Eighteen months ago, in the darkest days of the Eurozone crisis, Cyprus barely figured on anyone’s radar. Against the possibility of Greece, Spain or Italy going to the wall, Cyprus was a minnow. Now, even as the danger has receded for the three larger countries, it has grown for Cyprus to crisis levels. Suddenly there is a strong likelihood that, barely five years after joining, Cyprus will become the first country to leave the euro.
That this has grabbed the world’s attention is testament both to the fact that the euro crisis is not as bad as it once was (there aren’t worse stories to drive it off the front pages) but also to the enduring troubles facing the bloc. Perhaps the most interesting aspect is how quickly the talk has moved from bailout to outright exit from the EU. It took two years of missed targets and broken commitments before EU politicians began to speak openly about Greece leaving the euro. During the recent Italian election and the aftermath, which saw anti-establishment parties gain a majority, other countries made a point of not commenting on Italy’s economic viability in the eurozone. So why exactly has Cyprus moved so quickly towards the exit door? And why has the Troika decided to break one of its cardinal tenets, that bank depositors will be paid in full?
To answer, it is necessary to understand that this crisis has not appeared out of nowhere. Since the start of 2012, it has been obvious that Cyprus would have to bail out its banks, and would require external sources of financing to do so. Domestic consumption has largely been flat, and the country’s current-account deficit to GDP ratio has been hovering around the 10% mark for a few years. Almost all economic growth has been driven by the banking sector, which now has liabilities equivalent to approximately 800% of Cyprus’s GDP. Unlike Ireland, which entered its banking crisis with strong public finances, Cyprus’s debt-to-GDP ratio is already 84% and climbing.
In addition, Cyprus has found itself hard hit by externalities. In 2009, tempted by high bond yields, Cypriot banks bought large amounts of Greek debt, and were thus battered when Greece defaulted. Also, in July 2011 a massive munitions explosion flattened the largest power plant in the country. The comparatively low death toll of thirteen meant that it received relatively little coverage in the global media, despite the fact that the scale of the detonation was comparable to that of a tactical nuclear weapon. The direct cost of the explosion has been estimated at nearly €3bn, with additional costs incurred from the loss of nearly half of Cyprus’s electricity supply. As a result of the disaster, the ratings agencies hastily downgraded Cypriot debt.
Cyprus now finds itself in a perfect storm. Its banks are in dire need of recapitalisation and the government’s borrowing position is unsustainable. It has essentially been hit by a combination of the twin factors that drove Ireland and Greece out of the borrowing markets and into bailouts. For fifteen months the Cypriot government has been engaged in quiet talks with the EU/IMF about a loan, alongside the one it already has from Russia. There is one major stumbling block: Will Cyprus ever be able to repay the money?
As it stands, Cyprus’s public debt is just outside the danger zone. In order to bail out the banks and cover borrowing needs, Cyprus would require an additional €17bn, almost exactly 100% of GDP. This would push it’s overall debt position to nearly 200% of GDP, an unsustainable amount. Even at the low end estimates, Cyprus’s bank bailout will probably end up being 50% larger (relative to GDP) than Ireland’s, and may well exceed Indonesia’s bailout in 1997, currently the record holder. Present figures suggest that, prior to the events of the past week or two, the recapitalisation of Cypriot banks would cost Cyprus 56% of its GDP. With the loss in confidence this week, that figure is likely to face a substantial upward revision.
Assuming that Cyprus were to receive the desired sum, a debt restructuring would become inevitable. As the Troika would automatically become the most senior bondholder (a precondition of the previous bailout agreements), the burden of this writedown would fall upon the private holders of Cypriot debt, those who account for the existing bonds. Unfortunately, those bondholders largely consist of Cypriot banks. So the Troika would be bailing out the Cypriot government to bail out the Cypriot banks, who would then require additional cash to cover their losses on Cypriot bonds. In the case of Greece, the banks were smaller and more conservative, and were thus better able to survive a default. The balance sheets of Cyprus’s banks are too weak to withstand any additional asset impairments.
For the Troika, this was a Morton’s Fork. There was no satisfactory outcome. Within the above constraints, only three options existed. Cut Cyprus loose, front them cash that they would never repay, or very quickly find a way to improve the debt position of either the Cypriot government or its banks. Hence the decision to tax deposits. In terms of rectifying Cyprus’s debt position, it makes a lot of sense. Not only does it automatically reduce the banking liabilities, it also provides the government with ready cash that can be used to further improve the balance sheets. In terms of the political impact, however, the decision is irrational to the point of insanity.
Firstly, the banking situation. The claim is that this tax is a one off, but one man’s exception is another man’s precedent. Even accepting that Cyprus is a unique case, that this is a once-off, that its banking debts are too high to be repaid and that it would be wrong for Europe to simply give Cyprus the money will not reassure depositors in Cypriot banks. If, as is likely, the balance sheet is worse than first estimated, will more money be raided? For that matter, bringing this in is guaranteed to worsen the banks’ positions, as the strength of a bank lies in the confidence people have in it. Already Cyprus dithers as to when to reopen the banks, in the knowledge that a bank run is now a strong possibility. All of this was foreseeable. Equally, the tax was poorly sold by both the Troika and Cypriot politicians. The bailout is all that stands between Cyprus and a banking collapse, in which depositors would lose far more. This fact has not been made clear to the Cypriot people, who simply regard it as a raid on their savings.
