Ghost Agenda | March 28, 2013
This entire crisis was never supposed to happen in the first place. After all, Cyprus’ entire economy equals a mere 0.2% of the euro zone’s entire GDP. We’re talking about a small fish that could have been bailed out with spare change! (at least, compared with the rest of the euro crisis)
But regardless of it’s size, Cyprus did need help. It needed cash for a bailout. And it received it. But at what cost?
The Origins of the Cypriot Financial Crisis
Cyprus has few developed natural resources. Yes, there is plenty of natural gas in the Eastern Mediterranean, but these won’t be developed and operational for another 2 years or so. So like many other island nations located in a prime geopolitical location but with few resources, Cyprus became an offshore financial center and tax haven, with 37% of the country’s deposits being from abroad. It also became the tax haven of choice for Russians, especially criminals who need a place to launder their cash.
The result of all this money going into Cyprus was predictable: the banks grew to a ridiculously large size, with assets being 8 times larger than the national GDP. We’re talking about too big to fail on steroids, or as reporter Matt Phillips calls it, “stupidly big“. In fact, not only were these banks too big to fail, but it’s also too big to bail should anything ever go wrong.
So pray tell, what did the banks do with all this cash? Obviously, they wanted to invest it somewhere in order to generate a return. That sounds reasonable, right? So they took that money and invested it in… Greece.
Yeah, that’s right. Greece. The epicenter of the euro zone crisis, which politicians and investors freak out over on a monthly basis. Out of all places they could have invested into, they chose the riskiest economy on Earth. Why? Well, since most of Cyprus is ethnically Greek, the banks figured that they had a natural advantage by expanding there. Furthermore, an incredibly high interest rate on Greek bonds promised ridiculously high returns… though the Cypriot banks seem to have ignored the fact that the reason the interest rate is so high is because Greece is at risk of defaulting.
As you can guess, these investments/loans have not worked out. The Cypriot banks have lost billions in Greek bonds, and would have gone bankrupt if they weren’t for the fact that the European Central Bank (ECB) approved the decision to give these banks emergency funding.
This emergency funding is simple: suppose you run a European bank that is low on cash, collateral, and trust. You need money, but you don’t have any decent collateral to put up and nobody trusts you enough in order to lend you this cash. This is why lenders-of-last-resort (read: The ECB) exist: you give them your less-than-decent collateral and they’ll give you a high interest rate loan.
But what if your collateral is really bad? Like, barely worth bothering bad?
Well, thankfully, there is an option for you. The ECB won’t give you cash, but your national central bank will (with ECB approval). This is what we call “emergency liquidity assistance“, or ELA. It’s basically the same thing as before, only with a different name, higher interest rates, and really bad collateral. The big difference here is that if you default, then the national central banks is the one at risk, not the ECB.
Cyprus’ banks have been surviving on this stuff for months. If it wasn’t for this emergency funding, they’d all be dead. Of course, this dependence on money from the ECB means that the Cyprus is, for all intents and purposes, a vassal to the ECB (to put it in safe for work terms).
This was the situation Cyprus was in until last week: banks way too big to fail, a government that didn’t have enough money to bail them out, and in need of a lot of money.
It was not a nice situation. And what happened next was even nastier.
The Impossible Choice
As a result of all these conditions, Cyprus found itself in a situation where it needed €17 billion, and fast. Usually, Germany (which anyone can tell you wears the pants in the EU) would reluctantly hand over the money in exchange for the needy country adopting harsh austerity measures that pay back the loan at the cost of making the country in question absolutely miserable.
However, the EU is somewhat tired of bailing out countries (Cyprus is the fifth one). Furthermore, it’s an election year in Germany; I don’t know much about their elections, but I don’t think Angela Merkel would like to answer questions as to why she bailed out Russian criminals’ bank accounts. It makes for an awkward silence during political debates. Still, Cyprus needs to be bailed out no matter what, so a deal was proposed: the EU would provide €10-13 billion of the bailout money needed, but Cyprus needed to come up with the rest.
There are two ways a broke government could come up with money: either force it’s own creditors to take losses, or force the banks’ creditors to take losses. Unfortunately, as Joseph Cotterill from FT Alphaville points out, the government cannot currently force losses on its foreign lenders, and its domestic lenders are mostly the very banks that are in trouble. Basically, the only losses that the government can enforce would make the situation worse.
So that only leaves option 2: forcing the banks’ creditors to take losses. Now, these creditors are bondholders, of which there are three kinds: junior bondholders, unsecured senior bondholders, and secured senior bondholders (which include insured depositors). If a bank goes bankrupt, then the secured senior bondholders are first ones to claim whatever is left over, followed by the unsecured senior bondholders, and so forth.
