Cypriot bailout deadlock sparks fears of euro exit


Matthew Turner
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Analysts contemplate the possibility of Cyprus leaving the euro due to the political standoff in Nicosia and Berlin.

The decision by Cypriot lawmakers to reject an unprecedented levy on bank deposits has left the Cypriot government scraping the barrel for funding solutions to recapitalize the country’s insolvent banking sector, sparking fears of a euro exit. Although leaving the euro would be the worst possible outcome in the Cypriot debt saga, proposals put forward by the government have not led anywhere. The Cypriot parliament overwhelmingly rejected a proposal of a bank levy on deposits, with the government’s party members abstaining and the opposition rejecting the plan. This rejection highlights the need to find a different funding solution, with some pointing to Moscow as the most readily reliable funding source. Yet the form this Russian funding might take has not been established, and remains open to negotiation between Cypriot policymakers and Russian lenders. With a funding deadline looming, analysts are therefore worried a deal with Moscow might not be reached. Bernard Musyck, professor of economics at Frederick University in Nicosia and one of ECR’s expert contributors, says: “Nobody has told us anything about the funding solutions, no politicians have come up with concrete proposals, and nobody knows where the funding to raise €5.8 billion needed on top of the €10 billion bailout from the EU and International Monetary Fund will come from.” Anatoli Annenkov, euro-area economist at Société Générale, adds: “Funding from Moscow could take the form of out-right loans, it could involve some selling of state assets, but what that would entail is very unclear.” Furthermore, a funding programme in the form of more loans would not be enough to rescue the country from default and would only exacerbate the country’s debt burden, reckon analysts. “If the funding programme involves only more loans, it won’t really resolve the situation,” says Annenkov. “It will only exacerbate the country’s debt burden, and the country’s debt level will become unsustainable, which would come close to 120% of GDP, so more loans are judged not to be sustainable. The best solution would be some form of private sector involvement in taking losses.” A report by Société Générale states: “There is a need for a significant effort to clearly communicate the options to the Cypriot people. Given the stakes involved, there are no easy solutions available, and any solution is likely to be costly for the Cypriot economy.” Annenkov says the political deadlock could force the ECB to pull the plug, leading to only one outcome – default and the possibility of an EMU exit. “The ECB has been very clear that it can only fund banks which are solvent but the Cypriot banks are not solvent – they need recapitalization,” he says. “The €10 billion offered from the EU would go into some form of recapitalization, so therefore the ECB could still fund. “But if there’s no deal on the table, that will make funding very difficult, but the ECB will likely let the political process play out, so as long as there is still an attempt to reach a deal we would anticipate the ECB not to pull liquidity funding.” He adds: “A euro exit would occur if there was a deadlock in terms of funding negotiations. In that scenario, the Cypriot state would be fast running out of money and at that point they may be faced with defaulting on their debt. “But this would be a much slow-moving process, as an exit would need to be negotiated to some extent and in those negotiations you would have to find temporary solutions.” ECR Cyprus has been one of the worst performers in the ECR survey in recent months, falling 11 places globally in 2012, and 20 places overall since the eurozone crisis began in mid-2010. Cyprus’s global rank of 44th places it alongside Iceland and Ireland, countries that have experienced credit events of their own in recent years. Notably, Cyprus’s transfer risk indicator – a key survey measure of the risk to foreign depositors – has fallen by 0.5 points (out of 10) during the past six months as the dangers to deposit holders in the country have increased. Unsurprisingly, ECR data for Cyprus are expected to remain negative in the second quarter and are likely to see further score deteriorations this week, as other economists digest recent developments and update the consensus score.

This article was originally published in Euromoney Country Risk.