Demystifying Cyprus Bailout

Posted in Finance Articles, Total Reads: 3468 , Published on August 15, 2013

Cyprus is a small island nation on the eastern part of the mediterranian sea with population of less than a million and is divided into two parts.Northern Cyprus, officially the Turkish Republic of Northern Cyprus,is a self-declared state that comprises the northeastern part of Cyprus while other part which is focus of dicsussion here is a greek controlled area known as “The republic of Cyprus” which joined the E.U. in 2004 and the Euro Zone in 2008.

image:freedigitalphotos.net

Cyprus is currently making the headlines because it is the 3^rd nation after Ireland and Greece on the verge of bankruptcy and had to be rescued by the ‘Troika’(the European Commission, ECB, and IMF)in order to stop the contagion from spreading to the other weak European economies.

GDP Growth rate: Cyprus Vs. Rest of Eurozone (‘07-‘12)

As we can see that Cyprus was in a better position than most of the Eurozone itself.

Then how did the Crisis take shape?

Banking system of Cyprus is nearly 8 times its GDP,well above the Euro zone limit of 3.5 times.The size of the domestic banking system was about 7 times even if the overseas operations were excluded.

The Cypriot bank shortfall

There are certain things one needs to know about Cypriot banks:

Being a tax haven, a large part of foreign deposits in Cyprus comes from Russian oligarchs

For the Russians it serves as a backdoor to smuggle their money into the E.U.

They had invested a lot of money in Greek bonds
They are highly dependent on their Central bank for financial assistance

Cyprus found that turning into a tax haven is a lucrative business model and due to this it has around 37% of deposits from abroad of 68 billion€. 68% of all uninsured deposits above 1,00,000€ are from foreign.

So what was done with all this money?

* Greek Economy is 12 times of the Cypriot Economy

Cyprus: Long term Interest rates (2007-2012)

What is the Bail-out & Bail-in plan?

Under the current bailout plan the ‘Troika’ would give €10billion to the Cyprus government with a condition that €5.8 billion needs to be shelled out by the bank depositors known as “Bail-in” which is the first of its kind in Europe.
Insured deposits of less than €1,00,000 will be levied a 6.75%tax and uninsured deposits (more than €1,00,000) would be taxed at 10% with immediate effect
Laiki bank, the second largest bank in Cyprus will be closed. Its 4.2 billion of deposits over €1,00,000 will be put in “bad banks”. These deposits might get wiped out entirely.
Bank of Cyprus will undergo debt restructuring and its uninsured depositors above €1,00,000 could face approximately up to 40% cuts in their deposits
It will be a tough for the Bank of Cyprus ahead to reach the EU mandated levels as it has inherited the €9 billion debt of the Laiki bank.

Understanding Emergency Liquidity assistance (ELA) Mechanism:

The banking system of Cyprus would have collapsed much before had it not borrowed emergency funds from the European Central bank (ECB) through ELA Mechanism.

Normally,a Euro bank which is illiquid but not insolvent and which does not have a good quality collateral takes its poor quality collateral to the ECB in exchange for a loan subject to a ‘haircut’.
The poorer the quality of the collateral the higher is the interest that ECB charges
ELA comes as an angel to the rescue of the Euro bank even when it has the crappiest or zero collateral
In such cases, instead of the ECB it is the central bank of that particular country which provides the loan subject to stricter haircuts but only after the approval from ECB. Here, central bank gets the funds from the ECB and provides it to its Euro bank. The difference here is that the central bank will be on the hook if the Euro bank defaults.

Laiki bank and other 2 big banks kept themselves alive by gobbling up such ELA funds. Laiki bank gets 33% of its liability fulfilled from Central bank funding.

Troika’s approach for Cyprus

Unlike Greece and Ireland, where the taxpayers had to burn their hands;

For Cyprus Troika has decided the following approach:

Shareholder> Bondholder > unsecured deposit holder(haircut)> taxpayer

The bankrupt banks will be allowed to fail and insured depositors will be secured as per E.U. policy.

Implications of Cyprus Crisis

Capital Control

Strict Draconian capital control laws have been imposed. Daily withdrawals are restricted to €300 and checks are not allowed to cash. There is a limitation of €5000/month on the credit card transactions .There is a limit to €5000/day for business transactions and transactions above that will undergo review by specially formed committees. The Cyprus government said that the capital control measures are mostly temporary but considering the fact that their very business model has come to tatters, it seems to be a long austerity journey ahead for Cyprus coupled with long lasting years of recession.

