Cyprus: The ‘Glue’ of Europe

Following up on our piece earlier this week, the coming hours and days are pivotal for Cyprus. Whatever is decided will be bad. Choosing the right solution for Cyprus is like trying to pick the best horse in the glue factory.

The ECB has threatened to withdraw ELA from the Central Bank of Cyprus on Monday if a deal has not been reached. If this is the case, and the required two thirds of the ECB board vote to stop Cyprus’s ELA, then other eurozone banks will be ordered to cease the transfer of reserves to Cyprus, and not to recognize any reserves received from Cyprus as euros. Cyprus, at this point, will be the first country to leave the EMU.

Cyprus is a miniscule 0.2% of eurozone GDP and, in absolute terms, the numbers do not look too scary (in the context of this crisis – however, on any ‘normal’ scale they are still truly ginormous amounts of money). According to BIS data, as of the Q3 last year, European banks had €31 billion of exposure to Cyprus; most of the major eurozone countries individually have less than €2 billion exposure each. Even Germany’s exposure is under €8 billion.

However, it is the contagion effects that will be difficult to gauge, whatever the outcome to the crisis. If the levy on deposits is restricted to uninsured depositors, then this would not preclude the flight of uninsured deposits – nominally those over €100,000 – in other eurozone countries. Narrow money would likely collapse, catastrophic for economic growth, and TARGET2 imbalances – that record the theoretical debtor/creditor status of each country in the eurozone – will grow much larger, with Germany becoming a significantly bigger creditor than it already is, and the periphery countries the corresponding debtors. These imbalances, it must be remembered, are no longer theoretical if the EMU breaks up.

One likely solution for the Cypriot banking crisis is the creation of a Scandinavian style good bank-bad bank, the good bank containing mainly the insured deposits, those under €100,000, and the bad bank containing almost everything else. The good bank can hopefully operate as a normal, well-capitalized entity, and the bad bank is recapitalized with whatever Cyprus can conjure up, perhaps government-guaranteed natural gas bonds, promising a share in some of the future profits from this source.

We have often read that what is happening in Cyprus, and what will probably have to happen, is unprecedented. This is not the case. One of the more recent examples, aside from the Sweden and Norway instances, of this resolution was the Bradford and Bingley building society in the UK in 2008. B&B suffered from wholesale deposit flight, thus the regulator deemed it necessary to withdraw the building society’s status as a deposit taker. All depositors were protected, however, with this part of the business being separated from the mortgage book, personal loan book, etc. The latter assets and liabilities were taken in to public ownership, given government guarantees, and wound down over time. Most people in the UK have probably forgotten about the rescue of Bradford and Bingley, but this is precisely because it worked.

However, the parallels with Cyprus are obviously inexact. The whole banking sector in Cyprus is in need of bailout, and the banking sector in aggregate is many times bigger in relation to GDP than in the UK. Furthermore, the composition of liabilities in Cypriot banks are different, heavily skewed towards deposits, and large chunks of these are of dubious provenance, mainly Russian. Nevertheless, there are many extant templates for how this sort of fix might operate.

The Icelandic solution has also been mooted as a template for Cyprus. Iceland, too, had a banking system that was too big to save. With no institution like the ECB breathing down its neck, and coercing it to assume the debts of its broken banks (as it did with Ireland), Iceland cleaved off the bad assets from the good assets, told foreign creditors – including many depositors from the UK – to go hang, introduced capital controls to prevent flight of money, supported the poor, and implemented only very reduced austerity measures. As a result, Iceland took a sharp hit to growth up front, but now is back on the path to sustainable growth. Iceland took the view that the banks were not sacrosanct, and deemed it unfair to bail-in taxpayers to rescue them. As Olafur Grimsson, Iceland’s President, put it at Davos, “Why do they [the Western democracies] consider the banks to be the Holy Churches of the modern economy?” We couldn’t agree more.

However, one thing Iceland was able to do to help rekindle the fires of growth was allow a 50% devaluation of its currency, something Cyprus will be unable to do as long as it remains in the euro. It may be beneficial, in fact, for Cyprus to leave the euro and follow the Icelandic path. This would probably be the case for Greece too. Departing Europe, defaulting on debt, and devaluing the (new, post-euro) currency is quite possibly the shortest route to a return to prosperity. However, the political elite in both countries will do their utmost to prevent this happening, thus drawing out the pain.

As long as capital controls remain in place in Cyprus, this will prevent a bank run as soon as the extended bank holiday comes to an end. Yet bank runs, like bank-splits, are nothing new either. We have seen one in the UK as recently as Northern Rock in 2007. Going back further in time, to 1720, the Bank of England itself faced a run. The Bank had reneged on a promise to absorb bonds of the South Sea Company at a certain price. A run was imminent, so the Bank managed to organize its confidantes at the front of the line. They were paid off, as slowly as possible, in sixpence coins. The same confidantes then went to another door at the Bank and paid the cash back in, again slowly counted. It was then again paid out. This process was enough to prevent a run until the holiday period, beginning on Michaelmas. By the time the Bank reopened, confidence had returned and a run was averted. Thus history shows that the authorities will stop at no measure to achieve their ends.

We wait apprehensively for the outcome in Cyprus. A few things, however, are highly likely. Capital controls will be put in place, uninsured depositors will take a haircut, and nominal GDP will collapse. Contagion effects of at least some magnitude will occur, with deposit flight in the periphery countries causing narrow money to contract, and thus growth in the eurozone will struggle to retain any, frankly non-existent, momentum. Moreover, financial imbalances between the core and periphery countries will increase, after recently showing some signs of improvement.

Whatever is decided – and as we write this a bailout solution within the EU framework is apparently hours away – will likely not be the best solution for Cyprus as a whole and, if they do remain in the EMU, there will be no concomitant currency devaluation to help regain competitiveness quickly.

Once again, the question of the survival of the euro has come into view. That the catalyst has been a seemingly innocuous country such as Cyprus does not fill one with confidence given the much larger, and much less tractable, problems Europe will eventually have to deal with. It looks like there will be plenty more horses heading to the glue factory.

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