Pop Quiz: How Big Is the Bailout Of Cyprus?

Most publications talk about the 10B or 17B Cyprus bailout.   Let's take a pop quiz on the right answer (a) 17 B Euros (89% of GDP)

(b) 10B Euros (52% of GDP)

(c) 2.5B Euros (13% of GDP)

(d) -3.0B Euros (-15% of GDP)

(e) -7.5B Euros (-39% of GDP)

Now let's work through the answers, in steps:

(a)  The 17B figure was calculated assuming the bailout would provide 7B for the banks.    The final number provided not a single Euro for the banks who were asked, against the approach taken in the last 147 banking crises worldwide tracked by the IMF, to find the whole 7B out of their depositor base.   So, part (a) is wrong

(b) The remaining 10B is described as a bailout of the government.  Of this 10B however, 7.5B is being used to refinance maturing debt.

This debt, I would guess, is mostly at this point beneficially held by ECB.   This is just an assumption, but we know that 75% of it was held domestically, largely by the banks.   This was probably the first collateral pledged by the banks via the ELA, so ultimately if the Central Bank and the government default it will ultimately fall on the ECB's balance sheet.   The 25% is probably traded internationally and, again outside of Cyprus hands.

So, the 7.5B is being lent to Cyprus in order to be paid right back to Europe.   That is not charity, that is 'hiding their embarrassing losses until later when someone else is in office'.    If moral hazard requires clueless Cypriot retail depositors to pay for their banks' decision to lend to the insolvent Greek government, then presumably it also applies to the financial wizards at ECB that lent to the insolvent Laiki, despite having full access to their financial information.

That leaves 2.5B of fresh financing for the government which I will concede is new money, though until we see the Memorandum and the terms under which we receive this money, I am not too excited about it.    Cyprus could raise this amount domestically so long as it did not have to do it overnight (which it does not - it is to fund deficits over the next few years).

(c) Does that mean that 2.5B is the right answer?  Not really, see below.

(d) At least 5.5B of the ELA taken by the banks (I suspect it is more) was for losses in the Greek branches of the Cyprus banks.    These branches have 15B of deposits that presumably could have also been haircut, along with the Cyprus-based deposits, to make up for the losses.   Yet, under tremendous time pressure, they were sold to a Greek bank (very suspicious), while the liabilities (the ELA) stayed in Cyprus and are now, beyond all logic, is being transferred to the Bank of Cyprus.

We can call this: "Cyprus Contribution To Recapitalization of Greece, Part II".    And since Greece is insolvent and illiquid without EU assistance, it is really assistance to the EU.

Given that, it is perfectly fair to subtract it from the EU's assistance back to Cyprus.   That takes us to -3B

(e) The Greek PSI (write off of Greek government debt, implemented by the EU) impacted Cyprus, as Greece's neighbor, in a wildly disproportionate manner.   Cyprus banks took 4.5B in losses there.

One could have imagined a solution at the time that partially compensated Cyprus for these losses.  In any case, it was a contribution by Cyprus in reducing Greek public debt and given Greece is backstopped by the EU, it reduces the EU debt load, so that is how we get to -7.5B.

Cyprus has certainly contributed to Greece's bailout on a per-capita basis at a level vastly exceeding any of the nations that are putatively suffering from "bailout fatigue".   Cyprus, voluntarily or not, has contributed around 5% to Greek public and private debt reduction, despite being 0.2% of the European economy, so a rate of 25x the European average, plus or minus.

The apparent "thank you" from the EU, is to try to talk down the main basis of the Cyprus economy (financial services) and aim to destroy the rest of the otherwise fairly healthy Cyprus economy by sucking all liquidity out of the system, literally overnight.

I would grade (d) or (e) as correct answers.    But I don't see any version of the numbers where Cyprus is not a net creditor to the EU bailout regime, as opposed to a net beneficiary.

Stop The ELA

Dear Lawyers of Cyprus, Instead of getting pointless injunctions to preserve the existing Bank of Cyprus shares (that are worthless in all future scenarios), spend the time to figure out how to block the ELA transfer from Laiki to Bank of Cyprus which will preserve a few Billion euros worth of deposits.

It is hard to imagine how it is constitutional to force the liabilities of one private company onto another private company (while simultaneously stripping both company's Greek assets), just because the CCB/ECB does not want to recognize the reality that it has a loss on its hands due to its extension of ELA to the obviously wildly insolvent Laiki (which it extended in direct contradiction of its own regulations and policies).    Just in that one sentence, I can see three possible areas to attack this move.

