Counting the Cost of Cyprus
Author:
Robin Bew
Location: London Date: 2013-04-01
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.
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.
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.
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