Cypriot parliament narrowly approves bailout deal but plenty of hurdles yet to overcome

The Cypriot parliament has officially approved the bailout deal that the government agreed with its eurozone partners and the IMF. (See here for our previous thoughts on the deal).

A rejection of the deal would probably have led to a Cypriot exit from the eurozone. Given such serious consequences it was an incredibly close run vote with 29 in favour versus 27 against (often for such votes politicians shy away from risky decisions).

We’re yet to get the final breakdown of the votes but here are the early predictions (we will update this with final figures when we have them):

The government is likely to breathe a sigh of relief but it should not view this as the end – it is surely only the end of the beginning at best.

As we have noted at length before, the prospects for Cyprus are bleak. Growth is set to crumble over the next few years, while capital controls remain in place, keeping it at the edge of the eurozone (with close to a separate currency since Cypriot euros are clearly no longer worth the same as euros elsewhere). As recently as last Thursday, the controls were extended for 16 days and despite being eased at points, there is no clear plan for how or when they can be removed (strangely the responsibility for the rules seems to have switched from the Central Bank to the Ministry of Finance while the lengths of the extensions have ranged from 3 days to 16 days at random intervals – not effectively a decisive or clear policy approach).

Despite the vote being approved it is also clear that politics in Cyprus remains fractured. 29 MPs feel strongly in favour of the bailout programme and the associated actions, while 27 MPs were effectively willing to see Cyprus leave the euro rather than implementing the bailout deal. Meanwhile, the rift between the Central Bank and the government shows little signs of abating.

Surely, effective reform and governance will be tough in the future, especially as the anti-austerity feeling amongst the general public rises.

For a taste of this just see the quote from Green MP George Perdikis after the vote:

“A 'yes' from Cyprus's parliament is by far the biggest defeat in our 8,000-year history. Its democratically elected representatives have a gun to their head to agree to a deal of enslavement.” 

The Cypriot government has negotiated a large hurdle but the biggest challenges may yet be to come.

The Cypriot bailout: A catalogue of farce

Having followed the twists and turns of the Cypriot bailout for the last couple of weeks we’ve been struck by how – even by the standards of eurozone crisis management – it has been spectacularly mishandled often with farcical results (FAZ's Klaus-Dieter Frankenberger described it as "hara-kiri crisis management"). Here's our highlights:

Sunday 17th – The blame game begins 
The tentative agreement between Cyprus and its creditors was only a day old when the different parties tried to shift the blame for the politically toxic levy on small insured bank deposits. German Finance Minister Wolfgang Schäuble kicked it all off by seeking to distance the German government from the decision by blaming the Cypriot government, the ECB and Commission, which in turn prompted a series of denials from everyone else. The suggestion was that it was actually the Cypriot government who opted to include small savers in order to avoid hitting wealthier depositors (mainly Russians) even harder. The blame game continued throughout the week.

Monday 18th – Gazprom steps in with an alternative bailout? 
Following the acrimony over the agreement, it was reported that Russian energy giant Gazprom approached the Cypriot government the same weekend with an offer to fund the €10bn necessary to restructure the Cypriot banking sector in exchange for rights to Cypriot gas reserves. Although the story fitted in nicely with the geo-political tension narrative, it was quickly denied. Despite that, the rumours of a Russian bailout continued to be batted around for the entire week - none of which proved to be true.

Tuesday 19th (Afternoon) – Cypriot Finance Minster’s non-resignation 
On Tuesday Cypriot Finance Minister Michalis Sarris flew out to Moscow to see if he could secure more favourable terms than those offered by the eurozone. While he was there, rumours began to fly around on twitter, seemingly substantiated by respectable news outlets like Kathimerini Cyprus, that he had resigned as he no longer enjoyed the confidence of President Nicos Anastasiades. Confusingly, further rumours began to circulate that Anastasiades had rejected his resignation. However Sarris later told Reuters that there was “no truth” to the original rumours.

Tuesday 19th (Evening) - Cypriot Parliament rejects bailout deal after days of negotiation
Originally scheduled for Monday, the Cypriot parliament’s vote on the deal negotiated by the eurozone finally took place on Tuesday evening after attempts at further postponement failed. The parliament voted overwhelmingly to reject the deal, with not a single MP voting in favour. Of course, the democratic vote is itself not the issue but it was farcical that the deal was pursued for four days before being put to a vote when it was clear it would need to be altered again. Not exactly effective crisis management, especially since the 'No' vote raised questions over Cyprus' place in the euro.

