system can cause
havoc to an economy.
The particular manner in which a financial crisis manifests itself
may be different from country to country, depending on the ways that
country became financially over-reliant or over-liberalised, and also
on how ever-changing external conditions impact on the country.
For the past two weeks, Cyprus hit the headlines because of the rapid
twists and turns of its crisis, the terms of the bailout it negotiated
with its European and IMF creditors, the hit that bank depositors
are forced to take, and finally the "capital controls" that
the government has imposed to prevent bank runs and capital flight
out of the country.
Depositors with more than 100,000 euros could lose more than half
their savings. Bank customers can only withdraw 300 euros cash daily;
cashing of cheques is prohibited; transfers of funds to accounts held
abroad or in other credit institutions are prohibited; transfers due
to trade transactions above 5,000 euros a day require central bank
permission; the use of credit cards overseas is restricted to 5,000
euros per account a month; and travellers can only take out 1,000
euros in cash or equivalent in foreign currencies per trip.
These capital controls, announced on 28 March, were highlighted in
the media as the first to be imposed by a country belonging to the
European Union. It was like the slaying of a "sacred cow",
because the freedom to move funds out of and into the European countries
has been treated almost like a human right.
But it is this total freedom for the flow of funds that has contributed
or even been ultimately responsible for so many financial crises in
so many countries in the past few decades.
This liberalised system of capital flows enables residents to place
their funds abroad or to purchase foreign assets like bonds and shares.
It also enables foreigners to bring in funds either for short-term
speculation and investment or longer-term investment and savings.
After the Second World War, capital controls were the rule; flows
of funds to and from abroad were mainly restricted to activities linked
to the real economy of trade, direct investments and travel. But from
the mid-1970s the liberalisation of capital flows took place in the
rich economies and then gradually spread to many developing countries.
The de-regulated flows whether into or out of the country can cause
volatility and instability. For instance, the huge flows of capital
into emerging economies due to easy money policies in the United States
and Europe have caused these countries' currencies to rise (making
their exports less competitive) and their housing and property prices
The finance ministers of Brazil and other developing countries have
been protesting against the easy-money policies in rich countries
that have had adverse effects on emerging economies.
When the internal or external situation changes and investor perception
changes with it, the inflow of funds turns into its opposite. The
sudden outflow of funds, and depreciation of the currency, can then
cause an even more devastating effect on the economy.
In this reversed situation, the foreign reserves may fall to a dangerous
level, and local companies and banks that borrowed from abroad because
of the low interest rates face difficulties to service their foreign
loans because the local currency has depreciated.
In the 1997-99 crisis, East Asian countries that had over-liberalised
their financial system found that local banks and companies had borrowed
heavily in US dollars and when their currencies depreciated, many
of the borrowers could not service their loans. The countries' foreign
reserves dropped to danger levels, forcing them to go to the IMF for
Malaysia, fortunately, had some controls then over the amounts local
companies could borrow from abroad, which prevented it from falling
into an external debt crisis. But the large ringgit depreciation,
huge outflow of funds and declining reserves almost landed the country
into a crisis nevertheless. At that point, the imposition of capital
controls over outflows in September 1998 enabled Malaysia to avoid
a financial crisis requiring an IMF bailout.
The immediate response from the IMF and the Western establishment
was that the capital controls would destroy the Malaysian economy.
Today, the economic orthodoxy has changed, and most analysts including
at the IMF give credit to Malaysia for the capital controls.
The Malaysian controls included a temporary ban on foreigners transferring
their ringgit-denominated funds (for example, in the stock market)
to abroad, a limit to the funds local travellers could take out of
the country, and limits to overseas investments by local companies
and individuals. Outflows of profits by foreign direct investors and
transfers of funds arising from imports and exports were allowed.
The controls were relaxed and then removed in a few years as the economic
Today, the IMF itself has changed its position, saying that capital
controls in certain situations are not only legitimate but may also
be necessary. It has partially recognised that unregulated capital
flows can cause financial instability and economic damage.
In the case of Cyprus, on hindsight the analysts now conclude that
its growth model was flawed because it was too reliant on a bloated
financial sector, having become a haven for foreign savers, especially
But a major factor in its recent crisis was that the country's biggest
banks invested in Greek government bonds.
In October 2011, a bailout package was arranged for Greece by the
European Union and the IMF. Part of the bailout terms was that holders
of Greek government bonds would take a "haircut" or loss
of about 50%. This Greek debt restructuring meant a loss of 4 billion
euros for banks in Cyprus, a huge amount in a country whose GNP is
only 18 billion euros.
Now, it is Cyprus' own turn to be reconfigured and re-created as part
of a 10 billion euro bailout scheme. The two biggest banks, Bank of
Cyprus and Laiki Bank are to be drastically restructured, with the
latter to be closed.
The biggest innovation designed by the European Union and IMF creditors
is that the bank depositors will have to take losses. Deposits less
than 100,000 euros are to be spared, after an original plan to also
"tax" them by 6.75% was cancelled after a huge outcry and
the fear of contagion, with bank runs in many European countries.
The final plan is for deposits over 100,000 euros in the two banks
to take losses not by the originally planned 9.9% but by much more.
Big depositors may lose half of their money in the Bank of Cyprus
whereas those in Laiki Bank may lose even more than that.
The big depositors are not only rich Russians who parked their assets
in Cyprus but local institutions like the University of Cyprus which
had its assets deposited in the two banks.
The new European policy of getting bank depositors to take a big hit
in bailouts of banks will have big ramifications for public confidence
in banks. The new perception is that money put as savings in banks
is no longer safe.
The capital controls are another European first. They are considered
draconian, but necessary in the changed conditions of Cyprus.
The orthodoxy in finance and in economic policy is changing due to
one crisis after another. Sixteen years ago, the crisis was in Asia;
five years ago, its epicentre was the United States, and today, Europe
is in the grip of the crisis.
The question remains: will the policymakers learn the real lessons
from these crises?
(* Martin Khor is the Executive Director of the South Centre.) +