More than anything, the picture that is coming out about this bailout is one of confusion. Fifteen months of negotiations yielded an agreement that pleases nobody. EU diplomats speak of frustration at Cypriot vacillation. One gets the impression that the deal was the product of exasperation rather than agreement. For its part, the Cypriot government only belatedly started seeking alternative ways of closing the gap between what it needs and what the Troika will give it. Eventually, the inevitable was accepted and depositors were hit.
Cypriots can ask why their country has been singled out for such draconian terms. Nowhere else in the eurozone has targeted depositors. The problem is that the Cypriot case combines reckless economic policies with a very low reservoir of goodwill from the rest of Europe. Since it joined the EU in 2004, it has faced criticisms from other members about its loose business regulations. Cyprus has become a specialist in low-tax offshoring, notably of Russian assets. In addition, Cyprus boasts the fourth largest merchant fleet in the world, due to its status as a flag of convenience and ties to Greece. There is more than an element of reaping what has been sown to the EU’s attitude.
In the political sphere Cyprus has proved to be a nuisance for the EU, particularly in its relations with Turkey. In 2004, when a UN proposal for the reunification of Cyprus with the internationally unrecognised Turkish Republic of Northern Cyprus was put to a referendum in both territories. The Cypriot narrative in the conflict was that the TRNC was the spoiler, and that Cyprus was willing to make any concessions necessary for reunification. As a result, Cyprus was promised EU membership, with or without the TRNC, and the TRNC were told that the only path to EU membership lay through reunificiation. The voters of the TRNC duly obliged, agreeing to reunification by a two-to-one margin. Unfortunately their southern counterparts refused to play ball, with three out of four voters rejecting the the measure. The result: Cyprus entered the EU amidst accusations of bad faith. Since then, the Cyprus issue has poisoned relatons between the EU and Turkey, with the Cypriots stalling all attempts by the Turks to move their membership bid forward.
It is now obvious that Cyprus overstimated the strength of its negotiating position. EU diplomats complain that over a year of negotiations the Cypriots have failed to come up with any concrete proposals as to how to close the gap between what Cyprus needs and what the Troika will give them, assuming that sooner or later the EU would give them what they needed. Similarly, the assumption that Russia might be able to make good on any shortfall wa misguided. While Dmitri Medvedev may fulminate at the perfidy of the EU for targeting Russian deposits (and may well be justified in doing so), the fact remains that the main loser from the activities of Cypriot banks was Russia itself, in the form of lost revenues on offshore deposits. Finally, Cyprus put its faith in the idea that no eurozone country would be allowed to go to the wall. After all, the Troika was quite willing to throw good money after bad in Greece. However, the losses resulting from cutting Cyprus loose would be tiny in comparison to the potential liabilities of a so-called “Grexit”. Nor is it clear that ordinary Cypriots fully appreciate the gravity of their situation. On the streets, conspiracy theories abound. It is a plot by the Germans to destroy the Cypriot financial system, they claim.
It is now clear that, having rejected the deposit levy, Cyprus had no choice but to swallow it. Large depositors could lose up to half their cash. Meanwhile, the financial system exists in a strange halfway house, with capital controls imposed on an EU member state and withdrawals initially limited to €300 a day. Clearly, this situation is untenable. The question is, what happens when the dam breaks? And how long till normality returns?
Assuming that Cyprus avoids a run on its banks, their troubles have only just begun. The loss of confidence in the banks will probably necessitate a bigger bailout than originally agreed. Meanwhile, austerity is likely to take a growing toll on Cypriots over the next few years. Factor in a political system where the Communist party is often in government and the likelihood of Cyprus lasting through a prolonged spell of austerity is slim. The financial sector, a vital part of the Cypriot economy, is going to go into a tailspin. The polity has shown itself to be extremely volatile. As a result, even if the wider global economy steadies, Cyprus may only have put off the day of reckoning. Even the promised revenues from large natural gas deposits may end up being illusory. The vast amount of unconventional fuels coming onto the market means that the medium term price trend for gas is downwards.
The best estimates are that Cyprus will see a contraction of 8-10% of GDP in 2013, with a further contraction in 2014. Its future as a financial centre is nonexistent. Its banks are worthless shells. The rest of the eurozone has no great desire to prop it up. It has lost most of the goodwill it had from Russia. And it now faces years, if not decades, of austerity and uncertainty.
Even when things were at their worst, other European leaders were unwavering in their desire to keep Greece in the eurozone. The rhetoric for Cyprus has been less supportive. Perhaps it is merely a matter of nuance. But in the opaque world of the eurozone crisis, nuance counts. Those Cypriot pounds lying around houses in Cyprus may soon be worth something again.