Monday, March 25, 2013

A deal in Cyprus

A bailout deal has been agreed in Cyprus.  The deal involves the closure of the country’s second largest bank (Laiki Bank) and losses of up to 40% on deposits over 100,000 at the largest bank (Bank of Cyprus).  Depositors with funds under 100,000 will be protected from losses.  The Bank of Cyprus will receive the smaller deposits of Laiki Bank.  The Bank of Cyprus will also receive €9.0 billion in Emergency Liquidity Assistance from the European Central Bank that had previously been made available to Laiki Bank.

This will be sufficient for Cyprus to access the €10.0 billion bailout package from the troika of the European Commission, the International Monetary Fund and the European Central Bank.  Importantly, the terms of the deal mean that the Cypriot debt to GDP ratio should be held at under the 150% of GDP level indicated in the initial proposal.  How much that forecast has been altered by the events of the last week or what the underlying assumptions are for the Cypriot economy remains to be seen.

Markets have been remarkably sanguine during these negotiations.  On the one hand I get that.  Cyprus is 0.25% of Euro zone GDP, the deposit base of the banking sectors is 800% of GDP, more than twice the ratio for the average of the Euro zone.  Thirty per cent of deposits are from off-shore, mostly Russia.  It was only fair and reasonable therefore that foreign depositors wore some of the pain.  Cyprus is a special case, right?

My other hand worries that a new precedent has been set.  I worry that future runs on banks may eventuate in other Euro zone countries unless the authorities (the troika) get better at dealing with insolvency issues in a far more timely and co-ordinated fashion.

I get the sense that something has changed here, or at least exposed an inconsistency.  The Bankia arrangement in Spain was meant to lead to the end of the negative feedback loops between bank insolvency and sovereign debt.  Yet this week we have the German Finance Minister stating that deposit insurance is only as good as the sovereign backing the insurance.  I also worry about reports of a growing rift between the IMF and the European Commission.

Cyprus has been a timely reminder that Europe is not fixed yet and there is considerable work still ahead.  There is still considerable divergence in opinion about how to deal with issues as they arise, particularly issues of insolvency and who pays.

At least in the near-term we can move on from worrying about a Cyprus Euro zone exit and go back to worrying about that other recent timely reminder of the challenges that still lie ahead: politics in Italy.