25 March 2013

Graham Bishop: Cyprus - Will the deal last? Probably not

The Eurogroup finally agreed a deal with Cyprus link. It bears a great similarity to what was offered a week ago but the losses in Laiki and Bank of Cyprus (BoC) are now borne completely by shareholders, bondholders and large/uninsured depositors. For Laiki, the probability is that those classes will be wiped out completely; for BoC, large depositors may lose perhaps 20 per cent on current calculations as sufficient of their deposits are converted into equity to give a 9 per cent capital ratio. The loans offered to Cyprus remain unchanged at up to €10 billion.

This story is a long way from over. The economic outlook is now much worse than say a month ago and that will flow through into loan losses at other banks. To the extent that uninsured depositors also had back-to-back loans, then it may prove more difficult to collect repayment of the loans especially if they are outside Cyprus. The business model of Cyprus is comprehensively shattered and it will urgently need development aid rather than new debt.

This agreement has broken new ground in the eurozone’s search for solutions to excessive debt that should never have been undertaken by a host government, or permitted by the eurozone. The search for political mechanisms to give the collective power to stop this happening in the future still point inexorably towards a much greater degree of `political union’.  Financial markets will now apply far more discipline to weak banks and governments as no-one will believe that there will never be PSI again. Indeed, Cyprus will struggle to avoid that as the economy unravels. Uninsured personal/corporate depositors are now quite clear about what can happen in a bank resolution.

This episode also has a regional political dimension: Turkey staked an unambiguous claim on behalf of Turkish Cypriots to a share of any gas that eventually comes ashore.

Recent comments by Graham Bishop:

• The Cyprus Rescue of 16 March: Is this just a First and Small Step? Link
• Cyprus – over the brink? Sooner? Or Later? link
• (I tweet my latest thoughts so follow me on Twitter: @grahambishopcom)

Background Analysis

Sustainability has become the central issue in the debate. The need now is for more 'equity' in the game rather than piling on more debt that is expected to become unsustainable.

Solidarity Fund

If a 100 per cent debt/GDP ratio is the highest that the Troika is prepared to countenance, then a 'solidarity fund bond' of €6 billion (= 30 per cent of GDP) can hardly be the solution the outside world is looking for. The proposal simply illustrated the unrealistic plans emanating from the Cypriot system and has now vanished.

• There would have been few voluntary buyers of a bond collateralised by assets (such as national treasures) that are manifestly incapable of being seized and realised.
• Turkey has now introduced a new dimension by arguing that the natural gas is an asset of the whole island – not just the Greek part (see Gas below for discussion of possible value). Yesterday, the Turkish Foreign Ministry said: "Possible plans to put the island's joint resources as collateral for 'a solidarity fund' or any other loan agreement is just another reflection of the Greek Cypriot illusion that it was the sole owner of the entire island and it risks a fresh crisis in the region".

Cypriot Banks

Is the plan to 'resolve’ i.e. liquidate the second biggest bank and drastically reduce the BoC sufficient to create a sound base for long-term recovery? That certainly throws the pain onto the uninsured depositors – as they should have realised when considering that both of the two largest banks each had a balance sheet that was around twice the entire GDP of the host state.

However, the final and fatal mistake in this whole sorry story must surely have been the decision by the major banks to make very large investments in Greek Government bonds (GGBs). The Governor of the Central Bank of Cyprus (Orphanides from 2008-12) – as ultimate regulator – should have been aware that say Bank of Cyprus alone had invested more than 75 per cent of its shareholders’ equity (thus representing more than 10 per cent of GDP) in GGBs. If this investment was to meet standard liquidity requirements, then prudence might have pointed to a diversified portfolio that would have been mainly say short-dated French and German bonds. Instead, very low yields on deposit rates were used to fund very high yield bonds – perhaps the ultimate 'carry trade’ that not only broke the bank but also the whole country. Doubtless, an interesting story for the historians!

