19 March 2013

Graham Bishop: Cyprus – Over the brink? Sooner? Or Later?

The decision by the Cypriot Parliament to reject the eurozone deal cannot have been an accident: not even the new President’s own party supported the revised plans. The Finance Minister has gone to Russia to seek new loans. Whatever the twists and turns in the next few days, it is now very difficult to see a happy period for Cyprus in the next few years.

Conclusions:

• If the dalliance with Russia does not produce extremely substantial financial support in the very near future, 'catastrophic’ developments are likely unless the new Government can adjust policy very rapidly indeed to get back fully on track with Eurogroup’s offer.
• However, the probable unravelling of the business model pursued by the island for several years makes the medium term outlook bleak – until/unless the natural gas comes ashore.
• But the financial appeal to Russia underlines the remarkable factors that are specific to this situation so there should not be significant contagion to other euro area states in the short run.
• However, investors are now on notice that the current high levels of public, private and banking debt in Europe can easily create major losses if economic policy slips. Financial markets will be very nervous about any signs of such slippage elsewhere in the future.

Yesterday, the Eurogroup stated: “The euro area Member States stand ready to assist Cyprus in its reform efforts on the basis of the agreed adjustment programme". After the vote this evening, the Eurogroup Chairman stated: “I confirm that the Eurogroup stands ready to assist Cyprus in its reform efforts and reiterate the position of the Eurogroup as I stated yesterday". So there was no indication of any willingness to change position – at least at this stage.

Near Future

The key now is the willingness of the ECB to continue to provide liquidity to the major banks. However, it is difficult to see how the ECB can provide that continuing liquidity support via the 'ELA' when the country’s Parliament has voted down a key component of the Eurogroup’s offer of support. That offer was actually only a political agreement on the 'cornerstones’ of a programme. Eurogroup expects a 'strict implementation of the agreed conditionality’ and this seems to include an independent anti-money laundering analysis that would eventually include a loan by loan review. Without a satisfactory review, it is inconceivable that the German Parliament for one would approve the disbursement of ESM funds and thus any chance of recapitalising Cypriot banks from EU resources.

In any case, the ECB can only lend to solvent banks and re-opening the Cypriot banks would expose them to a deposit run that would demonstrate their inability to meet their obligations – a classic test for insolvency. Accordingly, the window for continued ECB support for banks that are likely to become insolvent in the very near future seems likely to close swiftly. Once the banking eggs are scrambled, they cannot be unscrambled!

The decision by the new Government to turn to Russia for support is extraordinary and fateful. Under the circumstances of a Russian-dominated bailout, it is inconceivable that the anti-money laundering analysis would be pursued with sufficient vigour to enable the Eurogroup to proceed with any part of its financing. So Russia would have to be willing to provide all the funding that Eurogroup would have done, as well as funds instead of the bank deposit levy. Would the ECB be willing/empowered to provide any special liquidity arrangements until it could assume its new supervisory functions under the SSM system agreed today between Parliament and Council? That would be at least a year away. In the meantime Russia would have to meet all liquidity needs to maintain the banks’ solvency as deposits flow out.

Accordingly, Russian support might have to be 10 times the €2.5 billion loan advanced so far. What could they get for this money?

• Protection for Russian depositors against a 15 per cent levy on perhaps €20 billion of deposits. Their countrymen’s deposits would have to be much larger than thought to make it worth paying out such sums.
• Political influence over Cyprus gas. This is exactly what Cyprus has refused to give to the EU so why would they give it to Russia instead? Russia would have to finance the investment to bring it to market in say 2018. But which market? The EU – just at a time it is trying to reduce dependency on Russian gas?
• Access to the British military bases at Akrotiri and Dhekelia to exert additional influence in the Middle East. But the bases are formally known as Sovereign Base Areas for good reason: they are British sovereign territory that was explicitly retained when Cyprus became independent in 1960. So Russia would have to seize them by military force – an unlikely event.

These possible benefits seem quite modest in comparison with the sums that Russia would have to advance in the near future. Given the Troika analysis that adding such debts to Cyprus would make the overall debt burden unsustainable, it does not seem an attractive economic proposition to convert Cyprus into a colony.

In a statement on Saturday, President Anastasiades described the deal as a choice between the "catastrophic scenario of disorderly bankruptcy or the scenario of a painful but controlled management of the crisis". The hiatus in the Cypriot banking market that now looks inevitable for at least a few more days has already done great damage to the economy. If the worst happens, then catastrophe will be the right description.

Medium Term

In recent years, the Cypriot national business model seems to have been based on a low corporate tax rate to attract international financial business that the Eurogroup now seems to feel included a lax application of the EU’s money laundering laws. If the Cypriot authorities decline to permit the agreed audit by Moneyval and a private international audit firm, then the EU will presumably regard the money-laundering case as proven. Some form of sanctions must surely follow that would have the practical effect of negating the benefits to the money launders of holding assets in Cypriot banks. The business model would be at an end.

An alternative scenario is that anti money laundering laws are rigorously enforced – also putting an end to the former business model. At that stage, the inability of some depositors to get their money back would probably induce them not to repay the back-to-back loans associated with the deposits. Major loan losses would then be recorded by the banks, perhaps requiring further recapitalisation. Publication of the PIMCO report will enable outsiders to gauge to what extent this scenario has already been taken not account.

Financial services now account for around 18 per cent of GDP so the destruction of this business model is likely to hit the overall economy very hard. Has this been taken into account in the Troika’s economic forecasts?

*****

See my earlier paper of 16 March - link– for discussion of a possible new 'narrow' bank to supply credit to the domestic economy quickly.

© Graham Bishop