The problem here, of course, is that most of the Cypriot banks’ funding comes from ELA (which I explained in the previous post) and depositor’s cash. The bailout can’t be funded by forcing bondholders to take losses because there simply isn’t enough cash in these bonds to fund the bailout. Charles Forelle of the Wall Street Journal points out, as an example, that the two biggest banks in Cyprus have €46 billion in deposits and €184 million in unsecured senior debt. So Cyprus had only the illusion of choice: Cyprus either has to make its depositors pay or force its national central bank accept billions of euros in losses. And it can’t make the central bank take billions of euros in losses.
In case none of the above makes sense to you, then it’s simple: the only way to fund the bailout of Cyprus is to use some of the money from peoples’ bank accounts, simply because there is no money elsewhere. And no, bankers aren’t sitting on a secret pile of cash they don’t want to share. There is, quite literally, no money to be found anywhere else. As a “wise ex-colleague” of Buttonwood over at the The Economist pointed out: “Savers will pay for the mess. They are the only ones that have any money left.”
So even though the EU/IMF was lending €10 billion, that still wasn’t enough to pay for the entire bailout. An additional €7 billion was needed, and the EU was making Cypriots pay for this remaining amount out of their own pockets.
€1.2 billion of that would come from the government austerity measures, such as cuts to spending and raising taxes. The remaining €5.8 billion would come from imposing a tax on Cypriot bank accounts. For people with accounts over €100,000 the tax would be 9.9%, while accounts below that number would be taxed 6.75%.
Now, to be fair, this could have actually been a sensible deal. Furthermore, the idea had been floating around for weeks leading up to the crisis, so shame on everyone for not paying attention. Nonetheless, it was still a somewhat good deal. As Anders Aslund pointed out on Foreign Policy, this deal had three things going for it:
There was one big problem with this entire plan, however: the depositor tax.
There was one thing that the European Union had promised it’s citizens that, regardless of whatever happened in the euro zone crisis, would never, ever, be touched: their bank accounts. So when it was revealed that a big part of the money for the bailout would come out of their own bank accounts, Cypriots were beyond livid and afraid.
The reaction was utterly predictable: utter madness.
Ordinary Cypriots took to the streets to express their outrage, while parliament voted overwhelmingly to reject the tax on bank accounts. Furthermore, banks were closed all week (and still are, as of the writing of this post) in order to prevent people from withdrawing all of their money, which would have caused the banks to collapse and made the entire situation worse. ATMs were still open, but quickly ran out of money as everyone tried to withdraw as much as they could.
And it wasn’t just the Cypriots that were afraid: but all of Europe.
Imposing this kind of tax sets a dangerous precedent: it indicates that European governments aren’t above taking money from depositors in order to pay for necessary bailout packages. If the EU ready and willing to do it in Cyprus, what’s to stop them from doing the same in other countries? The EU, to it’s credit, has stressed throughout the entire crisis that this depositor tax is a one time thing, unique to Cyprus alone. Naturally, that hasn’t stopped people across Europe, and the world, from freaking out. As Paul Krugman mentioned in his blog on The New York Times, “It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying ‘time to stage a run on your banks!’”
The rejection of this deal set off a panic, setting in motion emergency negotiations that led to Cyprus to nearly leaving the Euro.
Eye of the Storm
Having rejected the proposed bailout deal, the Cypriot government began to scramble, trying to figure out what the hell they were going to do while protestors raged outside of parliament.
They had three choices, as Matt Phillips of Quartz highlighted, and none of them were appealing:
As it would happen, the Cypriot government tried option 3. Cypriot Finance Minister Michael Sarris flew to Moscow and tried to negotiate for some help from the Kremlin. He was promptly turned down, as it seems the Russians weren’t interested in investing heavily in an economy in mid-crisis.
Over the weekend, the Cypriot government and the troika negotiated fiercely in an attempt to reach a deal. It came close, with the ECB firing an ultimatum and Cyprus threatening to leave the euro zone. But at the 11th hour, a deal was successfully reached that managed to save Cyprus.
The 11th Hour Deal
The deal that the Cypriot government and the troika reached late on Sunday night will save the country from bankruptcy. As this is a developing situation, some things said here may (or may not) be subject to change. It’s all very complicated stuff, so I’ll do my best to guide you through the details:
The country’s second biggest bank, Laiki, is going to be shut down, with viable assets and insured deposits of less than €100,000 being transferred to the country’s largest and more stable bank, Bank of Cyprus. Around €4.2 billion worth of uninsured deposits (in other words, deposits above €100,000) will be placed into Laiki, the “bad bank”, to be disposed of and used to pay down bad debt. Any bank deposits in the country with less than €100,000 will be totally safe from anything.
It is likely that the uninsured deposits being placed in Laiki, which will be used to pay down bad debt, will be wiped out (that means that a lot of Russian oligarchs and criminals must be fuming right now). If these actually succeed in covering all of the bank’s losses (something that will be determined in the future), then uninsured depositors in Bank of Cyprus may not incur any losses. Should this all work out well, then the emerges from Laiki will be merged with Bank of Cyprus.