Bank Runs

The capital control measures were enforced to prevent “Bank Runs” which could have spelled more trouble for the economy.

A bank run could also be triggered in already weakened economies of Spain and Italy fearing that the troika might follow the same approach of that of Cyprus. This could also lead to investors pulling out the money form any risky Eurozone bank triggering a domino effect. This would widen an already bad situation and increase the bank shortfalls and could lead to a continent wide crisis.

Currency Devaluation

Also the strict capital controls have led to a fall in Cypriot euro compared to euro in other economies .For example to a Russian whose 1million money is stuck in Cyprus bank is told to that he is allowed withdraw 9,00,000 for his 1 million in a Spanish bank then he will immediately switch his deposits if allowed because a Spanish euro is worth 9 times that of a Cyprus euro mainly due to its mobility.

It indirectly implies that Cyprus might be moving out of the Eurozone due to this difference in values of euros.

Economic slowdown

The credit rating agencies have downgraded Cyprus to junk rating and Cyprus might also be forced to sell its 400million worth of gold reserves Cyprus’s economy is expected contract by 8.7% in 2013 and 3.9 % in the next year. There is large scale resentment among the people who think that even the social and human cost of the crisis is not taken into consideration by the Troika.Banking and real estate, the two main sectors of income have gone boom to burst creating large scale unemployment.

Road Ahead for Cyprus

Cyprus has two promising sources of growth waiting to be tapped. One is the recently discovered Aphrodite gas field in the eastern Mediterranean. The other is its tourism industry, which is underdeveloped and has plenty of scope for foreign investment. The best way for Cyprus to exploit both as fast as possible would be to patch up its 40-year-old division.
Cyprus could also benefit from its weakening currency by becoming competitive in the exports and the service industry.

Precautionary measures set-up in Eurozone:

European Stability Mechanism: It is a kind of firewall set-up to protect the beleaguered Eurozone member states .

Bad Banks: A financial institution created to hold non-performing assets owned by a state guaranteed bank.

Things learnt from Cyprus crisis

The two Cypriot banks were very small compared to other Eurozone banks so they were allowed to go hang. ECB won’t do this with other big systemic banks.
European Banking Authority's stress tests to identify the health of the bank are rubbish as all the Cypriot banks passed these tests.
Cyprus being a small contributor to the EU of only 0.2% never had the bargaining power similar to the likes of Italy and Spain

When Cyprus joined the E.U. there was no such condition put forth them regarding the size of the banking sector one needs to maintain and the same thing is now a thorn in the flesh for Cyprus

No one can exactly predict the unintended consequences, the way the Cyprus issue was dealt with and will this kind of bail-in spell more trouble for the taxpayers remains a question to be answered. Such financial crisis brings a lot of mispriced risk thinking that tax payers can subsidize the banks. The building blocks to deal with it need to be worked on with proper legislation and advisory committee to be set up and banks to be adequately recapitalized. How the Troika tackles future crisis and what approach does it take remains to be seen.

The article has been authored by Kunal Sanghvi and Onkar Sovani, SIMSREE

References:

http://www.mckinsey.com/insights/financial_services/understanding_the_bad_bank

http://www.theatlantic.com/business/archive/2013/03/everything-you-need-to-know-about-the-cyprus-bank-disaster/274096/

http://www.guardian.co.uk/business/2013/mar/25/cyprus-bailout-deal-at-a-glance

http://www.guardian.co.uk/money/2013/mar/29/10-lessons-cyprus-bailout

http://www.washingtonpost.com/blogs/wonkblog/wp/2013/03/18/everything-you-need-to-know-about-the-cyprus-bailout-in-one-faq-2/

http://www.csmonitor.com/World/Europe/2013/0329/What-s-behind-the-bailout-crisis-in-Cyprus

http://www.guardian.co.uk/world/2013/mar/25/cyprus-bailout-deal-eu-closes-bank

http://www.ucy.ac.cy/data/ecorece/STEPHANOU_123-130.pdf

http://blogs.telegraph.co.uk/finance/jeremywarner/100023510/cyprus-should-do-what-iceland-did-and-just-conviscate-the-russian-money/

http://www.youtube.com/watch?v=FhYwlBvAomI