Cyprus – A Total Fiasco

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I summarise below (in note form), the current situation in Cyprus.

Background:

• Cypriot banks are some 8 times larger than the country’s GDP.
• Cyprus is one of the 17 members of the EZ. Its small – just 0.2% of EZ GDP, with a population of around 1.1 mn people.
• A number of the country’s banks are insolvent, in particular as they invested in Greece/Greek sovereign debt.
• Cyprus requested a bailout from the EZ, having previously received a Euro 2.5bn loan from Russia, which has kept the country afloat for some 2 years to date. Cyprus is negotiating with the Russians to reduce the interest rate on this loan and to extend its maturity.
• The country needs funds by May this year, or it will become bankrupt.
• Allegedly, a number of Russians, Ukrainians etc have laundered money, using Cypriot banks.
• Russians and others do use Cyprus due to its low tax rates and allegedly “lax” money laundering measures. Once the money is parked in Cyprus, individuals invest in Russia, with “clean” money. Russian banks have apparently lent some E40bn to Russian companies domiciled in Cyprus, though their principal activities remain in Russia.
• The EZ (Germany in particular) refused to negotiate with the former (Communist) regime in Cyprus.
• The newly elected Cypriot President (Mr Anastasiades), a Conservative, met with EZ heads of State and finance ministers on Thursday/Friday last week.
• He requested a bailout.
• A number of EZ countries, lead by Germany, though including Finland (in particular), together with Slovakia and (partly) Holland stated that Cyprus would have to contribute to the bailout.
• Germany was concerned that Cyprus would default on the EZ contributions in due course – they believe that Greece will. The German’s are increasingly wary of the cost of bailouts of EZ countries. Essentially, countries, including Germany and, in particular, Finland wanted Cyprus to contribute to their rescue for domestic political considerations.
• The maximum amount offered by the EZ (with, potentially, some contribution from the IMF) was E10bn.
• The IMF insisted that if they were to contribute, Cypriot debt needed to sustainable – that required around E6/E7bn more than the E10bn proposed by the EZ (effectively in the form of equity, rather than debt), making the total package E16/E17bn.
• The real crunch came when the ECB stated that they would not extend support to Cypriot banks, as they were deemed insolvent. This forced the Cypriot President to accept the bailout proposed by the EZ and to charge depositors a “levy”.
• Imposing a “levy” (in effect a tax) was the only way Cyprus believed that they could raise the extra E6/E7bn, demanded by the EZ. The current proposals will raise E5.8bn.
• Junior bondholders are to face a haircut, though senior bondholders (around E2bn) will not be affected !!!.
• The Cypriot President wants Cyprus’s banking sector to continue post the bail out and, as a result, does not want to impose material haircuts (over 10%) on large depositors. In addition, he believed that if everyone (including small depositors) shared the pain, it would be less damaging to the Cypriot banking sector, in the future. There were suggestions (allegedly) by some EZ countries, the EU, ECB and the IMF, that the Cypriot President apply the “Levy” on deposits above E100k. They proposed a rate of 15.6% on all deposits above E100k. However, they left the decision to the Cypriots. Amazing !!!
• As a result, an “agreement” was reached over last weekend, whereby ALL depositors in Cypriot banks would face a levy, which increased in percentage terms on larger deposits.
• Cyprus has an E100k bank deposit guarantee scheme, though no funds to back it up.
• The “levy” or tax does not (technically !!!) fall foul of the EZ deposit guarantee scheme, though there is no EZ wide deposit insurance scheme in place – the “guarantee” is the responsibility of individual EZ countries. Germany will not agree to an EZ wide deposit guarantee scheme or banking union at this time.
• Germany is keen to reduce the size of the Cypriot banking sector, quite rightly.
Politics