Bank of Cyprus will be treated as the “good bank”, where money is somewhat safer. It’ll be restructured severely, as current shareholders will be wiped out and bondholders, both junior and senior, will be bailed in. Uninsured depositors will probably incur haircuts (read: tax) of 35% to beat down debt.
Dutch Financial Minister Jeroen Dijsselbloem (more on him later), who currently heads the euro zone’s finance ministers group, stated that this deal is better than the previous one in these respects:
Furthermore, temporary capital controls (tools used to regulate the flow of money) have been imposed on Cyprus in order to prevent a flight of capital (from both the country and it’s banks). After all, this entire rescue plan is useless if everyone tries to remove their money from the country and it’s banks as fast as possible, since then the entire system would collapse.
The Future of Cyprus
These capital controls, however, are still a first in EU history. The think tank Open Europe argues that this moves defeats the entire point of the euro zone: the free flow of capital. As a comparison, they cite that Iceland still has capital controls 5 years on. At the same time, however, the inverse could happen: they’ll be a temporary life support measure necessary for the Cypriot economy to get back into shape. This is something we’ll see develop down the line.
Speaking of down the line, what will happen in Cyprus? While the short-term collapse has been avoided, the long-term is another matter entirely. The Economist’s Charlemagne points out,
Nobody doubts that, after such a severe blow to its lucrative banking sector, Cyprus will be pushed into a harsh recession. Some sources in the troika tentatively estimate that GDP will shrink by about 10% before any hope of recovery.
Perhaps the biggest question is this: once the banks have been cleaned up and shrunk, where will Cyprus find economic growth? The promise of offshore gas deposits is still too uncertain, and tourism may well decline if Russians suddenly find the island to be less hospitable to their money.
He is correct in regards to the Cyprus’ financial strength: nobody is going to be store their money there any time soon. All those Russians will probably move their cash over to Latvia or Brussels. As hedge fund manager Barry Ritholtz so eloquently stated on Bloomberg TV: “Anybody who leaves their money here [Cyprus] afterwards gets exactly what they deserve. If you’re that foolish, you’re too stupid to own any money in any bank.”
So Cyprus’ days as an offshore finance place are over, at least for the next few years. It still has tourism and natural gas, but how that pans out yet remains to be seen.
One thing is for sure: there will be a few months/years of austerity and recession awaiting the Cypriots. They can take solace, however, that the entire economy didn’t collapse and that they’ll probably recover quickly if the natural gas development pans out.
Back to EU
This entire affair isn’t a good thing for the European Union in the long term. Moody’s ratings agency noted that the way the crisis was handled “increases the likelihood of high-severity tail risks“:
The hard line adopted by euro area governments during negotiations suggests it is more willing than in earlier stages of the crisis to tolerate a risk of inducing financial market disruption when imposing conditions – a willingness designed in part to appease domestic political pressures, particularly in Germany.
The northern European countries, particularly Germany, seem unsympathetic to the plight of the Cypriot people. Just reading some of the commentary of the German press seems to reinforce this idea. In fact, they seem more satisfied that Russia’s tax haven of choice has been shut down (predictably, the Russians are pretty angry, with state-media RT blasting away criticisms and prophecies of doom).
Make no mistake though: this entire incident has taken a hammer to trust in the EU, as well as setting up some dangerous precedents that the EU could possibly replicate at a later date. Only time will tell how big of an effect the Cypriot Financial Crisis will have on the whole of Europe.
Today, Cypriot banks are finally reopening with strict capital controls. In order to prevent bank runs, the following measures are in place: cash withdrawals are limited to €300 per day, the cashing of cheques is temporarily banned, all transactions over €5,000 are reviewed, all transactions over €200,000 are scrutinized on an individual basis, and no one leaving Cyprus can take more than €1,000 with them (€3,000, according to some, not sure myself on the exact number).
In other words, the finance ministry and the government are going to incredible lengths to prevent the Cypriot financial system from collapsing while it’s weak, as they should. Ordinary Cypriots are calm, if a bit edgy, as they line up to collect what they can. How all of this will turn out is yet to be determined.
Things look dim, however, according to new forecasts reported by The Economist:
Cypriots have cause to lament that its rescuers have made a desert and called it peace. The tiny economy has suffered a massive blow. Earlier forecasts by the European Commission that its economy would shrink by 5% over the next two years were bad enough; a shrinkage of close to 20% is now plausible. That will render debt-sustainability forecasts null and void. Cyprus’s bail-out may have saved the blushes of its rescuers, but they may soon have to deliver another one.
Whether European policymakers realize it or not, these events have destabilized the entire euro zone. All the progress that was made in the past few months towards resolving the Euro Crisis has just been undone. As of now, we’re back in the mess.