The Cyprus bailout program
The Cyprus bailout program presented on Monday 25 March is much better than the proposal presented a week before. A Cypriot euro exit has been averted. However, the country will face a difficult and uncertain economic future. Furthermore, we will have to see to what extent the radical elements of last week’s proposal could still shake (future) confidence of savers and investors elsewhere. What is more, even as they stated that Cyprus was a special case, euro zone policy makers now seem intent on having bank creditors contribute more in case of financial crises.
Cyprus will get a EUR 10bn bailout package to allow it to finance its budget deficit, repay existing debt and bail-out its smaller banks. Cyprus will have to downsize its oversized financial sector to the EU average (currently 346% of GDP). Furthermore, it is forced to raise its corporate tax from 10% to 12.5% and to implement a number of privatizations.
The two largest banks, Bank of Cyprus and Laiki (also known as Cyprus Popular Bank) will be restructured. Creditors (and shareholders) will have to cover all the losses. However, deposits up to EUR 100,000 will be exempted:
- Laiki will be liquidated. All its good assets and deposits up to EUR 100,000 will move to Bank of Cyprus. Deposits above EUR 100,000 will be turned into equity of the bad bank. The owners of these deposits are likely to suffer heavy losses.
- Deposits above EUR 100,000 at Bank of Cyprus remain frozen and will partially be turned into Bank of Cyprus equity to allow the bank to raise its capital ratio to 9%. This is likely to result in losses between 30% and 40% for these depositors.
- Junior/senior bond holders and shareholders will share in the costs of recapitalization of the two banks.
Cyprus will remain in the euro zone (at least for the near future). Renewed fears about euro zone member state leaving the zone have thus been averted.
The deal confirms a trend towards placing more of the financial burden of banking crises on creditors, instead of on the sovereign or euro zone rescue funds. It was the first time that senior bond holders and uninsured deposit holders had to take a hit. While the head of the Eurogroup of euro zone finance ministers Jeroen Dijsselbloem stated that the Cyprus deal was a special case and not a template for other countries, he also confirmed that he was in favor of greater creditor participation in future bail-outs. We belief that systemic relevance of both the bank and the country concerned are important criteria for determining the extent to which bank creditors will be hit.
The guarantee of deposits up to EUR 100,000 is retained, even as the credibility of depositor guarantees has taken a hit as the ECB, the European Commission, euro zone governments and the IMF last week all agreed to implement a levy on deposits up to EUR 100,000. So far, there are no signs that deposits in other euro zone countries have been withdrawn in large amounts .
Only creditors of the banks with the biggest problems will be hit, instead of all deposit holders in a country, which would have happened if the original plan had been approved. If approved, the original plan could have been interpreted as a template for future crises. Severe problems at one bank would automatically be seen as a threat to all deposit holders in a country, which could increase the likelihood of devastating bank runs. However, the fact that such a provision was part of the original plan may already have increased this risk.
The proposal follows the existing creditor hierarchy. Last week’s proposal would hit deposit holders, without forcing bondholders to contribute. It thus upset the established creditor hierarchy, and could lead to more uncertainty about the way future banking crises would be dealt with. Again, the fact that such a provision was part of the original plan, may already have increased such uncertainty.
Cyprus will not only have to thoroughly restructure the two banks, but also the overall economy. The future of Cyprus as an offshore center was already extremely uncertain after last week’s proposal. In the longer run, a restructuring of the Cypriot economy seemed unavoidable anyway. It is unlikely that the euro zone would be willing to allow a highly leveraged financial sector that to a large extent depends on black and grey money to enter a banking union (in this sense an obstacle on the road to a full banking union has been removed, a blessing very thoroughly disguised). However, the adjustment now has to take place very abruptly and in crisis times, which will increase economic hardship. A comparison can be made with Iceland. Iceland’s pre-crisis financial sector was bigger (10 times GDP) than that of Cyprus (7 times GDP). While Iceland had some other export sectors (fish and metals), Cyprus does have some important export sectors as well. Transportation (primarily the maritime sector) and travel services (tourism), accounted for almost half of all service exports in 2009. Iceland’s GDP fell by 12% from its 2008 peak to its 2010 trough. The economy recovered afterwards, but GDP is still 5% below its pre-crisis peak. Unemployment increased from 1% to 9%, and has fallen to 5.3% afterwards. Iceland has still capital controls in place. Economic hardship for Cyprus is likely to be bigger, as unemployment is already 14.7% in Cyprus. Furthermore, in contrast to Cyprus, Iceland was able to smoothen the adjustment of its economy through exchange rate and monetary policy. Cyprus will not have this option as long as a part of the euro zone. The fall of GDP is therefore likely to be bigger than in Iceland.
As Cypriot GDP is likely to fall strongly, another bailout package may be needed. As the downsizing of the financial sector is an important part of the rescue package, one should expect the negative economic consequences of this downsizing to be incorporated in the rescue package. However, the economic assumptions of previous programs tended to be too optimistic. It is therefore very interesting to see the economic assumptions of the Troika report that will be released shortly.
Even after the restructuring, the Cypriot banking sector is likely to need ECB liquidity support and capital controls. Banks will be closed until Thursday and capital controls are likely to remain in place afterwards to limit an outflow of savings. Extensive ECB liquidity support (ELA) is nevertheless likely to be necessary. As the financial sector of Cyprus is really small in comparison with the overall euro zone economy, the losses the ECB could run by extending liquidity are relatively small and not a risk to the continued existence of the euro zone.