The €7bn Cypriot question

Eurozone finance ministers are currently meeting to try to sort out Cyprus - the country that accounts for 0.2% of eurozone GDP but has still managed to throw a spanner in the eurozone works. Ahead of the meeting, we published a flash analysis on the state of the Cypriot bailout. Hint: it's none too pretty.

The summary of the analysis is:

Though progress has been made, eurozone finance ministers are unlikely to reach a final deal on the Cypriot bailout at their meeting this evening. Even if they do, any deal is likely to be another fudge, shying away from more radical options such as significant bank restructurings or depositor write downs. Amid political resistance in Germany and elsewhere to another bailout, eurozone leaders will seek to shrink the size of the €17bn bailout by up to €7bn. However, we estimate that even in a best case scenario, only around €4.5bn could realistically be cut, due to practical and political constraints. This will leave Cypriot debt to GDP at 130% - a level that remains wholly unsustainable. In turn, this makes further financial assistance for Cyprus likely, reminiscent of developments in Greece.

Fundamentally, the row over Cyprus – which accounts for only 0.2% of Eurozone GDP – illustrates that firstly, three years into the eurozone crisis, the block still has no effective tools to restructure debt and repair banks amid the complicated politics of the eurozone. Secondly, the stand-off between the creditors in the eurozone north and the austerity-fatigued south could well be hardening.

There are a few reasons why we believe the Cypriot bailout is unlikely to end particularly positively for the eurozone. Firstly, the usual methods of cutting the debt burden and/or taxpayer contribution such as bank or sovereign debt restructuring are very tricky to enforce in Cyprus (see table below, click to enlarge):

Secondly, the alternative options on the table simply do not deliver enough savings (at least not without the risk of significant contagion which politicians are likely to shy away from):

That leaves us with a very familiar solution: another fudge.

In terms of what to expect from tonight's meeting, well, probably no conclusive deal for a start. At best an agreement on some of the options above. The audit of Cypriot anti-money laundering regulations is just beginning and the final result will likely play a role in determining the level of conditions Germany applies to the bailout. (As the WSJ noted recently, the institution running the audit has previously ranked Cyprus above Germany in terms of its rules on money laundering, so exactly how much the result will help remains unclear).

See here for the full piece.