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Satyajit Das: 6 Ways the Cyprus Solution Will Exacerbate the European Debt Crisis


Irrespective of the fate of Cyprus, the way the problem was solved has set a dangerous precedent.

Financial markets have taken Cyprus in their stride. But it is important not to underestimate the potential fallout.The impact of relatively small events is unpredictable. The 1931 collapse of the small Austrian bank Creditanstalt precipitated a major financial panic. One the smallest countries in Europe with little over 1 million people and about 0.5% of the European Union (EU) economically, Cyprus, may prove a key inflection point in the crisis.

The well anticipated EU bailout package included the controversial provision that ordinary depositors pay a "tax" or "solidarity levy" on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits. The deposit levy was 6.75% on deposits of less than Euro 100,000 (the ceiling for European Union account insurance) and 9.9% for deposits above that amount.

The unprecedented write down of bank deposits was designed to raise around Euro 5.8 billion to reduce the size of the required bailout package to Euro 10 billion, consistent with the requirements of the International Monetary Fund (IMF) and eurozone members like Germany. It was also designed to avoid losses to the European Central Bank (ECB) which has major exposures to Cypriot banks via its Emergency Lending Assistance (ELA) Program, estimated at as much as Euro 10 billion.

Commentator Karl Whelan's memorably described the EU proposal to allocate part of the burden to depositors as "a stupid idea whose time had come".

Initially, the parliament in Cyprus failed to pass the necessary enabling legislation.

Cyprus explored alternative strategies including confiscation of pensions, additional taxes, and other sources of funding. Unsuccessful discussions were held with Russia for a financing package to secure Cyprus' position and protect the interests of the Russian state, its citizens, and banks who have substantial exposures.

With no other source of funding available and the ECB threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse.

Under duress, Cyprus and agreed an amended plan on March 25, 2013. Whilst maintaining most of the original elements, the plan appears to amend the deposit levy.

"Small" depositors (below Euro 100,000) will be protected, being exempted from the levy.

A major restructuring of the two largest banks will take place. The troubled Laiki Bank will be divided into a good bank (including small depositors and emergency ECB funding) to be absorbed into the Bank of Cyprus and a bad bank which will be liquidated over time. Shareholders, bondholders, and ultimately larger depositors in Laiki Bank will have to absorb losses, the size of which is uncertain. There are some suggestions that losses may be capped at 40%. Shareholders, bondholders, and large depositors in Bank of Cyprus will then be written down so that the bank achieves a capital ratio of 9%.

Other measures include "temporary, proportionate and non-discriminatory" capital controls to prevent funds being taken out of Cyprus. There will also be a reduction in the size of Cyprus' financial sector to the EU average by 2018.

Two aspects of the agreed package are noteworthy. The bailout package (Euro 10 billion) cannot be used to re-capitalize banks, which limits its utility.

The plan does not need Cypriot parliamentary approval as it is no longer a "tax." The transfer of losses on large depositors takes place under recently adopted bank restructuring laws passed at Brussels' insistence.

The measures stave off the risk of immediate collapse and Cyprus having to leave the Euro. But the plan does not address Cyprus' problem.

As in Greece and Portugal, privatization proceeds and the revenue from increased taxes may not reach targets.

The bank restructuring plan may not raise sufficient funds. It will encourage remaining deposits to flee Cyprus when capital controls are eased, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance, entailing further write offs in a depositor's fund.

The proposed restructuring effectively cripples the Cypriot banking industry, which is a major part of the economy and employs over 50% of workers. The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations.

Russian businesses are unlikely to continue to patronize Cyrus. Press reports quoted one Russian business man's wry observation that the EU had killed Cyprus in one day: "When the Russians leave who is going to stay at the Four Seasons for $500 a night? Angela Merkel?"

Economic activity in Cyprus is expected to contract by between 15-25% over the next few years. Unemployment will also rise. The slowdown will reduces Cyprus' capacity to pay back its creditors.

Irrespective of the fate of Cyprus, the solution adopted will exacerbate the European debt crisis.

Firstly, the transfer of losses to depositors creates a dangerous precedent. In 147 banking crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses.

Depositors in weak banks in weak countries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain.

If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.

Banks runs and capital flights are difficult to control once they commence. As outgoing Bank of England Governor Sir Mervyn King argued it was not rational to start a bank run but rational to participate in one under way.

Secondly, the Cyprus bail-in provision will make it increasingly difficult for European banks, especially in vulnerable countries to raise new deposits or issue bonds. The ECB, national central banks, and governments will have to cover any funding shortfalls.

Thirdly, the Cyprus arrangements undermine the credibility of the ECB and EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability.

The ECB's OMT (Outright Monetary Transactions) facility allows it to purchase sovereign bonds to assist nations to finance and lower their cost of borrowing. The facility, which has not yet been used, requires the affected country to apply for assistance. After Cyprus, it will be politically difficult for countries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits.

Cyprus highlights the shortcomings of the EU's much vaunted "banking union." The arrangements did not provide sufficient funds to undertake any required re-capitalization of banks, an alternative to the levy on deposits. Cyprus also highlights the lack of a eurozone-wide consistent deposit protection scheme, backed by EU funds.

Fourthly, the Cyprus package highlights the increasing reluctance of countries like Germany, Finland, and the Netherlands as well as the IMF to support weaker eurozone members. Domestic political consideration and popular resistance to commitment of further taxpayer funds to such bailouts make such assistance increasingly problematic.

Fifthly, the negotiations surrounding the Cyprus bailout revealed policy maker's lack of understanding of the problems and the effects of policies. It also revealed significant differences between eurozone members and also between Europe and the IMF.

Sixthly, the EU by agreeing to potentially indefinite capital controls has effectively created a two tier euro, undermining the single currency in the long term.

The problems in Europe will affect the US is many ways. Europe is America's largest trading and the slowdown in economic activity will affect exports and also American businesses operating in Europe. Second order effects will include the effects on China and other emerging market which trade with Europe, which will flow on to US businesses.

A second channel of transmission will be the currency markets. The weak US dollar has assisted the US economy. Concern about the European real economy and also the debt crisis will put upward pressure on the dollar, which will reduce American export competitiveness.

A final channel of transmission will be the banking system. Problems in European banks, including funding difficulties, will flow through into large US money center banks, which in turn will pass them on to smaller banks and the US financial system.

In any debt crisis, there are several possible methods of allocating losses. The borrower bears the losses, either through austerity or bankruptcy. The lenders bear the losses. Some rich relative (in Europe read Germany) bails out the indebted borrower. Another option is to just to ignore issues, fudge the numbers, and hope that fortunate events will remedy the problems. Europe has now tried all of the above.

Unfortunately, in each attempt at resolution, as shown by the proposed Cyprus package, the measures have become the problem rather than a solution. Unfortunately, the Europe's problems will not stay confined to Europe.
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