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The Coming Cyprus Challenge for the Euro Area



Cyprus is small even by peripheral euro area standards. With a GDP in 2012 of less than €18 billion, the country is only about one-tenth the size of Ireland, Portugal, or Greece. In the context of the euro area's new €500 billion European Stability Mechanism, its financial problems look like a rounding error. Yet as European leaders seek to put their financial crisis behind it, Cyprus poses tricky challenges in coming weeks and months for the euro area and the International Monetary Fund (IMF).

First, the clock is ticking as the Cypriot government has announced it only has financing through March 2013. No one, however, should expect a deal much before then.

Second, Cyprus's financial problems derive largely from its oversized banking system at more than 700 percent of GDP . Following losses from their Greek sovereign debt holdings in the restructuring in early 2012, large parts of that sector are insolvent or in dire need of capital infusions to adhere to the European Union's new bank capital targets. An international bailout must occur.

The Cypriot case looks similar to that of Ireland in late 2010, where capital shortfalls in a collapsing oversized banking system also caused the collapse of government finances and the need for international financial aid. Because no one wants to pay for bailing out banks, especially in other errant countries, the Cypriot government faces substantial political obstacles in its quest for money from the euro area and potentially the IMF.

But that is just the start of the problems. Cyprus's particular difficulties arise from the fact that large amount of recent foreign investments into Cyprus and foreign deposits placed in Cypriot banks come from uncertain origins in Russia. A recent report from the German foreign intelligence service, the Bundesnachrichtendienst (BND), according to the German news magazine Der Spiegel, stated that "the main beneficiaries from a rescue of Cypriot banks would be Russian oligarchs, businessmen and mafiosi who have invested their illegal money in Cyprus."

In addition, unlike Ireland in 2010, Cyprus seeks a bank bailout just as the German election campaign has started. For Germans, the potency of this issue cannot be underestimated, despite Chancellor Angela Merkel's commanding lead in the opinion polls. The opposition Social Democrats have supported Merkel throughout the euro area crisis. Now they have an opening to attack her for being too kind to the international financial sector, including obviously in Cyprus.

Aggravating the political sensitivity of these issues is the debate over tax evasion, in which the Social Democrats (SPD) and the Green Party have blocked approval of a new tax treaty with Switzerland as too soft on tax cheats in Germany. There is no chance that the German government will back any bailout of Cyprus without something in return to protect it against domestic German political attacks of this nature. Apart from securing the solvency of the Cypriot government, any bailout must therefore also guarantee that German (and euro area) taxpayers' money is not seen as protecting foreign, particularly Russian, bank holdings and deposits.

A separate problem stems from the status of the Cypriot president, Dimitris Christofias, as Europe's last unreformed (though elected) communist head of state. As a good atavistic comrade, he has refused any request by the troika of the European Union, the European Central Bank (ECB), and the IMF to sell off state-owned companies as part a bailout. Politically, that is untenable. But it is likely to be a temporary obstacle.  Christofias will step down after elections in mid-February, probably to be replaced by the center-right and broadly pro-European leader of the Democratic Rally Party, Nicos Anastasiades. Since no deal on Cyprus is likely until after the change in power, a new Cypriot government will have only three to four  weeks to strike a deal with the international community.

What does Cyprus need? Preliminary estimates suggest that bank recapitalizations require up to €10 billion, and up to €7 billion for the government's other capital needs. That does not sound like much for the euro area, given the amounts granted to Greece. But it could approach 80 to 90 percent of Cypriot GDP and saddle the government with an unsustainable total debt burden after the bailout. (Its debt-to-GDP ratio was 70 percent in 2011.)

The euro area faces tough choices. Fearful of bond market contagion, it has ruled out more haircuts on private holders of euro area sovereign debts. But if Cyprus's debt burden is unsustainable, the IMF may refuse to become involved.

Cyprus should, in theory, do what the Irish probably wish they had done. It should force haircuts on bank creditors, reducing the total costs of the bank bailout. Such a step would be consistent with ground rules of the coming single resolution mechanism (SRM) in the euro area. Indeed the European Commission suggested last year that all unsecured creditors undergo debt restructuring—"bailed in"—before future taxpayer funded bailouts.

