We have a deal. After another memorable weekend in the so-far short but fateful life of the single currency, Cyprus and the Eurogroup finally reached an agreement on a package that, for the time being, should keep the island in the euro area. Within the detail:
- The lamentable deposit levy proposed nine days ago has been ditched, and so insured depositors (i.e. those <€100k) will be fully protected;
- Instead, the two largest banks – Laiki and Bank of Cyprus, which account for more than 40% of deposits – will be restructured;
- Laiki will be resolved immediately, with a ‘full contribution’ from equity shareholders, bondholders and uninsured depositors. And it will be split into ‘good’ and ‘bad’ banks, with the latter to be run down over time;
- The ‘good bank’ will be folded into Bank of Cyprus (BoC), with uninsured deposits in BoC frozen until recapitalisation has been effected;
- The ECB will provide liquidity to Bank of Cyprus, which will be recapitalised through a deposit/equity conversion of uninsured deposits (expected to imply a loss of no more than 40%) with a full contribution of equity shareholders and bond holders;
- The banking sector as a whole will be downsized to EU average size (i.e. more than halved) over five years;
- It is not clear whether the banks will reopen tomorrow. But when they do reopen, capital controls will be enforced and those are likely to be in place at least until the banks have been placed on a sound and secure footing, a process likely to take many years;
- In addition to the bank restructuring, other measures mooted nine days ago – including an increase in the corporation tax rate – are being demanded;
- The financing facility of €10bn should be agreed by the ESM Board in the third week of April. However, while further Cypriot legislation will not be required to enforce the bank restructuring and controls, removing the immediate possibility that the democratic process could inconveniently intervene as it did last week, the package will need to be endorsed by Parliaments in certain core euro area countries, most notably Germany.
Despite having its near-term future within the euro area secured, however, the outlook for the Cypriot economy now looks horrific, with the hit to large-scale (including business and pension fund) deposits, capital controls and an inevitable severe credit crunch likely to see an economic contraction and increase in unemployment at least comparable to that suffered by Greece. For a country where support for euro membership was already very low even before the past week’s events, popular support for the euro will only be undermined further by the ensuing economic depression.
Looking ahead, although the Eurogroup and IMF might insist for now that the Cypriot government debt stock, expected to rise above 140% of GDP next year, will remain sustainable, that seems most unlikely. As with just about all the other bailout packages, the larger-than-assumed economic contraction will decimate tax revenues and leave debt targets unrealistic. Odds on that, come the first or second Troika review, Cyprus’s government debt will be projected to surpass the target of 100% of GDP in 2020. And so, with further austerity, on top of the required adjustment this year of 4.5% of GDP, likely to be impossible, the chances are that the programme will need to be amended, possibly to include further haircuts if the IMF in particular is to be kept on board.
The euro area, meanwhile, will have been widely bruised and scarred from the experience of the past ten days. Although it remains just about intact, one of its key features, the free movement of capital, is now severely deformed by the Cypriot capital controls. And events in Cyprus can only serve to provide a further drag on confidence and growth in the euro area as a whole at a time when both were already under severe pressure.
While a run on peripheral banks is not to be expected, it seems inconceivable that, having seen what’s happened in Cyprus, depositors will not now be much more careful about where they put their money for fear that it will be frozen or, even worse, expropriated. That will intensify funding pressures on peripheral banks, pushing interest rates even higher and further hampering economic recovery. For Greece, meanwhile, the exposure of its banking sector to Cyprus (€16bn or so) potentially compounds the likely shortfall in its third bailout package that was always going to need to be addressed after the German elections.
Moreover, who can confidently predict that, having bailed in a wider group of creditors than in any other bailout when dealing with Cyprus, the next euro area bailout doesn’t see something similar? That can only be negative for confidence, not least given that euro area policymakers appear to be making up the resolution processes as they go along. If it was done within a predictable framework, the damage would have been less severe. But it hasn’t been, so all creditors, including depositors, are now fearful. An approach seemingly designed to create maximum fear.
So, the weekend’s agreement heads off immediate crisis and euro ejection for Cyprus. But it is a horrible agreement, particularly for Cypriots who will see their economy decimated. And it will have reverberations right across the periphery too. The euro survives intact for now. But its foundations have taken another battering. So, with some trepidation, attention now drifts back to Italy, where the politicians – who at times make those in Cyprus appear principled and rational – continue to go through the motions of trying to form a new government. For all of our sakes, let’s hope they don’t make a drama out of this crisis.
Chris Scicluna, Head of Economic Research
Grant Lewis, Head of Research