To Be Ireland or Iceland?—The Real Choice Before Cypriot Voters
In the first round of the presidential election in Cyprus on February 17, Nicos Anastasiades, the center right presidential candidate, won 45.5 percent of the vote, setting up a final round against Stavros Malas from the communist AKEL party of the incumbent president, Demetris Christofias. Malas garnered 27 percent of the vote. The new frontrunner is close to German chancellor Angela Merkel (who endorsed him earlier this year) and campaigned in favor of International Monetary Fund-style financial rescue.1 The results mean that shortly before Italy also goes to the polls, another crisis-stricken euro area electorate has clearly embraced economic austerity and reform measures.
Many euro area commentators seem to prefer to be guided by the street protests of an agitated few rather than reform-friendly electorates. The Cyprus election confirms that the economic policies pursued by the euro area are being implemented by governments with often fresh and legitimate democratic mandates.
The issue before Cypriot voters, however, was over how to extricate the country from its devastating banking crisis. Their choice will dictate Cyprus's economic prospects of Cyprus for decades.
Cyprus is the third small European island nation after Iceland and Ireland to suffer a catastrophic banking collapse. Maybe it is something in the surrounding waters, but banks in such places evidently should come with a "caveat insula investor" (Let the island investor beware) sign in the window!
In simplified terms, the choice is between an "Icelandic bail-in" and "Irish bailout" solution.2 (Forcing creditors to accept losses is what is known as a "bail-in.")
When the three big Icelandic banks went bust in late 2008, the government refused to bail them out and instead let them go bankrupt. Instead, the government's Emergency Act of October 6 protected domestic retail and wholesale depositors while imposing substantial losses on all unsecured creditors. These included foreign depositors in the United Kingdom and Netherlands (Icesave) and the many foreign banks that had provided wholesale liquidity to the doomed Icelandic banks.
By contrast, the Irish government in late 2008 issued its infamous blanket guarantee to all Irish bank creditors, which led to Dublin going to the IMF for an international rescue in late 2010. As discussed on RealTime last week, the Irish government has only recently moved towards liquidating some of its insolvent banks.
The economics dictate that Cyprus and the euro area will have to choose a solution resembling Iceland's more than Ireland's. The Cypriot banking system is 700 to 800 percent of GDP, bigger than Ireland's at "only" around 400 percent, approaching the 1,000 percent of GDP in Iceland before the crash. Cyprus also has a debt level of more than 70 percent of GDP in 2011, much higher than the levels in pre-crisis Iceland (29 percent in 2007) and Ireland (25 percent in 2007).3
Cyprus cannot afford an Irish-style bank bailout. Preliminary Cypriot capital needs are estimated at €17 billion (€10 billion for banks and €7 billion for deficit financing, totaling 100 percent of 2012 Cypriot GDP). Nicosia and the euro area will have to adjust the losses in the banking system before they are absorbed by the Cypriot government.
Substantial differences exist between options available to Cyprus today and Iceland in late 2008. Cyprus is a member of the European Union and euro area, while Iceland has its own currency and is only a member of the European Economic Area (EEA), which means that it participates in the Internal Market. As with Ireland in 2010, the Cyprus debt crisis has systemic implications for the euro area as a whole. Because the euro area (and the ECB) will finance much of the Cypriot aid, these concerns weigh more heavily than the domestic anxieties within Cyprus.
In January, the ECB and the Cypriot Central Bank provided €9.1 billion (or 51 percent of Cypriot GDP) in emergency liquidity assistance (ELA) to Cypriot banks.4 As the example of the Irish Bank Resolution Corporation suggests,5 no restructuring or liquidation of a Cypriot bank will be possible without fully protecting the ECB/Central bank of Cyprus against losses on the collateral they have accepted in return for this ELA. A rescue cannot be achieved without adding to the bill for Cypriot taxpayers or imposing additional losses on other creditors. Such is the price of being in a monetary union with a genuinely independent central bank, able to resist overt attempts at monetary financing.
In addition, EU law prohibits placing other European Union residents at any legal disadvantage vs. domestic residents. This means that adopting protections that apply only to domestic depositors and creditors, as Iceland did in 2008, will not be possible for the Cypriot government and the euro area. Any protections from losses resulting from restructuring or liquidating Cyprus banks that are extended to domestic economic agents must also be granted to all EU economic agents. This requirement has the added benefit of limiting the risk of contagions or bank runs in other euro area banking systems.
These concerns should not restrict Cypriot authorities and the euro area in designing an "Icelandic solution" for Cyprus. The aggregate balance sheet of liabilities for Cypriot banks (or monetary financial institutions, or MFIs as they are called in ECB jargon) makes this clear. Table 1 shows the latest data from December 2012;
As has been discussed before on RealTime, the Cypriot banking system contains both rotten and relatively healthy banks. Required measures will vary from institution to institution. We must wait for the independent external assessment from PIMCO about the detailed capital needs of Cypriot banks to get the full picture. As table 1 demonstrates, the minuscule level of debt securities held by Cypriot banks renders the imposition of losses on bank bondholders largely meaningless. Only bank depositors and external non-euro area creditors are potential contributors to restructurings, once bank shareholders have been wiped out. Table 1 further makes it clear that there are adequate resources to lower the cost to Cypriot taxpayers of their banking sector bailout.
