Fisher Investments Editorial Staff
Market Risks, Deficits


By, 03/26/2013

Sign of the times: Vladimir Putin is among the Cypriot bailout’s few supporters. (Photo by Mark Ralston – Pool/Getty Images.)

Cyprus agreed to bailout terms with the EU/ECB/IMF “troika” early Monday, securing a lifeline to recapitalize its insolvent banks, keep the government afloat and prevent a disorderly default and eurozone exit. Positively, deposits under €100,000 will be spared losses, upholding EU law. Otherwise, the package brings tough consequences for Cyprus and establishes a concerning precedent for eurozone states in need of future bailouts.

The deal centers on Cyprus’s largest and most troubled banks, Bank of Cyprus and Laiki. Consistent with legislation passed Friday, the more-troubled Laiki will fold, with its “good” assets and insured deposits (€100,000 and under) going to Bank of Cyprus. Its “bad” assets and uninsured deposits will form a “bad bank” to be wound down over time, potentially wiping out 40% or more of deposits. This is a more painful outcome than legislators expected Friday, when unfortunately named Central Bank chief Panicos Demetriados said restructuring would preserve Laiki, but it doesn’t require another vote.

Meanwhile, Bank of Cyprus, bolstered by Laiki’s good bits, gets recapitalized and remains eligible for ECB liquidity assistance. But help comes at a price: the conversion of a hefty chunk of uninsured deposits to equity, forcing savers to take massive losses (potentially 30% or higher, per varying estimates). And to ensure enforcement, capital controls will prevent savers from withdrawing uninsured amounts, transferring them to other Cypriot banks, or moving them off the island. How long this lasts isn’t clear—EU treaties permit capital controls only in extraordinary circumstances to preserve financial stability. The European Commission urged Cyprus to lift them after a few days, but they could last months, if not longer, which would disrupt the founding principle of monetary union: free and easy cross-border capital movement. Thus would turn Cypriot euros into a defacto second currency, valued differently than mainland euros. And unless the ECB provides assistance, deflation could set in.

Overall, for large depositors in Bank of Cyprus and Laiki, this is a far worse deal than the defunct 9.5% deposit tax proposal. Not only is the haircut much larger, but the compensation’s inferior. Under the tax plan, all depositors would have received bank-issued debt backed by Cyprus’s natural gas reserves. That’s hardly a like-for-like swap, given the exchange of liquid savings for illiquid, risky assets, but it’s better than receiving incredibly diluted equity near-guaranteed to tank upon issuance. This plan, like the tax, also amounts to asset seizure. Only instead of the government confiscating taxing it directly, the bank’s taking assets in an individual’s or corporation’s account—private property—at the government’s behest. Not what you want to see in a capitalist society.

So while EU leaders welcomed the deal they said would “ensure a sustainable future for Cyprus in the euro area,” aside from averting two banks’ immediate collapse, we have trouble seeing how it fixes much. Cyprus’s banking sector—the lifeblood of its tiny economy—gets whacked. Analysts predict the economy could contract by 25% or more over the next few years, likely jeopardizing the IMF-imposed debt target—100% of GDP by 2020. If that happens and the IMF doesn’t bend, Cyprus’s bondholders may yet have to take a haircut a la Greece.

In the meantime, the economy will likely struggle to find its footing. It’s unrealistic to expect Cyprus’s banking sector to return to its former glory. The foreign capital it once attracted likely goes elsewhere—maybe Switzerland or the Cayman Islands—scared off by these events. Bank credit likely remains tight for a while, making it difficult for entrepreneurs and non-financial companies to finance start-ups and expansion. Cyprus does hold one card: those natural gas reserves. Developing them could provide much-needed growth and jobs, and over time, energy could offset the hollowed-out financials. But not overnight.

Then, there’s the matter of precedent. Until now, bailouts have spared savers—shareholders, junior bondholders and taxpayers have taken the hit. Initially, most believed the focus on Cypriot depositors was a one-off tied to the large sums of Russian money. However, Jeroen Dijsselbloem, head of the “eurogroup” of eurozone finance ministers, called Cyprus the blueprint for future bailouts—from now on, “investors” will bear the brunt. And in recent days, EU officials have suggested “investors” includes anyone with a deposit over €100,000. Savers with large deposits might thus start splitting their funds into several insured accounts at multiple banks. We may also see deposit flight from the weaker eurozone states, lest officials try to revisit a blanket deposit tax.

Then again, Dijsselbloem could just be talking tough. His spokeswoman has already backtracked on his behalf, and EU officials aren’t known for sticking to their guns in these matters. Instead, they draw and redraw lines in the sand. The next country needing help could receive much friendlier treatment. Officials could change tack again and decide “breaking the vicious circle between banks and sovereigns” once again means recapitalizing the banks directly, rather than allowing them to wipe out depositors.

But only time will tell. For now, we only know that by tearing up the old playbook of bailouts in exchange for austerity and economic reforms, the troika’s increased eurozone uncertainty. Not enough to increase the likelihood of a disorderly collapse, but perhaps enough to give investors more cud to chew over.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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