Note: I understand that the Government of Cyprus backstops the Cyprus Central Bank and would become liable for these obligations.    Obviously the government will have to extend the maturities of these obligations and/or otherwise negotiate an approach.    But at least that is a negotiation between two parties that have some ability to negotiate, not an asset grab from powerless retail depositors.

The Cyprus Solution & Likely Implications

The Plan Watching the Eurogroup conference call, the agreed plan appears to be:

1.  Laiki is resolved via good bank / bad bank, with uninsured depositors (4.2B) most likely losing everything (along with shareholders and bond holders).

2.  Bank of Cyprus will have a bail-in of uninsured depositors losing between 30-40%.  Shareholders and bond holders will be wiped out.

3. Troika will lend 10B to the Cyprus government, solely for fiscal purposes and based on a memorandum to be determined.   None of the troika funds will be used for the bank bailout.

4. Insured depositors will be protected (sub 100K euros).

5. The 9B of ELA at Laiki will be transferred to Bank of Cyprus.   This is the single most bizarre and unfair part of the agreement.    It has not been discussed why the Bank of Cyprus creditors should be paying for the ELA of Laiki and no reporter pressed with a follow-up question.

6. Note that for the most part the bailout is NOT hitting the Russian depositors but will hit local Cyprus depositors hard.

Some Learnings

1. At the end of the day, the appropriate rule of law approach held for the most part.   This is a variation of our Scenario B.

Shareholders, bondholders and shareholders of the banks with the problems are the ones facing the consequences.   Depositors at other banks (that are solvent) are not touched.  This is what should happen under normal rule of law.   Given that the EU is *not* actually giving any money for this restructuring, Cyprus could have done this bank restructuring themselves anyway without this drama and reputational destruction re: its financial services industry.

The glaring exception to this is the transfer of the ELA transfer from Laiki to Bank of Cyprus which I simply cannot rationalize.    Greece should be taking some of this pain given that a large part of this ELA was to finance losses in Laiki's Greek branches.   In any case, I am not sure *why* Bank of Cyprus creditors should be expected to take responsibility for Laiki's official creditors...

2. Given that the fiscal situation in Cyprus was not too bad even as recently as 2008, one could have imagined if the prior government had been more serious about fiscal consolidation, the amount of the fiscal bailout could have been reduce to a level manageable in public markets.

3. Putting #1 and #2 above, if Cyprus had bitten the bullet itself and inflicted (severe) pain on itself, this all could have been avoided.   In other words, Cyprus assumed that the pain might be spread out via the troika.   In practice, what happened is that it had to absorb all its pain anyway, but with the extra dose of public humiliation.

4.  It is not a pretty sight being a small EU country and coming to the EU for help.   Malta, Luxembourg and Latvia, take note...

Implications

1. This will have an immediate negative effect on the local real economy through two mechanisms: (a) loss of savings of consumers hitting consumption and (b) partial or full loss of operating accounts of local businesses.

2. Additionally, the financial services sector (45% of the economy) will take a severe blow.   There is some mild mitigation in this approach in that, basically, Cyprus took all the pain itself and other foreign banks operating on the island (aka Russian Commercial Bank) have been spared.

On the positive side, there might be some ability to retain a few more customers under this approach rather than the across the board levies initially proposed.

3. Net net, we should expect a drop in GDP over the next 2 years in the 20-30% range.    This will inevitably lead to significant social and business disruptions and hardship and greater need for fiscal consolidation (as certainly tax revenue will shrink and automatic stabilizers will increase).   Government employees, take note...

4. Overall, this will be a very severe recession / depression.

How to Grow Now

So, what does Cyprus do now?  It still has a highly educated workforce and would need to find something to do with it to avoid major brain drain and permanent diminution of its prospects.

1. Find a way to eliminate the capital controls as quickly as possible.   Not much else is going to happen with capital controls in place.

2.  Preserve as much of the financial services business as possible.   This solution does at least allow a window for that to happen.

3.  Push more aggressively on tourism related improvements - in particular, casinos should prove interesting given its geographic location (no country really ever replaced the hole left when Beirut lost that role in the 1970s)

4.  Promote higher education.   We have links to the University of Nicosia so are biased, but Cyprus has a surprisingly advanced private university system.   With a few small tweaks to legislation, it could be a significant growth driver

5.  Professional services outsourcing.   The workforce is highly skilled, but still probably 50% less expensive than London and Western Europe.

6.  [longer-term] Start building technology capabilities.   It is a good fit for a small, highly educated nation.

