Cyprus bailout a deal good — for now?

Sometimes a situation is so messy you have to come up with a plan that is the least destructive. That appears to be the case with the last-minute deal to avert a full-blown banking collapse in Cyprus.

The 10 billion euro bailout for the tiny Mediterranean island has gripped global markets for the past week, with the world watching and fretting details of an agreement that could potentially set a bad precedent for any other bailouts in the region.

Riots and market angst ensued after the Cypriot government telecasted its original deal would introduce a bank levy on bank deposits in exchange for the bailout funds: generally speaking, a 9.9 per cent for those deposits over 100,000 euro, and 6.75 per cent for smaller depositors.

A shiny new deal, reached in the early hours Monday, induced a sigh of relief in global markets: policymakers clinched a deal to ensure Cyprus won't suffer an immediate financial meltdown or exit from the eurozone.

Still, something doesn't seem to sit right. Closing down the country's second-largest bank and inflicting huge losses on uninsured bank deposits? Shudder.

Good bank, bad bank

The bailout now aims to create a so-called "good bank" by winding down its Cyprus Popular Bank, widely known as Laiki bank, the country's second largest, and shifting deposits below 100,000 euro to the Bank of Cyprus.

Essentially, Laiki will be split into a good and bad bank; the bad part will be run down over time, while the good part will merge with the Bank of Cyprus.

Deposits over 100,000 euro in both banks, which are not guaranteed under EU law, will be frozen and used to resolve Laiki’s debts and recapitalise Bank of Cyprus. The raid on uninsured Laiki depositors is expected to raise some 4.2-billion euro, Reuters reported.

The effective shutting down of Laiki will likely translate into a lot of pain for Russia's wealthy as Cyprus is widely known as a favored spot to park money.

Dealmakers highlighted the deal as comprehensive and credible. Global markets perked up on the news, though by the time North American markets opened on Monday some gains had retraced a bit as caution set in.

There is speculation that as much as a 40 per cent loss would be taken by uninsured depositors. Uninsured or not, the bailout sends a bad signal that bank deposits are at risk. While the nation is seen as having a miniscule broader economic significance to the eurozone, the deal sets some questionable precedents namely wiping out bondholders, setting up of various capital controls, as well as opening the door to haircuts for investors. To be sure, the fallout from all this will unravel for a while.

"All in all, it's positive that there's a deal. However, the Cyprus situation is an overall negative for euro and the eurozone as it focuses the world on the risk to euro-area deposits," says Camilla Sutton, chief currency strategist at Scotiabank.

Already there is speculation and fear the country faces deeper recession.

"Cyprus will suffer. Its status as an offshore banking sector is now in doubt because confidence has been broken. Money goes where it is treated best – that is, taxed the least – and billions will flow out of the country when the capital controls are lifted," writes Eric Reguly of the Globe and Mail.

"The Cypriot economy, already in recession, will sink. Société Générale said Monday morning that it sees Cypriot GDP dropping by 20 per cent by 2017, which would put the economy into depression territory."