The problem, however, is that Cypriot banks have not issued many bonds that could be subjected to haircuts. This is illustrated with the latest available ECB data from November 2012 in table 1.

Table 1 Aggregated liability side balance sheet of Cypriot monetary financial instiutions (MFI), November 2012

Table 1 shows that only 1 percent of Cypriot bank liabilities are bonds. Even if all bondholders were completely wiped out, which would be unlikely, only €1.8 billion would be recouped for taxpayers1—hardly enough to reduce the size of the bailout and secure Cypriot government debt sustainability. Moreover, many of these bonds might be domestically held, increasing bank recapitalization needs. It would be robbing Peter to pay Paul to impose haircuts on one bank's bonds if they are owned by another Cypriot bank in need of capital.

Table 2 Cypriot Central Bank ELA provision in 2012

About 58 percent of Cypriot banks finance themselves (like all other regular banks except for bizarre business models like in the case of Dexia) through domestic and other euro area deposits. Since the Greek debt restructuring in March 2012, which imposed substantial losses on the Cypriot banks, an increasing amount of this funding has come in the form of liquidity provided the Central Bank of Cyprus through the so-called emergency liquidity assistance (ELA) operations. These are shown in table 2 with Cypriot data. Note the usual central bank balance sheet item used to "hide" these transactions: "Other claims on euro area credit institutions denominated in euro."

Table 2 shows how Cypriot banks had no liquidity problems before the Greek debt restructuring, but are today receiving more than 50 percent of Cypriot GDP in ELA assistance.

Table 1 shows further how Cypriot banks have nearly €35 billion in total non-euro area liabilities, or almost 200 percent of Cypriot GDP. Most of these non-euro area liabilities are in the form of deposits from non-financial institutions (i.e., non-bank financial institutions, non-financial institutions, and households). A striking feature of the system is the stability of this deposit base during 2012. There has been no outflow of deposits up until the end of 2012. This is illustrated in figure 1, showing that Cypriot banks experienced a small increase in deposits around the time of the Greek debt restructuring and election campaign in 2012. Ironically some money might have moved to Cypriot banks fleeing Greece, just as the Greek bond restructuring crippled the Cypriot banks.

Figure 1 Total deposits of non-MFIs held with Cypriot MFIs, by residency (millions of euros)

Considering that the euro area might well want to inflict losses on some of these deposits, not least to punish murky Russian investors, there is potential to target foreign investors in a Cypriot bank rescue. Indeed it is remarkable that such potential depositor targets have not yet fled Cypriot banks.

There may be several reasons why. Many of the deposits might be laundered dirty Russian money that would have difficulty finding another safe haven. Alternatively, holders of these deposits might be financially and politically illiterate and unaware of their vulnerability.2 Or they may have received an "all clear" from the governments in Nicosia and Russia about the safety of these deposits.

As if these complications were not enough, there are still more difficulties. Many Russian investments and bank deposits in Cyprus will have been structured as domestic investments and hence will not be included in the Cypriot banks' foreign deposits. Rather they would be listed as part of the domestic deposit category.3 Indeed, the strong surge in domestic deposits from 2006–10 suggests that they were at least partly of foreign origin. It is also unclear just how many of Cypriot banks' "non-euro area deposits" actually come from Russia. The euro area is going to need an army of forensic accountants to make sure they target the right investors and to do so without causing them to flee immediately. Will there be the stomach to order a deposit freeze or bank holiday in Cyprus as part of this?

Were the euro area to select such Russian investors in Cyprus, however, they would be negating the whole idea of "deposit insurance schemes" in the region, creating the likelihood of devastating retail bank runs elsewhere and even more contagion than the haircutting of sovereign bond holders in the euro area.

What will the euro area and the IMF do? They can't impose haircuts on sovereign bondholders and they can't "bail in" bank depositors either. The Irish bailout of late 2010 might provide a road map. There the euro area and IMF bailout was supplemented by bilateral contributions from non-euro area countries with sizable interests in the Irish banking system—namely the United Kingdom, Sweden, and Denmark.4 It is logical to expect direct contributions from Russia, given that country's direct interest in the Cypriot banking system. Russia already granted Cyprus a €2.5 billion loan in 2011, and was allegedly asked by Cyprus for another €5 billion in late 2012.

