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Monday, February 25, 2013

Do the Cypriot elections pave a clear path to a Cypriot bailout?

How big of a problem can a country accounting for 0.2% of eurozone GDP possibly be? Well, potentially pretty big it seems.

As expected Nicos Anastasiades, the centre right candidate, was yesterday elected President of Cyprus winning 57.5% of the vote in the runoff election – the highest vote share in 30 years. Anastasiades, along with other eurozone leaders, has said he is keen to move quickly towards finalising the Cypriot bailout which was first requested in June 2012 – meaning it has been in the pipeline for 8 months. Usually the fresh election of a reform minded government with a large majority paves a clear path for a bailout. While, it is true that the previous communist President Demetris Christofias has been an obstacle to finalising a bailout by refusing to countenance any privatisations, the path to a bailout is still littered with hurdles.

The first hurdle is the banking sector which needs a massive recap of €10bn (50% of GDP). Over the past decade it has swelled to seven times the size of Cypriot GDP, mostly off the back of a huge inflow of foreign (mainly Russian) money attracted by the low tax rate and reported lax financial regulation. Unfortunately, despite requiring a significant restructuring and overhaul, for which taxpayers should not foot the bill, there is a very limited amount of bank debt to ‘bail-in’ (circa €3bn against €128bn of assets). This leaves few options. One is writing down depositors, although the threat of contagion and the unprecedented nature of this means it remains someway off for now.

The second issue is fiscal. Cypriot debt has been increasing rapidly, already standing at around 84% of GDP. Adding the burden of a €17bn bailout would take it to 140% - far from sustainable. However, restructuring the sovereign debt is not much easier than the bank debt. Around half is issued under UK law, meaning the Cypriot parliament cannot simply pass a law restructuring it (as Greece did). The other half is predominantly held by shaky Cypriot banks making any write down counterproductive as these banks would simply need an even larger recapitalisation. The rest takes the form of official loans to EU countries and institutions – unlikely to take losses, as Greece has proven.

The confluence of the above problems ultimately makes this a very tricky political decision. The Cypriot bailout and the presence of large Russian deposits and lax financial regulation (in Germany’s view at least) is now becoming a topic in the upcoming German elections. As we noted in today’s press summary, a DPA poll over the weekend showed that 63% of Germans are opposed to a Cypriot bailout whereas only 16% are in favour. The SPD has also made this a point on which to differentiate themselves from the governing CDU. On the other hand the politics in Cyprus are also tricky. Many in the country are expecting a show of solidarity from the eurozone given that half of the bank recap needs are a result of Cyprus wilfully taking part in the Greek debt restructuring. And is Cyprus really systemically important, given its tiny size? Many would say it is not, however, as the problems above highlight there is substantial potential for contagion, not least because any radical solution would challenge the view that Greece is “unique and exceptional”.

Taken together, this represents a minefield of issues to negotiate when formulating the Cypriot bailout. Unfortunately, the technical and legal challenges balanced with the fragile turnaround in the eurozone mean that at this point in time it looks likely that eurozone taxpayers will be forced to foot the bill once again – albeit with very strict conditions and a significant financial overhaul. Potentially the most worrying thing about this bailout is how familiar the problems all seem. The banking issues are similar to those in Ireland and Spain, the fiscal challenges to those in Greece and the political ones, well, to everywhere. One thing that the Cyprus issue makes abundantly clear is that the eurozone lacks any new tools to overcome these very familiar problems. Of all the issues mentioned above, that may be the most ominous for the future of the euro.

1 comment:

Jesper said...

The numbers seem a bit out of the ordinary. 128bn of liabilities seem to include more than just depositors. 3bn of loss absorbing capacity seem very little. Is the quoted number excluding senior bank bonds?

If so, then it looks likely that holders of senior bank bonds (of the Cypriotic banks) might have to suffer a 'haircut'. If it were to happen when it would be the first time it happened in the euro-zone. (Denmark did it a couple of years ago and the Danes don't seem to be suffering for it.)

If that were to happen then the consequence might be that banks would have difficulty selling senior bonds (this would be the so called contagion). On the other hand it might not be possible to detect a worsening of the market for bank debt, from what I've read it can't get much worse.