7 Reasons Why Cyprus Is Hugely Important

Includes: DGL, DGP, GLD, IAU, UBG, UGL
by: David White

Cyprus is a small country with a GDP of only $24.69B as of December 2011. It should be unimportant. Its economy is roughly a tenth the size of Greece's economy. Here are 7 reasons it is important.

  1. It's not over. On April 12, 2013 Eurozone finance ministers formerly approved a new 17B Euro bailout deal after many had thought the 10B Euro bailout by the EU-IMF earlier in March 2013. This means Cyprus must now find 6B Euros more than it originally estimated to get the 10B Euros from the EU-IMF. The original number for the needs of the bailout was 17.5B Euros. That number has recently jumped to 23B Euros. I am not sure anyone knows where this new money is coming from yet. Cyprus is not over! The new deal may mean that all or virtually all of depositors' monies over 100,000 Euros will be confiscated. The contribution of depositors is expected to rise from 5.8B under the previous suppositions to 10.6B Euros under the new suppositions. A further 600 million Euros are expected to be raised through new corporate taxes. 400 million Euros are expected to be raised through the sale of excess gold reserves. Bank bond holders will also feel more pain as the value of their bonds deflate substantially. More taxes and more austerity are expected to be needed. There is no guarantee that the pain will even end here for Cyprus citizens. There is considerable doubt that the bailout is sustainable.
  2. Cyprus is confiscating much of bank depositors' monies. This is a new and worrisome tactic for everyone in the Eurozone, especially for everyone in southern and eastern European countries. Put yourself in their place. If it was possible or even probable that your deposits in your southern or eastern European banks would be confiscated in the near future, would you keep your money in such banks? There is the very real possibility that there will be a flight of wealthy depositors' monies from these countries to "safe haven" destinations. If this exit occurs (and it seems it is already starting), this will have a severely negative impact on the economies of these already troubled countries.
  3. Cyprus is levying new corporate taxes. While it is good that Cyprus will be more likely to pay its bills via higher taxes, it is bad that businesses will be frightened away from Cyprus. A heavier tax burden will mean fewer businesses will start up in Cyprus. It will mean businesses will leave Cyprus. Many other businesses that are in other southern and eastern European countries will see Cyprus as a model. They will start cutting back their presences in these other countries, and they may in fact opt to leave many such countries. This will push these countries into even deeper financial trouble.
  4. Cyprus is planning to sell a huge chunk of its gold reserves. This will destabilize its banking industry as many people view gold as a great safety net. This is again an example for other southern and eastern European countries. They too may be forced to sell gold. This kind of action leads to gold deflation; and indeed the price of gold worldwide has fallen recently to $1500/ounce as of this writing on April 12, 2013. Gold fell over $60/ounce just today. Many expect gold to go much lower. I have seen near-term estimates of $1380/ounce. It may go even lower (or not). When a major worldwide recession is in the offing, gold usually plummets. Many have to sell gold in order to raise cash. This should be especially true for many troubled European economies. When you also consider that India, a major gold importer, raised its taxes on gold imports again in January 2013. It more than doubled the import duty on gold dore bars (an alloy of gold and silver) and ores from 2% to 5%; and it raised the duty on gold to 6% from 4%. When you add this to the European need to sell gold, gold may be in for a sharp fall in price. Its safe haven status may disappear in a puff of smoke - at least temporarily. This current gold selling is a dire omen for the European economies and even for the world economies.
  5. Cyprus' economy is expected to contract sharply for the next several years. It is not supposed to resume growth again until 2016. Add the new seven year extensions for Portugal's and Ireland's bailout loans that were approved by the European Union finance ministers today, April 12, 2013. Then you get a very dire picture for the likely state of the PIIGS economies for the next several years. Why would they need seven year extensions? Why not three year extensions? The obvious answer is that they are not expecting a healthy recovery in their economies soon. Don't forget that IMF Chief Christine Lagarde warned of a possible "lost decade" for European economies and perhaps for all western economies more than a year ago. These recent events make that possibility a real likelihood.
  6. Cyprus' troubles probably mean less credit for Eastern Europe as those economies are weak. Further Eastern Europe has relied on capital inflows and easy access to credit and export markets to fuel growth of more than 5% per year prior to the 2008 crisis. The events surrounding the Cyprus debacle will cause a significant amount of the capital inflows and the credit access to dry up. Further the Western European countries were generally the biggest export markets for the Eastern European countries. The EU recession is sure to hurt the Eastern European countries badly. Where will the growth come from? How long will it be before many of these economies fail. Hungary, Latvia, and Romania were early bailout recipients. Slovenia may be the next in line. Few of these economies are stable. Paradoxically, it was often the PIIGS countries that invested heavily in the Eastern European countries. If the Eastern European economies fail (or approximate that), it will put even more pressure on the PIIGS economies.
  7. The virtual collapse of Cyprus' banking system (major banks confiscating most of rich depositors' deposits qualifies as a collapse) also brings to the fore the prospect of a domino effect. The chart below shows the relative indebtedness of the PIIGS and of the 10 largest mature economies. China may be #2, but apparently it is not considered mature. The chart from 2011 clearly shows that Greece's banks have already been decimated. Unfortunately, it also shows many other countries are hugely in debt with respect to their GDPs. This data may have changed in the last year or so, but it will still be extremely valid for such countries as Japan and the UK, which are both over 500% of their GDP in debt. The chart clearly points out the possibility or even the probability of a domino effect. Cyprus and the fear generated by the severe actions in Cyprus could be the catalyst for the dominoes to start falling.

Click to enlarge

What does this mean for your investing/trading. It most likely means that gold will not be a safe haven this year. If you check, you will find that gold has fallen sharply in virtually every major worldwide recession. You will want to sell your physical gold, your SPDR Gold Shares ETF (NYSEARCA:GLD), other similar ETFs and ETNs, and possibly even your gold mining stocks. Some of the more prominent names in this area are: SPDR Gold Shares, iShares COMEX Gold Trust Fund (NYSEARCA:IAU), PowerShares DB Gold Fund (NYSEARCA:DGL), ProShares Ultra Gold ETF (NYSEARCA:UGL), E-TRACS CMCI Gold ETN (NYSEARCA:UBG), and PowerShares DB Gold Double Long ETN (NYSEARCA:DGP). I would be especially worried about the ETNs as these may be more problematical. Other precious metals and really all commodities will likely be similarly punished. It may not be long before stocks follow suit. You should position yourself accordingly, although you might allow for a possible short-term rebound in gold after today's huge down move.

Good Luck Trading.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GLD over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.