Monday, March 18, 2013

EU Summit and the Cyprus bailout

I like the tone of the latest European Union Summit Communiqué.  Regular readers will know I have often criticised the approach of harsh front-loaded austerity as the ultimate solution to all that ails the Euro zone.  In taking such approach, the balance between growth and austerity has been lost.  While achieving fiscal balance was always going to be a part of the answer, the long-term solution to securing a pathway to lower debt to GDP ratios is higher economic growth.
To that end I was pleasantly surprised to see the following paragraph: 

“There should be an appropriate mix of expenditure and revenue measures at the level of the Member States, including short-term targeted measures to boost growth and support job-creation, particularly for the young, and prioritising growth-friendly investment.  In this connection, the European Council recalls that while fully respecting the Stability and Growth Pact (SGP) the possibilities offered by the EU’s existing fiscal framework to balance productive public investment needs with fiscal discipline objectives can be exploited in the preventive arm of the SGP.”

That’s the best paragraph I’ve ever read in an EU Summit Communiqué.  What it tells us is the authorities will be prepared to take a more flexible approach towards setting deficit reduction targets.  That means a better trade-off between austerity and growth.  It therefore paves the way for greater flexibility towards countries that would benefit from less extreme front-loaded austerity.

This has been made possible by the hard work that has already been done at the systemic Eurogroup level but also at the individual member country level where austerity has taken a huge toll on output and jobs.  In particular it has been made possible by the ECB stepping up as lender of last result which has been a key catalyst in reducing financial tensions and Euro zone tail risks.  Once again, while none of this has solved the Euro zone problem, it has provided the politicians with a window of opportunity to get on with the important job of structural economic reform.

The Summit Communiqué has been overshadowed somewhat by the Cyprus bailout which was also agreed over the weekend.  The total package is 10 billion, less than the 17 billion initially requested.  While the initial request was not large in terms of the amount, it was significant in terms of the size of the Cypriot economy.  A 17 billion bailout would be just under 100% of GDP.  That would have taken the debt to GDP ratio to around 185% of GDP, worse than the ratio in Greece and clearly unsustainable. The bailout will take the Cypriot debt to GDP ratio to 145% of GDP.

While Cyprus did not represent a systemic risk, whatever solution was found could be determined as precedent setting.  The Eurogroup was clearly not willing to back-track on previous commitments.  For example a Greek-style PSI was not an option give they had already anointed that particular solution in Greece a “one-off”.  The question then was how the cost of the bailout could be reduced.

The expectation prior to the Summit was that bank deposit-holders would shoulder some share of the burden.  That fact that all deposit-holders are to “participate” was a surprise.  Depositors of local banks will pay an upfront levy of 9.9% on deposits of over 100,000.  The surprise was the inclusion of deposit holders under 100,000, who will pay a levy of 6.75%.  In addition, the Cyprus government will adopt fiscal tightening measures of 4.5% of GDP and embark on a privatisation program. Some taxes will also rise (corporate tax and withholding tax on capital gains).

The key question is that in not breaching previous commitments, to what extent has the terms of this bailout set new precedents.   The surprise was the inclusion of deposit holders under the EU’s deposit insurance benchmark of 100,000.  That raises the spectre of a similar approach being taken in other countries, regardless of assurances that Cyprus was an isolated case.  While such confusion is not an issue right now, it could become so in the future of bank bailouts appears again necessary elsewhere.