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March 29, 2013

The long and the short of the Cyprus deal

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Written by: Politis

The Economist has published this excellent assessment of the aftermath of the Cyprus deal last weekend. More might be said of the political fall out, which will surely be felt more intensely as the economic situation in Cyprus deteriorates.

“The euro zone bail-out agreed for Cyprus means that the worst possible outcomes have been avoided: the country’s banking system has been pulled back from the brink of collapse and Cyprus’s future in the euro zone appears to have been secured, for the time being. Some initial missteps were reversed, with the authorities abandoning a plan to impose a levy on deposits below the insured limit of €100,000 (US$128,000). However, deposit-holders with more than €100,000 in banks will face big losses, and the country’s second-largest bank, Laiki Bank (also known as the Cyprus Popular Bank), is to be wound down. The deal was greeted with relief in Cyprus and across the euro zone, but the full cost has yet to be counted.

The first thing to take from the Cyprus package is that euro zone officials have shown a new determination to involve private investors in bank bail-outs (notwithstanding the confusion over the treatment of insured deposits). This is in keeping with the proposed direction of EU policy, as set out in the draft directive for a future resolution regime, which is scheduled to be phased in from 2015. Depositors across the euro zone may have been horrified by the suggestion that the savings of ordinary Cypriots should be expropriated, but the principle of limiting taxpayers’ direct exposure to bank bail-outs has widespread support.

It seems likely that Cyprus’s treatment was in many ways exceptional, reflecting the outsized liabilities of its banks in relation to the economy, its status as a tax haven, the high reliance on deposit financing and the origin of many of its banks’ creditors.

Cyprus is not a ‘template’

What has taken the markets by surprise, however, is that the ‘bail-in’ process for bank resolution (in effect, forcing financial institutions to recapitalise from within, using private capital from bondholders and uninsured creditors, rather than relying on a bail-out with taxpayer funds) was not due to come into place until 2018. Jeroen Dijsselbloem, the new head of the Eurogroup of finance ministers, certainly rattled the markets when he declared that the Cyprus bail-in should be seen as a model for the rest of Europe—he and other officials later sought to downplay his remarks to try to undo the damage.

It seems likely that Cyprus’s treatment was in many ways exceptional, reflecting the outsized liabilities of its banks in relation to the economy, its status as a tax haven, the high reliance on deposit financing and the origin of many of its banks’ creditors. The bail-in of depositors was the only way of getting round German objections to underwriting Cypriot banks’ (mostly Russian) foreign depositors. This case aside, the ECB in particular has been firmly opposed to bailing in senior creditors—as in Spain in 2012 and again earlier in 2013 when the Dutch authorities nationalised SNS REAAL. For the moment it seems hard to imagine that state involvement would not be a central ingredient of any major bank rescue in Spain, Italy, France or any other member state.

Contagion remains a risk

The uniqueness of Cyprus’s case does not mean that there is no risk of contagion. The EU’s supposed deposit guarantees have been revealed as less robust than previously assumed. Furthermore, the consent of euro zone finance ministers to the original Cypriot proposal to impose a levy on insured deposits under €100,000 will come to be seen as a big mistake, with potentially serious ramifications. In the event that a bank’s solvency is called into question, a run on bank deposits has probably become more likely, suggesting that any future bank-related crisis will develop more quickly. Depositors across the euro zone (particularly uninsured depositors) will no doubt feel much less secure.

Whether there have been large movements in deposits from banks elsewhere in southern Europe may not be known for some weeks. If events in Cyprus place already weak banks in further difficulty, policymakers’ willingness to restructure the banks in question may be put to the test again in the coming months, and the ECB may need to step up its role as a lender of last resort.

Capital controls are likely to endure

If the hit on deposits set a potentially dangerous precedent, possibly more worrying still is the introduction of capital controls in Cyprus. According to the country’s finance minister, these will be introduced for a seven-day period from when banks re-open on March 28th, and then re-evaluated. The measures will be tailored to each bank, but will include limits on the ability to withdraw money, or shift it between accounts or across borders. These measures might also delay the processing of cheques.

Although there is an evident need to deter bank runs when the banks reopen, it seems doubtful that once controls are introduced they will remain in place for a short period only, as policymakers appear to hope. With the economy expected to experience a severe downturn, and the financial sector in turmoil, the risk of deposit flight will persist for an extended period, suggesting that capital controls could remain in place for some time, as has been the case with Iceland since 2008. Although the EU treaties allow restrictions on capital flows in exceptional circumstances, extended capital controls would violate one of founding principles of EU membership, and the most important characteristic of the monetary union: the ability to move capital around without any restrictions. Investors in banks in other vulnerable euro zone states will take note.

For Cyprus, much more than principles are at stake… public debate [will be fuelled] on the merits of the country’s membership in the single currency, underlining that the threat of a euro zone break-up remains considerable and that the risk of such an occurrence is not tied solely to the situation in Greece.

Exit risk

For Cyprus, much more than principles are at stake. The closure of the banks has already seriously undermined the economy, with businesses demanding cash for goods and services, arrears rising and orders drying up. A period of extended capital controls could ensure that scarcity of cash remains a problem, particularly if businesses shun alternative payment methods. Greater reliance on cash transactions would put added pressure on tax revenues. Already, the macroeconomic scenario on which the €10bn (US$12.8bn) bail-out is based looks optimistic, suggesting that further bail-out loans and/or debt restructuring may be necessary. As it is, the EU/IMF will remain in charge of the public finances for years to come. This will fuel public debate on the merits of the country’s membership in the single currency, underlining that the threat of a euro zone break-up remains considerable and that the risk of such an occurrence is not tied solely to the situation in Greece.

The political atmosphere has deteriorated

In other vulnerable states in the euro zone the Cypriot bail-out is likely to be remembered as another example of the readiness of creditor governments (mainly in northern Europe) to impose harsh conditions in return for financial assistance. Germany may have been wrongly blamed for pushing for the raid on smaller depositors—the responsibility for that idea almost certainly rests with the Cypriot authorities—but Germany was also resolute that uninsured depositors and other investors should shoulder a significant part of the financial burden. As a result, Cyprus’s offshore financial sector, which has underpinned its economy for more than three decades, is set to be seriously downsized, leaving the country with little choice but to rebuild its economic model.

The episode underlines Germany’s determination to limit the exposure of German taxpayers to euro zone bail-outs. The Cyprus crisis came too soon to test the willingness of creditor governments to allow direct bank recapitalisation through the European Stability Mechanism (ESM)—the official line remains that this facility may only be considered once the new common supervisor is fully up and running (during the course of 2014). However, it reinforces doubts about how far the country will be willing to move towards greater sharing of financial risks via a deepening of the euro zone’s embryonic banking union. German objections have forced the European Commission to put aside plans for a common bank resolution fund and a single guarantee scheme to cover bank deposits. Although the issue of a common fund is likely to return to the Commission’s agenda, probably after the German election, the Cypriot crisis suggests that euro zone wide deposit insurance remains a distant prospect.”

Originally published on The Economist on March 28, 2013, at http://country.eiu.com/article.aspx?articleid=1220326306&Country=Cyprus&topic=Economy&mkt_tok=3RkMMJWWfF9wsRoiuq7NZKXonjHpfsX57uooUaeg38431UFwdcjKPmjr1YcET8J0dvycMRAVFZl5nQlRD7I=.






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