Cyprus bailout: a guide to the euro area’s future

The Cypriot parliament’s overwhelming rejection of the proposed levy on bank deposits has piled confusion upon uncertainty. In this note, we have looked back at the origins of the crisis, explored the kind of options left open to the authorities and pinpointed some of the consequences for investors.

Origins of the crisis
The attractiveness of Cyprus as a financial centre caused the size of its banking system to balloon to extremes. In 2010, its total balance sheet amounted to a staggering ten times the size of Cyprus’s economy (three times is considered to be normal size). The Greek PSI (debt restructuring) process at the beginning of 2012 shook the Cypriot banking system to its roots.

Recapitalising the island’s banks will cost €10bn (56% of GDP). In addition, the public sector needs €7bn to cover its financial needs over the next three years. As a result, the total bailout amounts to €17bn (100% of GDP). If this amount were lent, Cyprus’s public debt would increase by a corresponding amount, launching the island on an unsustainable trajectory. So, quite quickly, a group spearheaded by the IMF and creditor countries called for a more radical plan to consider drawing on other sources of funding.

The proposal was to cap the Troika’s loan at €11bn, with the remaining €5.8bn to be raised among the banks’ creditors.

PSI not an option for Cyprus
The particularity of Cypriot banks is that they are predominantly funded by deposits. The €72bn of banks’ loans are backed by €68bn in deposits. Banks’ bonds only make up a tiny portion (€2.5bn in junior bonds and €0.2bn in senior debt) – in any case, well short of being enough to finance the €5.8bn the Troika is looking to find. As a result, a PSI-like (Private Sector Involvement) solution à la grecque is not a valid option for Cyprus. This is why it has been envisaged to involve depositors in the bid to bail in banks’ creditors. Last weekend’s deal considered the following sources of financing: – €10bn from Europe (EFSF/ESM, EFSM);

– €1bn from the IMF;

– €5.8bn from a tax on deposits.

In addition, the following measures were also considered:

– corporate tax rate to be raised from 10% to 12.5%;

– a bail-in of junior debt;

– commitment to downsize the local banking sector to around 3.5 times the size of the economy;

– adoption of fiscal-consolidation measures amounting to 4.5% of GDP;

– a privatisation programme expected to contribute €1.4bn.

A limited array of solutions
The insistence on imposing a levy on small-scale deposits outraged the island’s population. The proposed bill was amended to ensure deposits smaller than €20,000 would not be liable for the tax. Despite this amendment, MPs still rejected the bill. In reality, Cypriot MPs appear keen not to tax even sizeable deposits. The reasons are understandable, being a blend of a willingness to protect the attractiveness of Cyprus as a financial centre and interconnected interests with big depositors.

At this juncture, the chances of seeing a €5.8bn contribution being financed through a levy on deposits look fairly remote.

What options does that leave then?
Euro area negotiators have revived an alternative plan – even more radical, originally advocated by Finland and Germany – that would see Cyprus’s two largest banks being merged. This would create a bank that would include all deposits under €100,000. The larger uninsured deposits (>€100,000) would be put into a bad bank, wiping them out! Not surprisingly, this plan has been resisted by Cyprus’s President.

A package of Russian aid?
The Cypriot government seems to have decided to seek aid from Russia, as the Finance Minister’s extended stay in Moscow would appear to suggest. A loan from Russia would not solve Cyprus’s problems as it would increase public debt by a corresponding amount. The other option would be for Russia to acquire equity. But, as Russian Prime Minister Dmitry Medvedev indicated recently, the Russian authorities are not all that enthusiastic about pumping good money into zombie banks. A concession licence for gas fields or a naval base on the island would certainly be more appetising for the Kremlin. Here though, we are obviously leaving the field of economics to enter the even murkier and blurred waters of geopolitics. Undoubtedly, any option along those lines would spark fierce opposition from the USA.