Thursday 21st - Cypriot ‘Plan B’ shot down immediately
Following the vote above, Cypriot officials sought to cobble together a ‘Plan B’ to keep their chances of a eurozone bailout alive. Options on the table included the creation of a solidarity fund securitised with social security fund reserves, state assets, Church property and expected natural gas revenues. However this was shot down immediately by the troika as it was feared that it would not lower Cypriot debt to sustainable levels. Adding to the farce, the WSJ reports that Sarris (still in Moscow at this point) wasn't returning calls from his eurozone peers. By Friday, the deposit levy was back on the table bringing negotiations full circle.

Saturday 23rd – Russia to retaliate by freezing European assets? 
With it looking inevitable that Russian interests would be badly burned however the Cypriot bailout was finally structured, the Guardian reported that former Kremlin advisor Alexander Nekrassov warned that “Moscow will be looking for ways to punish the EU. There are a number of large German companies operating in Russia. You could possibly look at freezing assets or taxing assets”. As usual, this was later denied.

Sunday 24th – Infighting within the troika
The negotiations also saw severe strains developing between different members of the EU-ECB-IMF troika with the latter (with German support) allegedly resisting attempts by the Commission to water down Cyprus’ own €5.8bn contribution to the bailout. The FT cites an IMF official as saying that “The commission keeps trying to work with [Cypriot leaders], to help them put something on the table, even if that something doesn’t add up”, although another source adds that the two sides have “kissed and made up”.

Sunday 24th – Cypriot President's resignation bluff backfires 
Unlike the non-resignation of the Cypriot Finance Minister, this really happened. Reuters cites a senior official as saying that this took place during a particularly heated exchange concerning the plans to restructure the country’s banking sector and the WSJ reports that at that point Anastasiades was calmly told by other leaders "to pack up and leave" if he wasn't ready to cooperate (he didn't).

Monday 25th (Afternoon) - Dijsselbloem's accidental honesty makes markets plunge 
You’d have been forgiven for thinking that with a deal finally having been hammered out, the situation would have settled down a bit. However, Eurogroup chief Joroen Dijsselbloem had other ideas, suggesting in an interview with Reuters and the FT that the Cypriot deal could become a template for any subsequent bailouts and bank restructuring in the eurozone. This saw markets around the world tumble for fear of further write-downs, particularly in Spain and Italy. Dijsselbloem then looked to row back from his comments reiterating that Cyprus was “specific” and that he was not even aware of the English word ‘template’ which had been widely attributed to him - although given this specific word was used by the interviewers we're not sure we entirely believe him. His comments got a mixed reaction - he was backed by the Commission and Finnish PM Jyrki Katainen - who said 'bail-ins' should be part of the eurozone's crisis management strategy - but ECB Executive Board member Benoit Coeure said that he had been "wrong" to suggest this.

Monday 25th (Evening) - Banks to stay closed even longer
It was originally announced that Cypriot banks would re-open on Tuesday with the exception of the two biggest - Bank of Cyprus and Laiki -which would re-open on Thursday. However, later that day, Cypriot authorities changed their minds and announced that all banks would remain closed until Thursday (this was just the latest of the many extensions to the bank holiday and the numerous other delays throughout the week).

Given that the final outcome of all of this was a plan which will likely slam the Cypriot economy and significantly reduce the standard of living (albeit while reducing moral hazard somewhat), it is hard to see the whole week other than an array of botched diplomacy and naive negotiations.

Let the guessing game continue: The Eurogroup's mixed messages on capital controls

As we have noted at length, the capital controls are a key part of the Cypriot deal and could have a huge bearing on how and when Cyprus recovers from this crisis. Unfortunately, as with almost all important eurozone decisions, this one lacks clarity.

The body of the Eurogroup statement said:

“The Eurogroup takes note of the authorities' decision to introduce administrative measures, appropriate in view of the present unique and exceptional situation of Cyprus' financial sector and to allow for a swift reopening of the banks. The Eurogroup stresses that these administrative measures will be temporary, proportionate and non-discriminatory, and subject to strict monitoring in terms of scope and duration in line with the Treaty.”

However, the Annex noted:

“Only uninsured deposits in BoC will remain frozen until recapitalisation has been effected, and may subsequently be subject to appropriate conditions.”

