Cyprus – An extra-large rescue plan

Cyprus has been helped by the European Union and the IMF. The loan will be € 10bn. This is huge, more than 50% of GDP as Cyprus GDP was € 17.9bn in 2012. This will bring public debt to GDP ratio from 90% to 140%. The requested plan from Cyprus was € 17bn which was too huge to manage. It is not thinkable to have a rescue plan of almost 100% of GDP and then there is a problem of debt sustainability. Even with 140 % there is a strong risk of unsustainability.

The remaining € 7bn will come from privatization receipts and higher corporate taxes for € 1.4bn and the rest will come from tax on bank deposits. From the first negotiation tax rate will be 6.75% for deposits below € 100 000 and 9.9% for deposits above € 100 000. (But since Sunday afternoon there are discussions on this issue to reduce tax rate for deposits below € 100 000 probably at 3 or 3.5% and increase tax rate to 12.5% for deposits above € 100 000. There is still an uncertainty because it is possible to have 2 tax rates: one for deposits between € 100 000 to € 500 000 and one above € 500 000).

Where does this come from? There are two sources: one economic and one from the banking sector.

The chart on the right shows Cyprus economic weakness. GDP level is below the post 2008/2009 recession level. This means that public finance dynamic are constrained and that commitments to reduce public finance imbalances will weigh on GDP outlook. It’s always the same story: low growth, public finance imbalances, commitments to rebalance and recession at the end. What could change this picture with a 140 % public debt to GDP ratio?

Cyprus-2012-Q4-GDPtrend

The other source of fragility is the banking sector. This sector is huge as its total assets represent 8 times the GDP. Three reasons for this distortion:

1 – There are a lot of Russian deposits because there is a tax shelter for Russian in Cyprus. Foreign deposits represent 100 % of GDP.

2 – Real estate market was strong before the crisis. From 2006 to 2011 mortgage loans were increasing by more than 25 % per year. As the economic outlook worsened, the real estate market has collapsed leading to a new banking fragility.

3 – The third shock came from the Greek debt restructuration. There was a large amount of Greek debt in banks’ portfolio. The PSI (Private Sector Involvement) last March has had a huge cost representing 25% of GDP. This has clearly changed banks’ strategy.

These three kinds of shocks have created distortions that cannot be managed and that are at the source of the rescue plan. Banks at least need € 10bn.

This situation leads to 4 questions

1 – The first is on deposit guarantee. When the crisis started in September 2008, after Lehman collapse, it was clear from European governments that below € 100 000 there was no risks on deposits. This is no longer the case even if in Cyprus the guarantee was not strong. One reason for this contribution is the fact that there is a huge amount of deposit coming from Russia and that Cyprus does not want to cut its links with this country. So they will have to pays but not too much.

There were tough discussions on the tax level for deposit below €100 000. (For details and for the ECB role in the negotiation read this article in the Financial Times http://on.ft.com/WuF44K)

So there is no more deposit guarantee and what is new is that it is a new mean of crisis regulation. That’s what we have to keep in mind and change the picture.

2 – From what was seen on Sunday afternoon there will probably be a modulation in the tax level for deposits below € 100 000. The new elect president Mr Anastasiades has just a coalition majority at the Parliament. His party controls only 20 seats, and the two other parties of the coalition are the Democratic Party with 8 seats and the European Party with 2 seats. 28 votes on 56 are required to pass the law. The political situation is still complicated to manage and probably on Monday there will be a new equilibrium in the plan.

3 – The main risk of the plan is contagion to other countries. On Saturday morning ATM machines were rapidly empty as people wanted to get their money back. In fact the deposit level that will help to calculate the tax was fixed on Friday night. For the other countries we can imagine two kinds of questions. The first is direct contagion. Will people from other Euro countries withdraw their deposits? From previous experiences in the Euro Area (Greece or Ireland for examples) we are not convinced by this kind of behavior. We have seen bank runs.

For the current situation the mean of adjustment is different as it weighs directly on deposit. Nothing has been done at this scale yet. That’s what we will have to be attentive to. On another point, this new adjustment says that everything now is possible. Everyone can now be involved in the way the crisis can be solved. For sure this will bring new uncertainty.

4 – The ECB will have an important role in the coming week to eventually avoid bank runs. It will have to bring liquidities and will have to stabilize the situation.

Two weeks after the Italian elections, Cyprus is a new source of perturbation in the Euro Area. This reflects the complexity for Europeans to exit from the old governance. Cooperation and coordination will be for the future and each has to pay for his own past. The risk is the way European citizen will consider the new mean of adjustment. Euro Area is in a period of negative growth, negative employment numbers and of strong constraints coming from the will to rebalance public finance. This recipe is already a condition for social unrest. With the drop of deposit guarantee this is another step as the range of instrument for crisis resolution has widened and has increased uncertainty on everyone financial and economic situation.

Will Euro citizens accept that will be the real question in the coming weeks and months? The political cost could be important.