My thoughts on the Cyprus bailout

Here are some quick points on the Cyprus deal which the Eurogroup agreed to last night. The agreement outline is very much along the lines of what I have been recommending regarding bail-in guidelines (extended version here for subscribers) and is therefore a much fairer deal than the deal presented to Parliament last week. But the debt sustainability of the sovereign remains a question, as do the capital controls and potential for deposit flight. The Cypriot economy will not do well in the coming years.

The full note for Credit Writedowns Pro subscribers is after the jump. Also note that I am visiting relatives in Germany during the next two weeks and will not post regularly during that time.

We have seen the terms of the deal hammered out last night at the 11th hour. What remains to decide is how the capital controls will be implemented and what level of haircuts uninsured depositors in Cyprus’ two largest banks will take. Both of these decisions rest with the Cypriot government and central bank. The Cypriot legislature will not vote on this deal because the bank resolution process being implemented falls under the existing resolution scheme which the legislature recently passed.

As it stands, Cypriot banks are scheduled to re-open on Tuesday. At present, there is a 100 euro limit on ATM transactions and wire transfers out of the country have been blocked. Likely, controls of these sorts will continue to be in place after the banks do re-open, with cash withdrawals also being limited. The pace at which these controls are lifted is uncertain, but is entirely dependent on how Cypriots react when the banks re-open. What we do know from situations in which capital controls were applied previously is that they are easier to erect than to tear down. The closest analogue we have here is Iceland, where four years later the controls are still in place.

Assuming everything goes well – something I would consider a bad assumption – the capital controls aspect of this decision is probably the most troublesome. In my post running through unilateral Cyprus exit scenarios, I said that the fact that capital controls are in place makes a euro zone exit easier to execute. And in fact, Cyprus already has a de facto national currency through the mere fact that a euro in a Cypriot bank is not interchangeable with a euro in a German bank or a Dutch bank. We can legitimately talk of Cypriot euros and other euros now. And this makes the exit plan I outlined easier, though politically it is unlikely to be given any consideration.

I have seen an interesting piece by Anatole Kaletsky suggesting that the Russians could still intervene and bail the Cypriots out, helping them convert their economy into a Ruble-based one. It is an interesting thought piece from a geopolitical perspective but unlikely to happen. However, what is key there is that it also depends on the already existing capital controls, meaning that Kaletsky also recognizes the potential to exit the euro zone is greatly enhanced by the capital controls, giving Cyprus a unique position of leverage.

As I have written in the past regarding the German political situation, there is no appetite nor is there any ability to sustain further bailouts for periphery countries. Germany is concerned about its own public finances, which have deteriorated in the wake of the crisis. Immediately after the Greek haircut for private investors last year, there was clear shift in support toward private sector involvement in all future EU rescues. During the Spanish crisis, a group of academics in German-speaking countries put together a manifesto of support for bail-ins, outlining the best way to conduct them going forward. This was two weeks before Germany was put on credit watch by Moody’s. So the support for bail-ins is only going to be that much greater now, especially in an election year.

The original bailout was indiscriminate, bailing in all depositors, both insured and uninsured in solvent and insolvent banks. As I said in my New York Times article, this makes no sense whatsoever. Why have a deposit guarantee if government can capriciously tax deposits this way? The deal was a half-cocked, ad-hoc fudge and the bail-in terms were deeply unfair. This is why the deal was unanimously rejected by the legislators.

The new deal follows bail-in principals by moving up the capital structure chain, wiping out equity shareholders and bondholders before coming to depositors. Moreover, while the deeply insolvent Laiki bank will be resolved and liquidated, the Bank of Cyprus will be recapitalized. Unfortunately for Laiki, this means that Laiki uninsured depositors are likely to lose a lot of money due to that bank’s insolvency. Reports still circulate suggesting the loss will be 40%. And because uninsured deposits in Laiki are frozen until the resolution is effected, it puts a huge burden on the banks’ customers, some of whom were just conducting ordinary business and now have no access to liquidity.

On the other hand, insured deposits from Laiki will go into Bank of Cyprus, which will be recapitalized to a 9 percent level by bailing in the uninsured depositors in a debt for equity swap. Therefore, all insured depositors, including the ones at Laiki and Bank of Cyprus, will remain untouched. Moreover, Bank of Cyprus will be a better capitalized and safer bank after the deal. Perhaps much of the equity capital owned by uninsured depositors will be available to sell at a later point, reducing capital losses.

This is very much in line with the European bank resolution scheme, which is scheduled to go into effect in on 1 Jan 2018. Under those guidelines, shareholders and unsecured creditors will be wiped out before any public money is used to deal with insolvent financial institutions. The difficulty in the case of Laiki and Bank of Cyprus was that the majority of the banks’ liabilities was in the form of deposits with only a thin layer of bonds. And it is this fact which has made depositors have to suffer so much. The principal of the bail-in, however, is sound. And the outcome here is probably the best we could have hoped for.

A long road lies ahead of Cyprus though. The Cypriot government is shut out of capital markets as it cannot finance itself at acceptable yields. The government therefore is to get 10 billion euros of bailout funds in quarterly instalments in exchange for the typical austerity conditions we have seen elsewhere. This will cause the economy to contract, widening budget deficits and increasing public debt. Capital flight will further reduce credit and shrink the tax base. Moody’s doubts whether the debt trajectory is sustainable and says Cyprus could still default. I agree and I should point out that accelerating a default is advantageous for Cyprus because it would also make an eventual euro zone exit less onerous.

Bail-ins are a more proper way of rescuing countries and financial institutions in the euro zone than state-financed bailouts if they can be effected without creating a chain-reaction of bankruptcy. As the German-speaking academics wrote in July, the fact that private sector involvement occurs also helps to break the tie between the state and the financial system. However, in the case of Cyprus, the fact set worked against a good solution. The Cypriot banks had no bond holder buffer for depositors. The banking system is an order of magnitude larger than the economy due to the size of the financial sector. And the bailed-in institutions are the largest banks in the country, making the economic impact that much greater. What’s more is that the private sector involvement in Greece is the direct cause of the bank failures in Cyprus as these banks were heavily exposed to Greek sovereign debt. This tells you that contagion has to be a very real concern regarding the bail-in principal and is a major reason governments in Europe and the US have used state funds to bail out institutions in the past. We have to suspect that the Germans in particular were concerned in the Irish case about the knock-on effect of an Irish bail-in on German banks. So there is certainly some political maneuvering and self-preservation going on here.

Now, bailouts like the Irish one are no longer an option. Like it or not, bail-ins are going to be the way bailouts are conducted in the euro zone from here on out. Spanish, Italian, Portuguese and Slovenian depositors should take notice. Spanish bank creditors in Germany and France should take note as well. Ultimately, the jumpiness of depositors, having seen what occurred in Cyprus, and the interconnectedness of Europe’s financial system will make bail-ins more difficult. Cyprus is tiny and is much more of an exception than a rule.