The euro - It is all about trust

The euro dominos are lined waiting to fall; first Cyprus then Greece then perhaps Finland. Where will it end?

Banking is all about trust. Even well run banks cannot survive a loss of trust. I give an example of the safest bank I know. Our local Building Society is mutually owned with a long standing place in the community; it is managed prudently and only lends to people who can afford to repay and then only against property where the loan taker has provided a substantial deposit. It has about £500 million in deposits from local people and a similar amount in mortgages on local properties. It also has around £30 million of other assets. There is no reason not to trust this bank but it does not have the cash paid in by its depositors. The cash has been recycled back into the economy as loans on property. If a rumour circulated that people took seriously, and they tried to withdraw their money, the cash reserves would soon be empty.

In Cyprus, trust in the entire banking system has collapsed and it will take months or years to be rebuilt. Contrary to speculation in the press, the big foreign investors had plenty of warning that this was coming and a wall of money left the Island before the banks closed. It is now Cyprus residents, small businesses and other local organisations that are caught up in this. It is no defence that they managed their own affairs prudently; if trust has gone everyone suffers.

Here is my analysis based on three assumptions:

1. People no longer trust Cyprus banks.

2. People will increasingly come to realise that the return of the Cyprus pound is the only credible solution.

3. People would rather have euros than have their savings converted into Cyprus pounds.

People with accounts outside the island will transfer electronically as much money as the rules allow out of the Cyprus banking system. Resident of Cyprus will withdraw their maximum daily allowance each day in cash (currently €300). In this case, cash kept under the bed really is a better investment than keeping it in the bank. No one with any sense will pay money into the banking system.

Let us say that the EU central bank shipped €5 billion in cash to Cyprus overnight (as widely reported). The population of Cyprus is a little more than one million. That means a demand for €300 million per day. In 17 days the €5 billion will have been paid out. Will another €5billion be sent from Frankfurt? That would give Cyprus another two weeks.

The bankers and politicians in Cyprus will have daily reports of the cash exodus and plan the shift to the Cyprus pound. I would hope the plan is already quite advanced and that the printing presses at De La Rue have already been set in motion to produce the new notes.

Cyprus will become the model for trouble euro zone countries. Greece will be watching closely and be the first to follow. The next domino to fall is a tough call but the surprise choice which I plump for is Finland. The prudent Finns may baulk at the prospect of paying for more bailouts and take the exit before they are presented with the next bill.