Italy isn’t the only eurozone country for which a recent election result might presage fundamental change in economic fortunes. Unlike that in Italy, Cyprus’s election did produce an outright winner on February 24 – the right-wing Democratic Rally (DISY) party under new president-elect Nicos Anastasiades. What it also did was remove the last obstacle to the signing of the memorandum of understanding (MOU) with the troika of international lenders that has been under negotiation since June. The MOU, now due to be signed before the end of March, will lay out terms for the €17 billion bailout that the stricken country is seeking.
The contents of the agreement have been the subject of intense speculation since the leaking of a confidential memorandum in February. This suggested that the bailout of Cyprus’s banks could involve the bail-in of their uninsured depositors. Such a move would have disastrous consequences for the island state, which has staked all on its reputation as an international financial services centre. It would also have far-reaching consequences for eurozone banks across the region due to likely deposit flight.
In mid-February, EU Economic and Monetary Affairs commissioner Olli Rehn took care to emphasise that the bailout for Cyprus would not impose losses on private creditors as the Greek PSI did. But on the subject of the rest of the package, he merely said: “The Commission’s intention is to ensure a fair burden-sharing of the cost of restructuring or resolution of Cypriot banks."
Not exactly a ringing denial. The prospect of such a move has arisen due to the island’s perception as a haven for wealthy expatriates – particularly Russians. It has provoked particular ire at home. “Any haircut to depositors would be destabilizing and dangerous,” declared a source close to the government recently, rejecting the suggestion there was considerable wealth on the island that should contribute to the bailout. “The average annual income per capita in Cyprus is €20,000.”
Deposits of up to €100,000 at Cypriot banks are insured, so any haircut would only be applied to monies over and above that level (of which there could be an estimated €25 billion). As such, any depositor haircut might certainly be expected to provoke more unrest on the streets of Moscow than Nicosia. Between 7% and 14% of bank deposits in Cyprus are believed to be non-domiciled Russian, a figure that does not include deposits held by Russians resident in the country. The coastal city of Limassol (population 154,000) has 20,000 Russian residents.
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It is these strong links between the island and Russia that make the prospect of bailing in uninsured depositors so worrying for Cyprus’s new government. The country has received a €2.5 billion bilateral loan from Russia that was rescheduled to run until 2016. Haircutting Russian depositors will do untold damage to its relations with its huge northern creditor. Russia is understood to be willing to be involved in any bailout of Cyprus but has yet to commit to any new funding.
US-based asset manager Pimco completed a review of the Cypriot banking sector in January, which calculated a bailout requirement of around €7 billion under a baseline scenario and €10 billion under an adverse scenario. The latter, which envisages property devaluation of up to 65%, is the scenario that has been adopted.
The country has already implemented a series of measures designed to persuade its reluctant eurozone partners to assist it. Cost-of-living allowances have been halved and teachers’ working hours increased. Business-class travel has apparently also been denied to all but the president and one other senior official. But one measure that has not yet been implemented is a wealth tax.
It is perhaps of little surprise that a bailout of this magnitude has attracted speculation about radical solutions such as depositor haircuts. The banks have huge problems and very few places to turn. According to JPMorgan, Cyprus’s banks hold 87% of its €15.3 billion outstanding government debt. Their holdings of Greek government debt were such that the Greek PSI cost them €4.5 billion – or 25% of GDP.
One place they can – and probably will – turn is to subordinated bondholders. An estimated €1.4 billion subordinated bank debt is outstanding, including the March 2011 issue of convertible contingent convertible (CoCoCo) bonds by Bank of Cyprus that was arranged by HSBC and Barclays Capital. It is very difficult to see any bailout for Cyprus being approved without the bail-in of this debt. Indeed, retail buyers of these bonds held demonstrations outside the Bank of Cyprus’s headquarters in January, threatening legal action over having been allegedly mis-sold the bonds.
Analysts have also speculated that Cyprus could include the unprecedented step of bailing in senior bondholders. The banks have €500 million senior debt outstanding – a relatively small amount on which to adopt such a contentious measure, the ramifications of which would reverberate around the entire region.
However, the problems of the banking sector are such that almost nothing is off the agenda – a bad bank is up for consideration, as is the merger of the two largest banks. With assets of €120 billion, Cyprus’s bloated banking sector is equivalent to seven times the size of its €18 billion GDP. This is on a level with Ireland pre-crash (seven times) and the UK (six times). Banking assets in the island grew by 50% between 2007 and 2012, partly due to capital flight from Greece.
Seventy per cent of the banking sector is accounted for by just two banks: Bank of Cyprus, which has assets of €37.5 billion, and Cyprus Popular Bank, with €34 billion. The latter received €1.8 billion of public money in 2012 and is now under state control.
The government might be able to scrape together €2 billion from privatizations of utilities such as the telecoms operator CYTA. It also has €600 million in uncollected taxes – a large proportion of which is owed by the church. Much hope is being pinned on the expropriation of natural gas reserves to the south of the island in the Aphrodite gas field. Potential revenues from the gas would not be due before 2018 to 2019, but the government has already raised €150 million from the sale of exploration licences.
The incoming president has, however, expressed reluctance to implement privatization in the near term and time is running out. Without the EU bailout funds, Cyprus’s debt position is deeply unsustainable but there is strong resistance from within the bloc to commit the funds due to concerns over its reputation as a tax haven and for money-laundering. The involvement of Russia makes this a highly political and contentious situation – despite Cyprus only accounting for 0.2% of EU GDP.