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.

Krugman's Arithmetic on Cyprus is a bit FUBAR

I generally love Krugman, but his math this morning on Cyprus is not correct.  Note:  I am not in the habit of correcting the arithmetic of Nobel prize winning economists -- I think he is just working off misinformation I think. This morning, Krugman analyzed Cyprus and came to the following conclusions:   Domestic Deposits are 500% of GDP and local real estate was a big part of the problem.

I’ve done some asking around, and cleared up something that was puzzling me. Officially, only about 40 percent of the deposits in Cypriot banks are from nonresidents, which would imply resident deposits of almost 500 percent of GDP, which is crazy. But the answer is that I do not think that word “resident” means what you think it means. Some of the money is from wealthy expats living in Cyprus; much of it is from rich people who have resident status without, you know, actually living there. So we should think of Cypriot deposits as mainly coming from non-Cypriots, attracted by that business model..

Instead of 'asking around', here are the actual figures directly from the Central Bank of Cyprus as of end of January 2013

(1) Deposits:

Total Deposits:  68,420M

Domestic Residents: 42,789M (62.5%)

Non-Domestic EU Residents: 4,748M (6.9%)

Non-Domestic Non-EU Residents: 20,882M (30.5%)

So this would that domestic resident deposits are 225% of GDP , not 500% (Cyprus GDP is a shade under 20B euros in nominal terms, though presumably falling hourly at this stage).

Sure, some of the deposits are actually foreign depositors in the guise of domestic corps, but note that of all domestic depositors, 26,290M is domestic households so 16,056M makes up all domestic financial and non-financial corporations in Cyprus and given that Cyprus does have a real economy, a good chunk of that is true domestic corporations.  The balance is govermental deposits, fwiw.

Also, keep in mind that there are 60,000 British retirees in Cyprus and 40,000 Russians living in Cyprus (the latter, generally wealthy, as it has become a preferred location for rich businessmen to safely raise their families) and their savings will not necessarily correlate with GDP.

(2) Domestic housing loans are 12,601M or about 60% of GDP.  I don't have any comps offhand, but that does not seem unreasonable.

The true issue driving the crisis from the Cyprus perspective are:

(a) yes, a banking sector large for its size but not out of line of similar locations --  Malta, Switzerland, Singapore -- each, like Cyprus, with their jurisdictional advantages and disadvantages -- and a fraction of Luxembourg's (25x assets/gdp).

(b) massive uncompensated losses in the GGB restructuring (25% of GDP overnight) and general commercial weakness in the Greek and Cyprus loan portfolios of the two major banks.   Of course, as Greece and, now, Cyprus are forced into destructive deflation, yes, eventually the commercial portfolio will become a huge problem too.

As before our perspective remains that:

The initial bailout plan was misguided: http://www.cyprus.com/cyprus-bailout-stupidity-short-sightedness-something-else-.html

Cyprus has a series of unappealing options ahead of it now: http://www.cyprus.com/cyprus-bailout---what-to-do-now.html

Cyprus Bailout: What Now?

Yesterday we discussed why we disagreed with the last week's Troika proposal. But since it is easy to disagree but harder to propose something to do, today we analyze what appears to be the latest deal on the table and propose three alternatives of our own, noting that we are working off nothing more than public data. Our strong preference, if it is achieveable, is to accomplish our Scenario B which preserves our long-standing relationships with the EU and Russia and our reputation for rule of law and predictable treatment of issues under long-standing principles of common law. It is the right solution.

If Scenario B is not achieveable with our partners, however, then Cyprus needs to be equally protective of its interests (as they are of theirs) and move fearlessly to Scenario C. This is not a time for muddled thinking -- Cyprus should be clear-eyed about the implications of its decisions as this week will determine the rest of its decade economically...

Read more here:

What Cyprus Should Do...