EU Internal Market Commissioner Michel Barnier added earlier today:

“Any measures to restrict or limit freedom of movement may only be enacted exceptionally and temporarily and that is what has been requested by the Cypriot authorities.”

Some pretty mixed messages. The first suggests that “administrative measures” (which is widely being taken as capital controls or related measures) will be generally applied. Bruegel suggests that this may not even need to take the form of full capital controls and could be limited to measures slowing down the movement of capital. This is contradicted by the second point which suggests they will only apply to the Bank of Cyprus uninsured depositors. Barnier’s point is closer to the first point but suggests actual controls will be needed.

FT Alphaville has an interesting run-down of the different type of capital controls and their implications. Paul Krugman makes the valid point that, if the trade-off of the single currency is reduced transaction costs in exchange for an overvalued currency, once capital controls are introduced, what is the motivation to stay inside? As he notes, wider points on the EU and access to ECB liquidity apply but it gets to the crux of the choice facing Cyprus.

As we have suggested, we find it hard to imagine that the banks could survive long without capital controls, while the economy would likely take an even bigger hit. As we have mentioned, it would fall on the ECB to continue to sanction ELA to keep banks afloat during deposit outflows, but this would amount to a large transfer of risk towards the Cypriot Central Bank (and therefore the Cypriot state, and therefore the eurozone). Meanwhile, access to the ELA is limited by the ECB’s view of bank solvency (one they have shown they may not stretch indefinitely) and assets which can be posted as collateral.

One thing that is for sure: this lack of clarity is certainly not helping an already messy situation.

Full circle in Cyprus

Update 13:15 22/03/2013:

Thinking about the plan in more detail, it occurred to us that this may amount to trying to burn the larger depositors twice. As we noted in today's press summary, the plan essentially is to move all the bad assets to a bad bank, along with the large uninsured depositors (€100,000+). These assets would then be wound down or sold off at a large discount with the depositors footing the bill (and taking losses of 20% - 40%). This, along with the merging of Bank of Cyprus and the good bank, is how the recapitalisation costs will be reduced by €2.3bn.

So, the large depositors will take significant losses here and yet may still face a large deposit tax as well? That seems to be pushing the boundaries to us, although it is not impossible. Cyprus would not recover as destination for foreign investment for some time. One way to structure this could be for the tax only to be applied to depositors above €500,000 (as we suggest below) and the bad bank to apply to all uninsured deposits. Obviously, the bad bank scheme also only applies to Laiki bank, but as the second largest Cypriot bank it is still likely to account for a large amount of big deposits.

Still this could see larger depositors taking up to 50% hits in some cases. We can't imagine Moscow would take that one lying down, especially given comments earlier in the week...

****************** Original Post *********************

It now seems we have come all the way back round to the deposit levy as a solution in Cyprus. Overnight, the EU/IMF/ECB Troika rejected the plans for a Cypriot solidarity fund, particularly one based on pension assets and gas reserve revenues (which German Chancellor Angela Merkel specifically spoke out against).

The bank restructuring plan does seem to be holding water for now, so this has at least reduced the money Cyprus needs to raise by €2.3bn. Unfortunately, though, that still leaves €3.5bn to be found. As we noted a week ago, there are few options for doing it – and it slightly worries us that Cyprus and the eurozone are only just realising this.

Inevitably, that has led us back to a deposit levy. Fortunately, with the amount of money needed reduced, a new version can focus on larger depositors – which is reportedly what was originally proposed by the Troika last week. Barclays has a useful table on the breakdown of deposits (via @FGoria):

Going from these figures, a 12.2% tax on deposits above €500,000 would yield the €3.5bn necessary. A 9.46% tax would also be sufficient if applied to all depositors over €100,000.

Either of these options would probably be acceptable to the Cypriot parliament. Sources suggest that the Democratic Party (DIKO, Cypriot President Anastasiades's junior coalition partner) has indicated its support for such proposals, which would bring the government up to 28 votes – so potentially needing only one more.

There are plenty of pitfalls left, but we may get a vote this evening. That said, noises from the Troika earlier suggested they could take the weekend to review the bank restructuring deal.

As has been the case for the whole of this week, uncertainty seems to be the order of the day. One thing we can take away is that a deal may be inching closer…

What if the Cypriot parliament votes against the deposit levy?