None of the above will be easy, but Cyprus did perform miracles economically after the Turkish invasion in 1974.   This is the chance to aim for an Act 2 in this regard.   And, cliched as it is, its greatest asset is its people.

It is time to dig deep and start again...

Time to Play Hardball

Here is the current state of play: (1) Cyprus agreed to break up Laiki (2nd largest bank) into good bank/bad bank structure, imposing huge losses on the uninsured depositors (they have announced 40% but the real number will be 90% plus - in the meantime 100% of these deposits will be frozen for years).   This is right and fair, albeit very harsh locally.

(2) Cyprus agreed to put huge haircut on uninsured depositors of Bank of Cyprus (largest local bank) -- in the 20-25% range.   Hysterical smears in the Western press aside, depositors >100K euros in Bank of Cyprus are primarily local individuals and, more importantly, local businesses (only a single digit % of all Bank of Cyprus deposits are Russian - about 1B euros).

Bank of Cyprus is the main money center bank in Cyprus (Laiki is #2) and at the heart of most commercial utility banking transactions so this will have a large effect on working capital / liquidity of local real-economy businesses.

#1 and #2 above are a major concession for Cyprus, along the lines of our Scenario B here, in that it protects foreign depositors in solvent banks.   It is noble though I think a bit quixotic.   After the burning Cyprus has received, we really should be considering our Scenarios C and Scenarios D to make the debt load bearable.

However, it does not appear that the Troika has any interest in any solution that does not leave Cyprus in the Stone Age, banking-wise.

The current *NEW* ask from the Troika is that Bank of Cyprus assumes the 9B of ELA that Laiki has.   I can not think of any possible reason why it should do that:

(a) Why is it the Bank of Cyprus's problem that the ECB is going to take losses at Laiki?

(b) This would immediately make Bank of Cyprus insolvent, leading to an even larger (60-90%) haircut of Bank of Cyprus uninsured deposits (which are, I repeat, overwhelming local businesses).

Cyprus is already headed to a 25-30% drop in GDP based on our predictions just from:

(1) Reduction of financial services business (45% of GDP, pre-crisis)

(2) Reduction in consumption from confiscation of deposits

(3) General austerity

If Bank of Cyprus is also sent into full resolution, a large majority of the non-financial businesses in Cyprus will never re-open and economy will revert to, I dunno, bartering goat cheese...

If this is what they are pushing Cyprus toward, then Cyprus has nothing left to lose.   It is time to pull the hand grenade in the negotiations, as follows:

1.  Announce a 100% haircut of depositors in the Greek branches of Bank of Cyprus and Laiki.   They are branches of the Cyprus parents, so I believe regulated by the Central Bank of Cyprus, not that of Greece.

This will save 8B euros, which coincidentally be very close to the 7B they have cost the Cyprus people (5B of ELA + 2B of absorbed losses).   It has the virtue of allocating blame where it is due.   Moralizing aside, Cyprus is not bankrupt because Russians may or may not be evading their taxes to the Russian Treasury nor because of local profligacy.  It is bankrupt due to the Troika led PSI and subsequent depression in Greece.

It is time to throw those losses back where they belong, in the hands of Greece and its handlers.

2. Announce pending default on the sovereign debt payment in June (yes, a lot is held by local banks, but not all of it) and on the ELA

3. Large haircuts of non-EU depositors in Cyprus (no offense to anyone, but I think the offshore sector is gone anyway.  If need be, you can always do a side deal later with Russia for some compensation if it is strategically important).

4. Whatever local haircuts and pension plan nationalizations are needed to make up the difference

Is that the end of Troika assistance plan?  Yes.

Does that mean we go to the Pound?  Not sure, have not run the numbers, but there are quite a few tens of billions available in 1-3 to confiscate, so it is just conceivable that, with capital controls, you could squeeze by if the cuts are deep enough.

But whether it is hard default within the Euro or return to the Cyprus Pound, it is hard to imagine this is worse than 90% haircuts of Laiki and BoC large depositors, aka almost every functioning business in Cyprus.   If the Troika is compelled to set Cyprus back several decades, we can at least do it with honor and on our own terms.

And this at least puts some pressure back on Troika to:

(1) Explain despite 2 weeks of assurances that it is a Cyprus-only problem, why there are suddenly depositor haircuts in Greece that either need to be bailed out by Germany (Greece certainly does not have the money) or set a precedent that depositor haircuts can happen anywhere in the  EU

(2) Discover if the irreversability of the euro is real or not.