Cyprus: What’s Next?

It now appears that the Cypriot Parliament will reject the government’s amended plan for haircutting deposits. The revised proposal, which reportedly exempted depositors under €20,ooo, satisfies almost no one–Cypriot depositors, the Russians, nor European creditors (including their increasingly agitated banking regulators).   The government looks ready to try and renegotiate the bailout, but no creditors have stepped up to fill the hole left by the failure of the tax.  There may be pressure on Cyprus for additional fiscal measures, but it’s hard to see that as confidence boosting given the damaging growth effects we have seen in the periphery following aggressive fiscal cutting.

The most likely scenario would seem to be to revise the tax to fully exempt insured depositors.  But how to fill the gap while still maintaining a viable debt path?  One approach would be to restructure the sovereign’s €8.2 billion debt.  I have blogged in favor of this in the past. Whether or not it becomes part of the plan, I think the government will have a hard time explaining to its citizens why external bond holders are being paid in full while they are being taxed.

One thoughtful approach on how to move forward has been tabled by Lee Buchheit and Mitu Gulati.  Their plan has three elements:

1.  Protect all insured depositors (no tax).

2.  Uninsured deposits in excess of €100,000 would be replaced, at par, with interest-bearing and tradeable bank certificates of deposit. A menu of different rates and maturities could be offered, and the CDs could be partly secured by natural gas revenues.  (I would add here that the CDs could alternatively include an option that would pay out if the government is successful in exploiting its natural gas reserves.) This would mean a loss to depositors in net present value, but provides security and principal conservation.

3.  The maturity dates of all sovereign bonds would be extended by five years, without a haircut to interest or principal.

This approach would reflect a rank ordering of creditors that makes sense (and more closely matches the principles of creditor ranking in bankruptcy), as well as a more politically sustainable burden sharing.  It would lock in funding for the banks.  Most importantly, it keeps Cyprus’ main creditors "at the table".  If good policies and a natural gas boom makes Cyprus’ debt and fiscal policy sustainable, creditors would avoid a loss of principal and perhaps even capture some upside; if not, the future restructuring could be calibrated to the need.  Anna Gelpern and Felix Salmon also have analyses of the proposal out.

Whatever path is chosen, they need to move quickly.  The bank holiday is unsustainable for long on political and economic grounds, and if not resolved the question of euro exit could move to center stage.