Domestic resources?
Another option would be to mobilise domestic resources by nationalising the State pension fund and issuing emergency bonds backed by future revenues from offshore gas discoveries. This plan has, however, already been rejected by the IMF and the European Commission on the grounds, once more, that public debt would be launched onto an unsustainable course.

The hunt for a solution
Meanwhile, banks’ doors will now remain shut for a while longer, until 26 March, to allow policymakers more time to come up with an alternative plan and possibly some emergency measures, such as capital controls to forestall outflows from Cypriot banks once they do reopen for business.

The ECB threatening to pull the plug
In the meantime, the ECB has cranked up the pressure on the Cypriot authorities. In a terse communiqué, the European Central Bank announced current Emergency Liquidity Assistance (ELA) would be maintained until Monday, 25 March. “Thereafter, ELA could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks”.

Knowing that Cypriot banks are currently being kept afloat thanks to ELA, the end of Frankfurt’s assistance would mean a full-scale banking collapse, a disorderly government default and, possibly, an exit from the euro area.

Handling of the Cyprus crisis: a guide to the euro area’s future
The Cypriot crisis offers a good guide to understanding the EU authorities’ line of thinking and some insight into what kind of solution to the euro area crisis would be envisaged. In recent decision-making, creditor countries’ will has prevailed. Bailout fatigue in creditor countries and an election year in Germany are making it very hard to persuade national parliaments to vote in favour of any attempt to bail out banks or sovereign states on the euro area’s periphery. The German authorities, in particular, consider that the EU has done enough in terms of transfers (EFSF/ESM), that the ECB has even gone beyond its mandate in terms of monetisation (LTRO, OMTs) and that now the time for restructuring has dawned. Creditors of insolvent banks run the risk of being bailed in. Even creditors of over-indebted sovereign states run the risk of being subjected to haircuts. Use of mutualised funds (ESM) will be restricted to rescuing systemically important structures. This line of conduct will prolong the deleveraging process in the euro area, which would fundamentally maintain a deflationary environment.

 

Euro area as the bogeyman for investors?
Cyprus is undoubtedly a special case, but, after the exception of the Greek PSI, this proliferation of exceptions seems to be proving the rule. With last weekend’s proposed deal, the spirit of the decision on guaranteeing deposits taken in the aftermath of the Lehman Brothers collapse has clearly been broken. Moreover, it has clearly been shown to the world that rules can be rewritten overnight. This could ultimately scare depositors throughout the whole euro area periphery with the risk of seeing full-blown runs on banks or foreign investors being put off.

Consequences for investing in European equities
So far, the contagion has been muted, but the risk of seeing runs on banks across the euro area cannot really be ruled out. In any event, the Cyprus crisis will certainly not help matters. As credit conditions are already very tight in the euro area’s peripheral member states, the crisis and the process of resolving it could add to the difficulties. This turn of events reinforces the preference for defensive investments in European equities, geared towards companies with strong balance sheets/low leverage and growth opportunities coming mainly from outside Europe.

Consequences for investing in bank equities
Bank equities have moved in lockstep with sovereign risk spreads over the past two years. With renewed macroeconomic fears arising out of events in Cyprus, already following on from the unsatisfactory outcome to Italian elections, wider sovereign spreads round the periphery seem most likely to lead to lower prices for bank shares on the periphery. The rising cost of bank funding for banks round the euro area’s periphery will be one of the channels through which peripheral euro area banks’ share prices will be affected. The impact will vary from country to country, with weaker domestic banks in Spain, for instance, suffering more than the larger, better‐funded BBVA/Santander. Growth in deposits in peripheral member states may react as well: for instance, complicating deleveraging for banks in countries like Greece, Slovenia (often mentioned as another country that might require a bailout) or Portugal. So, overall, the convergence in valuation levels that has taken place over the last 12 months is at risk; increasing differentiation between banks may again lead to higher‐quality, more defensive names outperforming, primarily the national champions in the core nations of Europe (BNP, Deutsche Bank, HSBC, the Nordics, etc.).

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