Monday, 25 March 2013

Cyprus - When a bail-in is not a bail-out

The last minute deal done in Brussels to cement the 15.6bn bail-out for Cyprus is, as with everything in Europe, something of a fudge.  The bail-out is required to re-finance both the Cypriot banks and the Government. The troika of the IMF, the EU finance ministers and the ECB have agreed to hand over 10bn of the loot but only if Cyprus can find the other 5.6bn.  Given that the country is bust the only immediate source of finance left on the island is private capital held by the insolvent banks.  The Cypriot government have decided that they cannot raid (tax) all deposit holders so the money will be raised exclusively from savers with bank deposits in excess of 100,000 (the insurance limit).  The blanket ‘tax’ will take no account of income or the value of other assets (property, stocks, etc.) and will probably have a disproportional impact on overseas investors who were attracted to Cypriot banks by the benign regulatory regime and overly generous interest rates.  Many of these investors are Russian and they may well have to take a haircut of over 20%.  Quite apart from the distasteful precedent of getting foreigners investors to finance the bail-out, the solution raises some other important questions.

Since the ECB put together its fighting fund to rescue the failed economies in the Eurozone there has been a principle that Banking debt and reconstruction would be separated from government solvency.  So in Spain a number of banks have been bailed out in advance of the deal to resolve government indebtedness.  With Cyprus there was apparently no willingness to use European Stability Mechanism (ESM) money directly to recapitalise the banks, even though that is being done successfully with the Bankia in Spain.  By linking government debt and banking debts the troika risk the flight of capital from fragile banks all over Europe.  If you had over 100,000 in an Italian bank this morning what would you do?  The answer is - move it to Switzerland!  This may be a good time to buy shares in UBS!

The second major issue is that to successfully raid private deposits in Cyprus the government will have to put in place capital controls to ensure the banks don’t lose deposits.  Russian depositors were threatening to remove their spoils if they are subjected to any kind of a haircut.  Any significant fight of capital would quickly render these organisations insolvent;  as almost no amount of capital is sufficient for a bank which has lost the confidence of its depositors.  These temporary capital controls replicate what happened in the Icelandic banking crisis, where temporary controls have proven impossible to remove.   Interestingly to have these controls within the borders of a “single currency” is in breach one of the basic principles of a single currency; as by introducing capital controls Cyprus is creating its own currency within the Eurozone. 

So the results for the Troika is the worst of all worlds;  they have had to inject money into Cyprus at the same time as guaranteeing its exit for the Eurozone, they could have saved themselves  10bn and simply pushed Cyprus into default!  Additionally, they have probably destroyed any confidence the wider European public might have in the ESM.

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