Table 2 shows more detailed liability-side balance sheet data for Cypriot MFIs from the end of September 2012, including the cross-border deposit positions vs. different country groups.
Table 2 shows how €62 billion of Cypriot bank deposits came from domestic sources, with another €19 billion from the other 16 euro area countries, and a relatively limited €3.5 billion from the 10 non-euro EU members. Assuming that the Cypriot government would want to protect its domestic depositors, this €84 billion in EU-27 deposits would probably be left untouched in any restructuring. That, however, still leaves more than €30 billion in non-EU deposits and other creditors in Cypriot banks vulnerable to losses or haircuts, ensuring that Cypriot taxpayers will not inevitably be stuck with a €10 billion bank bailout bill.
European authorities may make further distinctions and protect all depositors below the statutory €100,000 deposit guarantee scheme (DSG) threshold. If that happens, only large non-EU depositors would bear the necessary losses. Perhaps special treatment will also be granted to depositors from other countries in the European Union's immediate vicinity in the Western Balkans. In the end, the restructuring of the banking system will depend on the financial assessment of the sector being prepared by the independent outside auditors. But there is no compelling reason for Cypriot taxpayers to be stuck with this enormous bill. To the extent that they are, it will represent a political choice, rather than financial necessity.
There is no reason why Cypriot authorities and the euro cannot divide Cypriot banks into viable and non-viable categories, and then transfer the banks needing public support to a new legal entity. The ECB, and all domestic and other EU depositors and creditors in this new "bad/bridge bank" entity, would be guaranteed by the Cypriot government and ranked ahead of unsecured non-EU depositors and creditors. These non-EU creditors would only to be compensated to the extent that insolvency procedures and asset sales yield revenues in excess of what is required to honor the Cypriot taxpayer guarantee.
Such an arrangement would not be costless to Cyprus and its status as an offshore financial center for many non-EU clients, notably from Russia. The euro area will not provide the financing for a Cypriot financial rescue that, in the style of Ireland, shields all banking creditors from losses, saddling Nicosia with a government debt of perhaps 150 to 200 percent of GDP after the financial rescue. Perhaps it will be the political preference of the new Cypriot government to go hopelessly into debt to protect such non-EU depositors and creditors and with it Cyprus' offshore banking driven economic model. But that seems unlikely. In the end, Cypriot taxpayers will not vote to burden their economic future to bail out non-EU bank depositors and creditors.
Rather, the new Cypriot government (and ironically the euro area) should take some inspiration from the hardball way Iceland dealt with the Icesave situation in 2008. Like Iceland, whose banks opened up overseas Internet-based deposit-seeking banking operations in the United Kingdom and the Netherlands, Cyprus has an unusual high proportion of foreign depositors in the banking system taking advantage of numerous legal and tax shelter reasons. (The Cypriot corporate tax rate at 10 percent is LOWER than in Ireland!) In 2008 the Icelandic government refused to honor the deposit guarantee to the bankrupt Landsbanki's overseas online savings account holders in the United Kingdom and Netherlands, which amounted to 60 percent of Icelandic GDP. As a result, British and Dutch authorities stepped in to safeguard financial stability and reimbursed their nationals.
Let Russia today do the same with any Russian depositors, and creditors that might lose money in a Cypriot bank restructuring process similar to the one sketched out above! To the extent that Moscow has been indifferent to the scope of Russian financial inflows into the shaky Cypriot banking system, let them now face the consequences of their apathy.6
So protect all EU depositors and creditors in Cypriot banks, while protecting Cypriot taxpayers and inflicting losses on non-EU creditors. The risks of bank runs in Cyprus and elsewhere in the euro area will be negligible. Cypriot taxpayers will not be unnecessarily burdened with the costs of shoring up a doomed national economic model. Meanwhile, the euro area will signal to its own taxpayers that they are not called upon to finance unsustainable offshore banking based economies. Non-EU bank creditors will not be pleased. But at least American ones will be familiar with the risks of losses in bank closure procedures from the way the Federal Deposit Insurance Corporation (FDIC) deals with such situations in the United States.
1. Stavros Malas also supports a bailout, albeit he is against potential state asset sales.
2. I am indebted to fruitful discussions with Achim Duebel on these issues.
3. Data from IMF October 2012 World Economic Outlook (WEO).
6. Ultimately, asset recoveries from Landsbanki has proved sufficient to cover all Icesave depositor losses in the United Kingdom and the Netherlands, so perhaps in the end losses suffered by Russia will be similarly limited.