As deadline looms, Cyprus’ fate lies in the hands of the troika

Cyprus is making a last-ditch bid to negotiate a bailout deal from the IMF, the EU and the ECB. AAP

Last week, the Parliament of Cyprus rejected a bill that would impose a levy of 9.9% on bank deposits over the insurance threshold of €100,000 and a levy of 6.75% on deposits below the insurance ceiling.

This bill was part of a package designed by the government to raise €7 billion and qualify for a further €10 billion bailout from the European Union and the International Monetary Fund.

The decision of the Parliament opens new, uncertain scenarios for one of the EU’s smallest member states. With the economy going through a deep recession and the banking system dangerously near collapse, Cyprus needs international financial support to restore investors/depositors confidence and prevent bank runs and massive outflows of capital.

Time, however, is short. The ECB has said it will cut off the financing that is keeping Cyprus’s teetering banks from collapsing today.

While the government works on a plan B and seeks supports from other international partners (Russia in particular), many suggest that this is yet another example of how EU and ECB (and IMF) seem to be doing their best to worsen — rather than cure — the European crisis.

€17 billion is a relatively small amount if compared to the rescue packages granted to Spain in 2012 (€100 billion), Greece in 2010 and 2012 (€110 billion and € 130 billion, respectively), and Ireland in 2008 (€85 billion). So, why isn’t the troika prepared to provide the whole amount? Why is the Cypriot government being forced to undertake draconian fiscal measures in times of recession?

From stars to dust

Between 2000 and 2008, figures from the IMF showed that economic growth in Cyprus averaged around 3.8% a year. This was significantly higher than average growth in the EU (2.4%) and the Euro area (2%).

The expansion, largely driven by the service sector and the inflow of large foreign capitals attracted by a favourable fiscal regime, came to a halt in 2009, when the global crisis led to a slow-down in tourism and banking.

The explosion of the Greek crisis in 2010-2011 severely affected Cypriot banks, which were heavily exposed to the Greek debt. In 2012, the sovereign debt of Cyprus was downgraded, which made it difficult and expensive for the government to raise finance through international markets. The write-down of Greek debt further weakened the banking sector, starting a credit crunch which continues to choke the economy.

The request for a bailout of €17 billion came in July 2012 and protracted negotiations continued until early March 2013. The EU-IMF agreed to provide €10 billion, but only under the condition that Cyprus would mobilise the residual €7 billion.

On 16 March, Cyprus announced that it would raise €5.8 billion by imposing a one-off levy on bank deposits. The residual €1.2 billion would come from privatisations and an increase in capital gains tax and corporate rate tax.

However, on March 19th, following three days of harsh protests in the streets, the Parliament rejected the levy on deposits, forcing the government to start thinking about a plan B. This includes seeking financial support from Russia (whose exposure towards Cyprus amounts to €55 billion in deposits of corporates and individuals and loans of Russian banks to Russian firms registered in Cyprus) in exchange for access to the gas reserves recently discovered off the Cypriot coast.

A first attempt at implementing a plan B was made on Friday, when the Parliament voted a series of new bills for (i) the restructuring of the banking sector, starting from Laiki Bank (the second largest bank of Cyprus), (ii) the creation of a solidarity fund comprising the nationalised pension funds and other state assets, and (iii) the approval of capital controls to prevent large fund withdrawals out of the country.

It is also rumoured that plan B should include a levy of 20% (some say 25%) on deposits above € 100,000 held at the island’s largest lender, Bank of Cyprus, and 4% on deposits above the same level at other banks. At this stage, it is unclear whether this proposal will have to go through a new parliamentary vote.

Moral hazard and European solidarity

The EU is an economic giant with a total GDP of close to €13,000 billion. Together with the IMF, this giant has already paid more than € 420 billion to bailout some of its most distressed members. Why, then, is the EU being so strict on a mere €17 billion package for Cyprus?

There are two possible explanations. One is rooted in economic theory and the other in political calculus.

The risk in bailing out a country is to induce “moral hazard”: if governments know that no matter what they do, someone will come to their rescue when going bankrupt, then their incentive to adopt sound economic policies is significantly weakened.

One way to mitigate moral hazard is to make sure that the country bears part of the cost of the bailout or, equivalently, that the bailout does not cover the whole of the loss associated with going bankrupt.

This might be particularly relevant in the case of Cyprus, which indeed undertook some risky policies (such as allowing the banking sector to grow to the point where its assets are worth 800% of GDP) in its attempt to attract foreign capital.

€17 billion is equivalent to almost 100% of Cyprus’ GDP. In relative terms, this would be a bailout of massive proportions and hence it would be at higher risk of generating moral hazard. In fact, only Greece has so far benefited from a bailout of comparable size: 50% of GDP in 2010 and 67.1% of GDP in 2012. The bailout of Spain was equivalent to only 10% of GDP, while the one of Ireland amounted to 47%.

In addition to moral hazard, the bailout of Cyprus has some relevant political consequences. The money for the bailout ultimately comes from EU taxpayers and, in many countries, these taxpayers are losing their sense of solidarity.

Cyprus has become a financial hub thanks to its low tax rates, high interest rates offered on bank deposits, and lax application of anti-money laundering rules. Taxpayers in Northern Europe might wonder why they should pay the bill for these “aggressive” financial policies of Cyprus.

Similarly, taxpayers in Italy might not be willing to pay for Cyprus after being squeezed by their own government in the past eighteen months. Overall, EU leaders probably fear that they could lose consensus back home if they were to push this bailout forward. Hence, they prefer to use the stick rather than the carrot.

The unfair levy

While there are reasons that might explain why the troika is unwilling to grant Cyprus a full bailout of €17 billion, it is difficult to make much sense of the choice of the Cypriot government to raise funds through a levy on deposits below €100,000.

Sure enough, corporates and individuals who deposited in Cypriot banks have earned quite a large interest in the past few years. So, it might be reasonable to hit them before any taxpayer in another EU country.

However, €100,000 is the insurance guarantee limit. Taxing deposits below this limit constitutes a dangerous precedent that might trigger panic and bank runs in other European countries.

But there is also the issue of fairness. This levy asks smaller savers to bear a large share of the cost of the crisis while senior bank bondholders, sovereign debt-investors in Cyprus, and depositors in the Greek operations of Cypriot banks remain largely untouched.

A plan B that excludes a levy on lower deposits and increases the levy on deposits above € 100,000 is somewhat of an improvement on the original plan. Still, one wonders how the rich international investors and depositors who chose to send their money to Cyprus would react to a levy of 20% (or higher).

One way or the other, Cyprus has to recapitalise its banks. One option would be for the EU to give money directly to banks (rather than the government) through the European Stability Mechanism. But this option does not seem to be on the table at this stage.

The alternative might be a strong intervention of Russia. For instance, Gazprombank, the bank of the gas corporate Gazprom, might be willing to absorb Laiki Bank at zero cost, provide the € 4 billion necessary to its recapitalisation, and get a share of Cyprus’ gas. The Russian rescue of Cyprus would probably be the most evident failure of the EU approach to the crisis, at least so far.