Developments in Cyprus over the past week suggest that the key lesson euro area policymakers took away from the messy Greek bailout is that they should no longer underwrite a deal that doesn’t resolve a country’s debt position once and for all. Equipped with this new insight, in hammering out Cyprus’ bailout package, euro area finance ministers made their latest aid proposal conditional on an effective large-scale haircut of the Cypriot banking system’s deposits.
This was – in principle – a sensible approach to take. Indeed, without the requested contribution from depositors, the EU/IMF bailout package would have amounted to 100% of Cyprus’ GDP. This would have lifted the country’s debt burden to an evidently unsustainable 190% of GDP, even above Greek levels.
As so often, however, the devil was in the detail. And here euro area finance ministers made two crucial mistakes. First, they proposed a socially- and politically-unacceptable deposit levy, which in its initial form did not foresee exemptions for the poorest nor a sufficient degree of progressivity in the rates applied. This led to the inevitable and humiliating rejection of the “stability levy” by the Cypriot parliament on Tuesday night and the subsequent uncertainty surrounding Cyprus’ solvency, with the ECB threatening to withdraw its emergency liquidity support if no bailout is in place by Monday.
The second mistake was that bailing in depositors below €100k sets a disconcerting precedent, notwithstanding all the protestations that this is a one off. By raising the spectre of a tax on deposits below the €100k threshold of the deposit-guarantee scheme, this has inevitably sparked concerns among savers across the euro area on the true worth of deposit insurance.
Even in Germany, the opposition parties criticised the government of Chancellor Merkel to unsettle domestic savers with their decision to undermine the EU’s deposit insurance scheme. And while we are not predicting immediate bank runs other than in Cyprus – when banks finally re-open – pressure on bank deposits is likely to re-emerge in all peripheral member states just as they were showing signs of recovery. This, in turn, will add to the pressure on lending rates in the periphery (see last week's blog).
So, implementation of an otherwise good idea was poor. But this is unlikely to stop core member states using a similar approach to handling future crises. Indeed, with Cyprus being the second “special” case after Greece, the current episode highlights the risks that private sector involvement (PSI) – in whichever form – will likely be a cornerstone in any future bailout package (or extension of existing ones).
If applied consistently and in a better-organised manner, this could be positive news for the euro area. Cutting down unsustainable debt positions of sovereigns and banks through appropriate means would help to accelerate the necessary deleveraging process, which is otherwise likely to be a major drag on growth for many years to come. Indeed, the massive bailout costs in Greece, Portugal, Ireland, and possibly also in Spain, are likely to require some (further) debt restructuring in the near term.
But if this approach is to be taken, it needs to be accompanied by a courageous institutional overhaul in the euro area. The importance of an active role of the ESM in breaking the link between sovereigns and banks to ensure debt sustainability can, of course, not be overemphasised in this context. In Spain, Ireland and Cyprus, direct recapitalisation of ailing banks, accompanied by appropriate restructuring efforts through a common bank resolution framework, would undoubtedly have reduced (if not avoided) the solvency concerns that have led to the escalation of this crisis. A common deposit insurance scheme, meanwhile, would have avoided the fears of deposit flight that have emerged after last week’s decisions.
Better and predictable institutions would also reduce the indirect costs of the current chaotic approach to bailouts. In the absence of last year’s market turmoil, Germany’s economy is likely to have grown by an extra percentage point, increasing German tax revenues by around €10bn – enough to finance Cyprus’ current bailout package. This week’s drop in Germany’s IFo survey and the PMIs brought a timely reminder that low growth outcomes are the collateral damage of political uncertainty.
None of this is new, of course. But the repeated reignition of the crisis – Slovenia might well be the next candidate – coupled with unsustainable debt positions in many member states – suggests that without further steps towards a true banking and fiscal union, a (partial) break-up of the euro will never be far from the surface.
Restructuring excessive debt levels, as proposed in Cyprus, is the right path to go down. But core member states, and Germany in particular, need to accept that some of the unavoidable costs must be socialised in this process to preserve cohesion, avoid turmoil and contain contagion. Only then will the euro have a decent chance of long-term survival.
Tobias S. Blattner
Euro area Economist