This is the question which is now holding global financial markets on the edge - could it really happen and what would it mean, we assess the possible scenarios below.

Could the Cypriot parliament vote against the levy?

According to Reuters, Cypriot government spokesman Christos Stylianides told state radio that the vote “looks like it won’t pass”. Meanwhile, via Zerohedge:

• CYPRUS PRESIDENT: PARLIAMENT BELIEVES BAILOUT PLAN UNJUST, GOVERNMENT MAKING OTHER PLANS.
• CYPRUS PRESIDENT: PARLIAMENT WILL REJECT BAILOUT PLAN

As we were tweeting yesterday, the DIKO party (junior coalition member with 8 MPs) had said it would not vote for the deal without some improvements, although we suspect reducing the burden on small depositors could help convince them. The European Party (2 MPs) had previously said it would not support he levy, however, according to CYBC, it has now said it would support the levy if depositors are compensated with interest bearing government bonds (we assume linked to gas revenues, something which the government has already offered).

That said, according to the Cypriot press, the latest proposal sees deposits below €20,000 exempt, deposits between €20,000 and €100,000 taxed at 6.75% and deposits over €100,000 taxed at 9.9% - this is unlikely to satisfy demands to exempt smaller depositors. It also seems unlikely to raise the required €5.8bn, not least because it applies the same rate as the original to a smaller pool of deposits.

Separately, there are conflicting reports this morning on whether the vote will be delayed again. The government is unlikely to put this to a vote until it is almost near certain of getting it through.

What would the fallout be?

The fallout of voting down the package could be explosive and we can only speculate about what could happen next, but its eurozone membership would likely be brought into doubt. As we noted in our flash analysis, there are few other alternatives for Cyprus to raise the necessary cash, while the eurozone has made it clear it cannot foot the entire bill (such an option would make Cypriot debt unsustainable anyway).

The eurozone would likely give Cyprus a few days either to change its mind or come up with an alternative way of financing the €5.8bn. Another parliamentary vote could be held (the EU of course has form when it comes to demanding the 'correct' vote).

The ECB has already reportedly warned that rejecting a levy would have dire consequences. Specifically, the two largest Cypriot banks would go without recapitalisation and could see their liquidity from the ELA (sanctioned by the ECB via the Bank of Cyprus) cut off, leading to them becoming insolvent and collapsing – putting their €30bn of deposits at risk, since the government obviously cannot guarantee them. This would likely bring down most if not the entire Cypriot financial system.

With the financial sector close to or in the process of collapsing and no support forthcoming from the eurozone or ECB, since Cyprus rejected their terms, Cyprus could even be forced to leave the eurozone and begin printing its own new currency, one that would have little international trust and could lead to a spiral of hyperinflation, etc, etc (i.e. a very nasty scenario).

There is, of course, a chance that if faced with the prospect of Cyprus leaving the euro, the rest of the eurozone could blink and find an alternative way to bailout Cyprus but the politics of such a scenario would get very ugly indeed. The ECB may not follow through on its threat to withdraw liquidity for Cypriot banks but this would only be a temporary reprieve. The Cypriot government will run out of cash at the start of June when it needs to pay off a €1.4bn bond, while the banks' position could be worsened by the likely deposit outflows once banks open, even if the tax is not applied.

What are these “other plans”?

It’s not clear exactly what Cypriot President Nicos Anastasiades meant when he suggested the government is making 'other plans'. We have long noted that deeper connections to Russia remain a viable option for Cyprus. With Russia angry at the eurozone for trying to burn some of its depositors, some more financial support could be forthcoming (but maybe only for Cyprus outside the eurozone) – with significant geopolitical implications as we noted here.

Other options which have been bandied around include: a financial transaction tax and the recent proposal from Lee C. Buchheit and Mitu Gulati (the men partly behind the Greek restructuring) to convert deposits into deposit certificates with fixed long term maturities. However, the former has been widely rejected by Cyprus and may not yield sufficient funding. The latter is an interesting proposal but may only offer liquidity support rather than solvency, while the banks would still remain under-capitalised. Such a proposal would still require significant backing from the eurozone and Russia – both of which are likely to come with onerous terms – and present similar obstacles to a deal.

So, all in all a 'No' vote, however tempting to Cypriot MPs, only leaves more drastic alternatives, hence it remains a possible but not probable outcome.