Why Cyprus Matters

Cyprus measures 0.2 percent of the Eurozone economy.  A proposed rescue package is only €17 billion, of which perhaps €9 billion will be used to recapitalize banks weighed down by bad loans and losses on the Greek government debt.  A new government has signaled its commitment to reform, and creditors want to get a deal done by end month, before government cash reserves run out and well ahead of a €1.2 billion June debt maturity.  Yet, as European leaders meet, negotiations look to be deadlocked.  What happens next matters:  because of concerns about contagion and for what it tells us about the future course of European policy, Cyprus punches above its weight.

The problem, which we have seen before through the periphery of Europe, is that the proposed package will leave Cyprus with an unsustainable debt level and an economic reform path neither markets nor policymakers believe can be sustained.  If the entire package is financed with new lending, Cyprus’ debt rises to from just over 90 percent of GDP today to around 140 percent GDP. Optimists note that Cyprus has large natural gas reserves that will ultimately provide the resources to make good on the debt, but there are significant political and economic hurdles to overcome to make that happen.  Given fiscal and structural imbalances and negative growth, it’s hard to make a convincing argument the program will succeed.

A restructuring of Cyprus’ liabilities would both reduce the near term financing needs and provide a sustainable level of debt in the medium term, as well as help creditors with the politics of a bailout of a banking system alleged to have facilitated tax avoidance and money laundering.  The debate appears centered on uninsured or large value deposits, and subordinated debt of the banking system. Deposits could be haircut through a domestic “solidarity tax” or restructured through a conversion of demand deposits to term deposits.  This seems the most likely scenario, but substantial concern about contagion to deposits in other periphery countries has prevented agreement.

A second option would be for Europe, concerned about contagion and loathe to admit that Greece was not unique, to kick the can down the road with a financing package that leaves bank and sovereign creditors untouched.  The problem, in addition, to the optics of rewarding bad behavior, is financing the larger gap.

A better approach would be to look at the full range of liabilities that make Cyprus’ position untenable, including the sovereign as well as the banks.  That would point to both a restructuring of the government’s private external debt (PSI), and for relief on its official sector claims (OSI).  The former seems unlikely given Europe’s concerns about contagion and precedent, while the latter is a red line Europe will not cross, at least not before German elections this fall.

An external debt restructuring could be done quickly, would allow the burden sharing to be spread more broadly, and even if done on relatively market friendly terms would have the advantage of keeping private creditors “at the table.”  In contrast, delaying the restructuring with a series of short-term financings allows private creditors to exit, putting more of the cost of restructuring on European governments.  Some would welcome that as part of their federal vision for Europe, but it’s hard to see how that helps Europe to get to the governance reforms necessary for better crisis management.

Cyprus is pressing for agreement on a package by the end of the Month, before the government runs out of funds.  During this period, the primary source of funding for the government is likely to come from domestic banks, which in turn are funded by the Emergency Liquidity Assistance (ELA) facility through national central banks.   The harder deadline is a June 3 external debt amortization.

Finally, here are five issues or questions to keep in mind while watching the debate unfold

1. Mind the Gap.  There has been talk of assuming a smaller gap, perhaps E10 billion, through rosy assumptions and perhaps delaying the full recapitalization of the banks.  This likely would be resisted strongly by the IMF and experience suggests that would be counterproductive, further undermining the credibility of the package.
2. Imf – In or Out?  In addition to the financing challenge, the IMF reportedly has serious concerns about the sustainability of Cyprus’ debt, and wants debt to GDP to be reduced to around 100 percent no later than 2020, and perhaps sooner.   If the program goes ahead, without any bail-in or on unrealistic assumptions, the IMF could withdraw its financial support for the program (while continuing to provide technical assistance and an assessment).  As with Spain, an EU-only financing package provides Europe with more flexibility to kick the can, at the risk of a loss of credibility.
3. What’s the “adjusting” finance?  Recall that, in Greece, the financing gap was not filled until the last minute, and the residual or adjusting finance came from an increased haircut on private bondholders.  Similarly, this negotiation is likely to noisy, contentious, and come together only at the last minute.  How will the financing gap be closed at the end? There are hopes in Europe that it will be the Russian government, given the involvement of their citizens in the Cyprus financial system.  I’m not sure why Russia should agree, beyond perhaps an extension of maturing claims.  For this reason, the debate on PSI is not over.
4. What does it all mean for Greek banks?  Greek banks could be hit hard by any restructuring in Cyprus, and a desire not to undermine the recent bank recapitalization there would work against a bail-in of private creditors, or lead to a Greek carve out.
5. How does Italy figure in?  There is little question that the Italian elections have changed the political dynamic in Europe.  But how will this play out here?  Public reaction against austerity argues for more gradual paths for fiscal adjustment, and thus more financing.  Facing significant Italian uncertainty, some feel policy should take unnecessary risk off the table, so why go for PSI now?  On the other hand, one could argue that Italy makes it all the more important that Cyprus be held to a strong program, with burden sharing.  To do otherwise would suggest that bad behavior is rewarded while serious efforts to adjust are not.