Before any useful answer can be given to the sustainability of the new situation, commentators need to see the full analysis of the banking situation by PIMCO so that its analysis can be judged against assumptions other than those of the 'Steering Committee’. Property prices may well be a key variable for alternative views under the economic circumstances that are looking ever more likely.

Moreover, the analysis was limited to the major banks but only a sample of cooperative banks. Reports suggest that the cooperative banks – around 100 per cent of GDP – are not immune to the non-performing loans problem affecting commercial banks. A central problem of the cooperative banking movement in general has always been that they have little access to new capital other than retained earnings. So a period of heavy loan losses would force a corresponding de-leveraging, with associated adverse effects on the economy.

Economic Outlook

Ministers gathering for the Eurogroup meeting say that the same numbers are on the table as last week. However, the assumptions underlying those numbers may have been seriously outdated by the decision by Eurogroup that Cyprus would have to shrink its banking system back to the average size of EU banks relative to GDP – a reduction of 30-40 per cent. Events since the Cypriot Parliament rejected the bailout proposal so decisively have probably only served to make such a contraction inevitable now. There will be domestic economic consequences of some magnitude – epitomised by the protest marches of bank workers.

The Commission Winter Economic forecast for Cyprus discussed the balance of risks to the economy: “On the domestic front, downside risks are associated with domestic credit conditions due to financial sector deleveraging, the worsening of labour market conditions, a stronger than expected fall in house prices, and a further loss of business and consumer confidence from prolonged economic uncertainty. Also, the restructuring of the Cypriot banking sector could have stronger effects on related professional business services.” Only a few weeks later, all the downside risks appear to be materialising – with a vengeance. The extract (Appendix below) from the Commission’s 2012 'In Depth study’ of Cyprus amplifies some of the grounds for fearing that these downside risks could become very negative for the remaining banking system as the Cypriot economy lurches downward.

Capital controls

It is reported that 'capital controls’ have been imposed – but what does the term mean within the euro area? In the old days of separate currencies, this term meant limits on the amount that could be converted into foreign currencies. But the euro is not a foreign currency! So it can really only mean the power to stop transfers out of a bank account – in effect, a compulsory extension of the term of a deposit. To the extent that a bank is being liquidated, that will happen naturally. Reducing the daily limit on ATM withdrawals hardly constitutes a significant 'control’. Have major transfers out of the banking system been halted? Only the ECB will know the full picture as they will have to inject the liquidity to enable any such transfers to happen. 

Gas

Reuters has just published a detailed analysis of the value and timing of potential gas exports from Cyprus (link). The bottom line is that the gas discovered so far – as opposed to what might be in the geological structures may have a Net Present Value of just €2 billion. But the cash might only start flowing in 2020. However, the value is based on a price of gas price of $13 per million British thermal units (mmBtu) and the impact of US LNG exports of shale gas could push the price down to $10-11 – according to Soc Gen. With that uncertainty, the field may never warrant development. Moreover, the Turkish attitude may make development even more uncertain – see above.

Role of Russia

Some commentators argue that Russia is playing a long game and aiming to foment trouble in the EU that might halt the march towards a substantial degree of political union in the eurozone that would leave Russia permanently as a small economic player. But it would be able to pick up cheap assets later – perhaps gaining access to the long-cherished goal of a warm-water naval port. I pointed out in an earlier article (link) that access to the British military bases at Akrotiri and Dhekelia to exert additional influence in the Middle East would be difficult. 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. Otherwise, its naval operations would be totally overseen by NATO forces. Even a non-military person sees that as a serious disadvantage to this concept.

What else could (or should) the EU do to help Cyprus?

As Cyprus remains a part of the EU and the eurozone, EU political leaders should be very anxious to help ordinary Cypriot citizens who have been so let down by their political and business class. But it is 'equity‘ that is required now – not more debt. So a key part of the recovery programme should be co-financing by the EU – perhaps the EBRD could deploy its skills from emerging economies? The provision of development capital from the EU on a substantial scale is a necessity to demonstrate solidarity with the ordinary people of Cyprus.

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Appendix 1: Extracts for European Commission In-depth study of Cyprus, 2012

© Graham Bishop