Would Russia play along? It is hard to say. But presented with the alternative of a team of Kroll's forensic accountants, and the attendant embarrassing disclosures, President Vladimir Putin might be interested in avoiding revelations about his inner circle or indeed himself. Having turned a blind eye to so much money leaving Russia, the Kremlin might be willing to pay to keep their foreign stashes hidden!

A Russian loan of another €5 billion to Cyprus would reduce the financial cost to the troika but not solve Cyprus's other political problems in the form of German election politics and the need to prove debt sustainability to the IMF. But these issues could be dealt with in other ways.

Chancellor Merkel, for example, will be able to say that many of the Cypriot banks' bondholders will be bailed in, yielding perhaps two-thirds of the outstanding €1.8 billion. Second, Russia will probably be asked to participate as a junior creditor to the euro area in this bailout, so that the ranking shows the IMF on top, then the euro area, and then Russian bilateral loans.

Combined with an ex ante Russian rescheduling of its existing €2.5 billion loan (perhaps in the form of a maturity extension with repayments beginning in 30 years), such steps would allow Merkel to say that the first losses would be borne by Russia. Russia—and not the euro area—would be bailing out its own residents in Cyprus while keeping its holdings secret. Add to that a tough and coercive general IMF program for Cyprus—complete with extensive structural reforms, privatizations, and banking sector overhaul/deleveraging—and the politics in Germany might just work.

Would status-conscious Russia accept designation as a junior creditor to the euro area and the IMF,5 considering that the United Kingdom, Sweden, and Denmark are not explicitly junior to the euro area in the Irish rescue, but rather just silent participants in the bailout? Some creative financial engineering and diplomatic language might satisfy both German political demands and Russian status concerns over Cyprus.

As for securing longer-term Cypriot debt sustainability, the IMF Board will likely be flexible in its interpretation of what that constitutes, as it has been with respect to Greece. Any agreement acceptable to the euro area, Germany, and Russia will almost certainly be endorsed also by the IMF Board, if not the IMF staff. In any case, the small amounts of money make it feasible to envision future debt relief granted to Cyprus, perhaps as part of its future reunification.

This raises the final broader political implications of Cyprus. First, there will inevitably be talk of Cyprus exiting the euro area in coming months.6 As usual, that is nonsense. Where would Cyprus get help if not from the euro area? In addition, a Cyprus exit would invite reunification on Turkish terms. Greek Cypriots will avoid that fate at all costs. They will 100 percent stay in the euro.

But the euro area should demand "constructive engagement" of the Cypriot government on the issue of reunification as a part of its deal. Beggars cannot be choosers, and the days of the Greek Cypriot government blocking progress on Cypriot reunification must come to an end.

A larger lesson from tiny Cyprus relates to the "parliamentary approval risks" in the euro area, and why Prime Minister Mariano Rajoy of Spain is reluctant to seek a lifeline in the form of Outright Monetary Transactions. He is afraid that—as in Cyprus—there will be specific political demands placed on him as part of the deal.

Ireland should also take heed from the Cyprus deal, because it paves the way for a deal on Ireland's promissory notes from their own bank rescue. The euro area cannot haircut Cypriot bank bondholders to protect the solvency of Nicosia, and then not grant Ireland financial assistance to overcome its legacy bank bailout debts. Look therefore for an Irish promissory note deal after the Cypriot bailout has been completed in the second quarter of 2013.

Cyprus poses excruciatingly complex and politicized challenges. But it will not derail the stabilization of the euro area in 2013.


1. I am indebted to Dimitris Drakopoulos from Nomura in London for further fruitful discussions of this issue.

2. I am indebted to my colleague Anders Åslund for making this possibility clear to me.

3. I am indebted to Douglas Rediker for this important point.

4. The United Kingdom contributed €3.44 billion, Sweden €598 million and Denmark €393 million for a total of around 7 percent of the total €67.5 billion in European Union and IMF money to Ireland.

5. I am again indebted to Anders Åslund for pointing this out.

6. The first Wall Street calls are already out there on Bloomberg.

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