Mishandling of Cyprus in monetary union goes back to its entry and is serious stain on record of EU institutions

Cyprus could still upset the euro area

It is by no means impossible that one small country, such as Cyprus, could set off a chain of events which spread across the whole euro zone. Euro zone policy makers should be thankful that the Cyprus debacle has not so far had a severe adverse effect on the rest of the euro zone, particularly given political paralysis in Italy. They should not be complacent that there will be no such contagion. So far Cyprus is the only country where opinion polls have shown a majority wanting to leave the euro zone, reflecting a deep sense of betrayal. If one country, albeit a small one, leaves the euro zone, the possibility that others might do so is likely to be more prominent in investors’ and depositors’ minds. A key factor against leaving is the threat to savings of being compulsorily changed into a much weaker currency. The Cyprus deal has now led to a loss of savings over €100,000 of up to 50%, although the belated decision to protect savings up to this threshold has reassured those with moderate savings.

 

The principle of moral hazard has been applied brutally and selectively

Given the small size of the Cyprus economy and therefore of its required bail-out relative even to those of Ireland and Portugal, it is surprising that the key creditor countries, Germany, the Netherlands and Finland, did not agree to the whole €17bn needed, or at least to leave a much lower amount to be lost by depositors. One reason is election politics in such creditor countries, particularly given publicity over the fact that a significant proportion of the depositors being bailed out would be Russian investors and would include many tax evaders (both Russian and non-Russian) and might indeed include worse forms of money laundering. Another, perhaps better, reason is that bailing out an irresponsibly over-stretched financial sector would cause “moral hazard” by setting a precedent of bailing out irresponsible behaviour on the part of banks. It may be desirable that depositors look to how well banks are being managed and so give earlier warning of financial crises by withdrawing money from poorly managed banks anywhere in Europe. However, the risk is that sensible caution turns in to an exit stampede from not just one or two badly managed banks but from all the banks of one or more countries.

Secondly avoidance of moral hazard should apply to all not just the ill-starred deposit-holders in Laiki Bank and the Bank of Cyprus. Why should not banks in core euro zone countries including German banks have been forced to take losses on their ill-judged loans to Irish banks rather than forcing all the losses to be shouldered by the Irish taxpayer? Why has a Netherlands’ bank recently been fully bailed out by the state?

 

EU institutions should take responsibility for leading Cyprus up the garden path

Even more important, the EU institutions, including the European Central Bank, European Commission and the European Council (meaning the member states especially the most influential ones) should take responsibility for their gross negligence towards Cyprus. Eight times its GDP in Cypriot owned bank balance sheets are eight times the country’s and unlike Switzerland for example, the banks had little experience of risk management on such a scale until the expansion began in the 1990s. In addition, an excessive amount was invested in one basket, that of Greek government bonds, even if it were not evident that Greek public finances were amongst the weakest in Europe. A weakness lay in the Maastricht treaty itself limiting euro admission criteria to macro-economic and fiscal indicators and not including the viability of banking systems, and in the lack of regulatory powers at the euro zone level, but warnings could still have been made by ECB and other institutions. While Greece has to accept a large part of the blame for its predicament because it did not follow clearly laid down rules on public finance management, Cyprus did not disobey any such rules. By being admitted to the euro zone, it was in fact being led up a garden path into a supposed area of stability which turned out to be the opposite. There is little wonder that Cypriot deposit holders, such as small to medium businesses, who may have lost up to half their savings feel betrayed. It is too late for a U-turn. But measures should be taken to enable Cyprus to rebuild a service economy on stronger foundations. The size of the country means that a small proportion of EU structural funds could make a significant impact if used well.

 

 

Cyprus: from safe haven to verge of insolvency

The Republic of Cyprus (the Greek Cypriot ruled majority of the island) seemed in 2009–at the time when the Greek sovereign debt burst into the international financial scene and set off the wider euro zone crisis–to be a relatively safe haven. Its then successful banking sector continued to thrive helped by deposits from a wide range of foreign investors from Greece itself to Russia. The move over four years from safe haven to country on the edge has been a gradual deterioration rather than the sudden plunge that happened in the case of Greece. However, today, Cyprus is arguably the most problematic country in the euro zone after Greece through the interplay of sovereign debt crisis and banking crisis—the latter resulting partly from contagion from Greece. Recapitalisation by the Cypriot state of Cypriot banks, to make them viable following losses in Greek and other investments, now looks likely to cost €10bn or 55% of Cyprus’s GDP, which combined with ongoing government deficits would push sovereign debt to about 140% of GDP by 2016. This would be substantially higher than in any other euro zone country other than Greece and, according to consensus opinion, by around 20% of GDP higher than the solvency threshold. On the positive side, some of the gap could be closed by privatization which could bring in €2bn and the situation of the country should be also helped by the development of gas reserves, although their extent remains uncertain and they are not a panacea.

Nicos Anastiades, who is likely to be elected as president of Cyprus in the second round on February 27th, faces tough negotiations to secure a bail-out by euro zone partners which would put the state on the path back to solvency and restore confidence in the economy. For this to happen, the conditions applied –, though stringent in terms of policy – will have to be favourable as regards interest rates and repayment schedules. For the euro zone’s European Stability Mechanism (ESM) of €500bn, the amount required to rescue Cyprus is relatively small, but that does not make it easy from a political standpoint. A haircut on sovereign debt as already applied to Greece (itself exacerbating the problems of Cypriot banks) would damage the credibility of the insistence by euro zone policy makers that that the Greek haircut was a one-off and so could have adverse repercussions across the euro zone.

A bail-out, especially one on favourable terms, itself faces resistance from creditor countries like Germany and the Netherlands, because such a rescue would in part go to rescue banks from the consequences of expanding deposits from often dubious sources. For this reason a bail-in of large deposit-holders has been mooted. This would be a powerful discouragement to the use of small countries as tax havens but it would be disastrous for the Cypriot economy given the importance of its banking sector. But any bail-out should insist on increased transparency for bank deposits. This should apply even if tax evaded is in a non-EU country like Russia.

To get back to managing its sovereign debt and stabilising its banking sector, Cyprus is likely to require ongoing support. At the very least this should be on condition that Cyprus commits to not blocking closer relations between the EU and Turkey bearing in mind that it was the Greek Cypriot side not the Turkish Cypriot side which in 2004 blocked the most recent UN-led effort to solve the division of the island. Ideally, although that would require careful and skilled diplomacy, rather than threats, the Greek Cypriots should be persuaded into new negotiations on ending the stalemate in which part of the island has for almost 40 years, been under the authority of an entity, the Turkish Republic of Northern Cyprus, which is only recognised by Turkey.