• The Cypriot President’s Party (Disy) has only 19 seats out of the 56 member Parliament. Its coalition partner has indicated that it will vote against the “levy”. The other 4 parties are also opposed to the current proposals.
• Mrs Merkel needs the approval of her Parliament in respect of any bailout of Cyprus – which she cannot be assured of. In addition, she does not want to be accused of bailing out alleged “Russian money launderers” ahead of her September general elections. Furthermore, there is increasing bailout fatigue in Germany.
• As a result, Mrs Merkel wanted Cyprus to share in the burden, inspite of the overall sums being relatively small.
• The main German opposition (the SPD) have traditionally been more EZ friendly than Mrs Merkel’s CDU/FPD. Indeed, Mrs Merkel has had to rely on SPD support to pass legislation to bail out other EZ countries for example, as members of her own coalition opposed such measures. For political purposes (ahead of the September general elections), the SPD does not want to be seen to be too generous to Cyprus and the peripheral EZ countries, as it will lose them votes. The alleged money laundering charges has helped the SPD’s argue its case to be tougher on Cyprus. Indeed, the SPD have demanded an increase in Cypriot corporation tax and other fiscal measures, including a financial transaction tax.
• In particular, the Finns, for quite some time (domestic politics, once again), have increasingly opposed bailouts, as have the Slovaks, with the Dutch becoming increasingly sceptical.
Russia is furious. They were not consulted. They deem the levy unfair or worse. The Cypriot authorities (and the EZ) are to discuss the situation with Russia. The Russians have threatened that they will not amend the terms of the existing E2.5bn loan.
• The relative insignificant amount of funds required to bail out Cyprus is not the issue. Its the domestic political considerations, as far as Mrs Merkel and other EZ leaders are concerned, which are paramount.

Current situation:

• Cypriot authorities have advised their banks to remain closed until Thursday. The Cypriot Parliament are to debate a proposal, which would charge depositors a “levy”. The original proposals have been amended, such that depositors with E20k will not be subject to a levy, though the levy on sums above E500k will be increased. The Cypriot President is wary of raising too high a levy on large deposits, though there were some discussions that the “levy” is raised (possibly to 15%) on deposits above E500k. The numbers are changing all the time.
• The current view is that the Cypriot Parliament will not approve the proposed “levy” on depositors, even in its revised form. The clock is ticking. Banks cannot continue to be closed. Some deal is necessary this week.
• Press reports suggest that the Cypriot finance minister has offered to resign, though this has been denied.
• The ruling party has announced that it may (will?) abstain from voting on the proposed levy.
• If depositors are charged a “levy”, inspite of being technically legal, what’s the worth of a deposit guarantee scheme, in particular by financially weaker EZ countries.
• The threat of contagion spreading to say Spain and Italy is high. Spain, for example, cannot afford to pay out on “guaranteed deposits”.
• Why wont depositors withdraw funds from banks in the peripheral and weaker EZ countries?. Money was returning to a number of peripheral EZ countries – this trend will reverse. Banks in a number of the peripheral EZ countries will have to rely on ECB liquidity, once again. Target 2 imbalances will rise.
• Whilst talked about, it is unlikely that Russia will impose any trade sanctions (involving energy) on the EZ.
• Cyprus allegedly has significant reserves of offshore gas. Russia is deeply interested in these reserves. Gazprom has suggested that they will bailout Cyprus if they are, in effect, granted exclusive rights in respect of the offshore gas. Whilst possible, such a scheme looks unlikely at present. The Cypriot politicians/officials are to meet with Russian officials shortly.
• To date, the market reaction has been muted, admittedly – a surprise. This lack of concern will embolden Germany (and Finland and Slovakia) to continue to take a tough line. However, does such a deal raise the risk of contagion spreading to other EZ countries. I very much believe that it does.
• Cyprus could default, though its bonds are bound by UK law, making a restructuring problematic. Furthermore, the prospective currency would be much weaker than the Euro as they would have to exit the EZ and forego ECB support. Not attractive, at all.
• The EZ claims that this is a “special case”, a view which is complete nonsense. There have been too many special cases.
• The contagion risks to peripheral EZ countries (Spain and Italy) are extremely high. The Euro looks vulnerable.
• The risks to a number of EZ peripheral countries, in particular of the Cypriot proposals to tax allegedly “guaranteed deposits” (of up to E100k), are a huge mistake in my humble opinion.

Kiron Sarkar

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Kiron’s daily newsletter can be accessed on his website www.sarkargm.com

19th March 2013

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