Could Cyprus reignite the eurozone crisis ?

Chypre est considérée, à juste titre, comme un cas particulier mais une faillite incontrôlée des banques chypriotes ou une sortie de l’île de la zone euro pourrait avoir des conséquences sur l’ensemble de l’Union européenne, estiment Simon Tilford et Philip Whyte, du Centre for European Reform, de Londres.

Each of the crisis-hit eurozone countries shares some responsibility for its predicament. Italy used membership of the single currency as an excuse to go slow on pushing through much-needed structural reforms of its economy. The Irish and Spanish were excessively relaxed about their booming housing markets. Greece and Portugal were simply not sufficiently converged with the rest of the eurozone to be able to flourish within it ; they should not have applied to join or been allowed in. At the same time, all were to a greater or lesser extent victims of the structure of the currency union and the tardy response of its member-states.

But Cyprus is different. The country really is the architect of its own misfortune. This makes finding a workable solution to the crisis even more difficult, and explains why a country with a population of around 1 million could pose a systemic threat to a currency union of 400 million.

How did Cyprus get into this mess in the first place ? The answer is that it managed to combine all the excesses of every other European country. Cyprus was Spain, Ireland, Iceland, and Greece rolled into one – but with a Russian twist. Like Spain, it ran large current-account deficits. Like Spain and Ireland, it experienced a real estate bubble. Like Ireland and Iceland, it developed a runaway banking system (with assets reaching 800 per cent of GDP). As in Greece, the public finances were mismanaged. And as in Iceland, the sovereign could not afford to rescue insolvent banks. The twist is that Cyprus achieved all of this while offering high interest bank accounts to non-resident ‘residents’ – mostly wealthy Russians. So Cypriot bank liabilities consisted primarily of deposits, rather than bonded debt.

Ever since the eurozone crisis flared up in late 2009, the politics of crisis management have been marked by the conflicting perspectives of creditor and debtor countries. The same has been true of the Cyprus crisis. Given the sheer accumulation of Cypriot sins, the desire of creditor countries to draw a line in the sand over moral hazard is understandable, not least because of domestic political constraints : it would be impossible for political leaders in other eurozone countries to explain to taxpayers at home why they should have to honour commitments made by Cypriot banks to wealthy Russians. Even so, the terms of the proposed bail out of Cyprus were badly designed. In effect, policy-makers brandished threats that undermined much of what they have spent the past year trying to achieve.

Broadly-speaking, the deal agreed on March 15th looked like this. The Cypriot sovereign would be bailed out by the eurozone, provided it agreed to ‘bail in’ the creditors of its banks. Since Cypriot banks mostly funded themselves from deposits rather than by issuing debt, this meant that depositors in Cypriot banks would have to take a haircut. The precise form of that haircut would be for the Cypriots to decide. But if they refused to play ball, no bail out would be forthcoming – and Cypriot banks would not qualify for ECB funding under its Emergency Liquidity Assistance (ELA) programme. The result : Cyprus would default and its banking system would collapse. Faced with this choice, Cyprus agreed to ‘bail in’ bank depositors. It announced a 9.9 per cent tax on deposits over €100,000 and a 6.75 per cent tax on deposits under €100,000.

By March 18th, however, the deal was already beginning to unravel under the weight of its contradictions. Several problems had become apparent. First, the Cypriot tax cast doubt over commitments under EU law to guarantee deposits up to €100,000. Second, the Cypriot tax seemed to subordinate the interests of ordinary depositors to those of bondholders. Third, the deal seemed to be at odds with broader attempts to build a banking system in which investors, rather than taxpayers, pay for banks’ mistakes. Fourth, the deal did not ‘bail in’ creditors of the banks in the framework of an orderly bank resolution procedure. Fifth, the ECB’s threats to cut off emergency funding to Cypriot banks cast doubt upon its willingness to do “all that it takes” to save the euro (or to keep a country in it). Finally, the bail-out highlighted some of the design flaws of the currency union that have still not been resolved.

Where does this leave Cyprus ? The Cypriot authorities appear to believe that it is still possible for Cyprus to remain in the eurozone while retaining the country’s offshore banking model. It is not. The only hope the Cypriots have of staying in the currency union is to impose much larger losses on their foreign depositors. These creditors knew what they were doing when they deposited money with Cypriot banks, and the investment has proven highly profitable for them. Only by forcing much larger losses onto foreign creditors can the Cypriots have any hope of raising their share of the costs of the bail-out, and of defusing the understandable anger felt elsewhere in the eurozone at the prospect of tax-payers’ money being used to bail-out Russian oligarchs.

In exchange for forcing the Russians and other foreign creditors to finance more of the cost of the clean-up, it is possible (though far from a foregone conclusion) that the rest of the eurozone could increase the amount of money it is prepared to contribute to the bail-out. Any attempt by Cyprus to raise the necessary funds by imposing haircuts on domestic bank deposits or attempting to borrow the needed funds against future revenue streams from offshore gas or privatisations will end in failure. First, the needed sums of money are simply too big in the context of an economy as small as the Cypriot one. Second, the Russians need to be seen to be taking a big hit if other eurozone countries are to be able to persuade their reluctant electorates to come up with more money for Cyprus.

Where does this leave the rest of the eurozone ? If the Cypriots fail to impose the lion’s share of the costs onto foreign creditors, some eurozone governments (not least the German one) could face insurmountable political obstacles to a bail-out of the country. However, if Cyprus imposes a big haircut on large (mostly foreign) creditors, the rest of the eurozone would have more political wiggle room, possibly opening the way for a workable deal. If not, the outcome will be an uncontrolled default. Cyprus would not necessarily have to leave the currency union, but in reality would probably have little choice because the Cypriot central bank would need to print money in order to keep the country’s banking sector afloat.

So far, financial markets have taken the latest crisis in their stride, suggesting that they do indeed see Cyprus as a special case. But the ramifications of an uncontrolled default and/or exit from the currency union could still be far-reaching. In such an event, investors could conclude that the membership of other indebted member-states cannot be taken for granted, igniting a fresh wave of capital flight from the periphery which may be difficult to control.