The Cyprus (Self) Bailout - Time To Dig Deep


The Plan


Watching the Eurogroup conference call, the agreed plan appears to be:


1. Laiki is resolved via good bank / bad bank, with uninsured depositors (4.2B) most likely losing everything (along with shareholders and bond holders).


2. Bank of Cyprus will have a bail-in of uninsured depositors, with them losing between 30-40% most likely. Shareholders and bond holders will be wiped out.


3. Troika will lend 10B to the Cyprus government, solely for fiscal purposes and based on a memorandum to be determined. None of the troika funds will be used for the bank bailout.


4. Insured depositors will be protected (sub 100K euros).


5. The 9B of ELA at Laiki will be transferred to Bank of Cyprus. This is the single most bizarre and unfair part of the agreement. It has not been discussed why the Bank of Cyprus creditors should be paying for the ELA of Laiki and no reporter pressed with a follow-up question.


6. Note that for the most part the bailout is NOT hitting the Russian depositors that hard but will hit local Cyprus depositors hard. Russian depositors were not largely at Bank of Cyprus.


Some Learnings


1. At the end of the day, the appropriate rule of law approach held for the most part. This is a variation of our Scenario B.


Shareholders, bondholders and shareholders of the banks with the problems are the ones facing the consequences. Depositors at other banks (that are solvent) are not touched. This is what should happen under normal rule of law.

Given that the EU is *not* actually giving any money for this restructuring, Cyprus could have done this bank restructuring themselves anyway without this drama and reputational destruction re: its financial services industry.


The glaring exception to this is the transfer of the ELA from Laiki to Bank of Cyprus which I simply cannot rationalize. Greece should be taking some of this pain given that a large part of this ELA was to finance losses in Laiki’s Greek branches. In any case, I am not sure *why* Bank of Cyprus creditors should be expected to take responsibility for Laiki’s official creditors, except for the fact that the official creditors don't want to take losses.

(I suppose it is theoretically possible that Laiki has enough good assets to cover all the insured depositors and the ELA and will transfer a neutral Good Bank to Bank of Cyprus. However, that seems...optimistic..)

2. Given that the fiscal situation in Cyprus was not too bad even as recently as 2008 (the government ran a surplus!), one could have imagined if the prior government had been more serious about fiscal consolidation (and resolved the banks), the amount of the fiscal bailout could have been reduced to a level manageable in public markets.


3. Putting #1 and #2 above, if Cyprus had bitten the bullet itself and inflicted (severe) pain on itself, this all could have been avoided. In other words, Cyprus assumed, not unreasonably, that the pain might be spread out via the troika over several years. In practice, what happened is that it had to absorb all its pain anyway, but with the extra dose of public humiliation.


4. It is not a pretty sight being a small EU country and coming to the EU for help. Malta, Luxembourg and Latvia, take note…


5. It is also fair to say that Spanish, Portuguese and Italian uninsured depositors at weak banks should consider themselves duly warned...


6. Also: As if it was not clear before, it is perfectly clear now that the EU has no real institutional processes for this topics and basically makes things up as it goes along, based on what 4-5 people in a room decide at 3am. It is quite unbecoming for a serious Western super-power.


Implications


1. This will have an immediate negative effect on the local real economy through two mechanisms: (a) loss of savings of consumers hitting consumption and (b) partial or full loss of operating accounts of local businesses, some of which will never recover. The small and medium businesses in Cyprus will face a wave of bankruptcies unfortunately.


2. Additionally, the financial services sector (45% of the economy) will take a severe blow.

There is a mild positive in this approach in that, basically, Cyprus took all the pain itself and other foreign banks operating on the island (aka Russian Commercial Bank) have been spared.

Given this, there might be some ability to retain a few more customers under this approach rather than the across the board levies initially proposed.


3. Net net, we should expect a drop in GDP over the next 2 years in the 20-30% range. This will inevitably lead to significant social and business disruptions and hardship and greater need for fiscal consolidation (as certainly tax revenue will shrink and automatic stabilizers will increase). Government employees, take note…


4. Overall, this will be a very severe recession / depression.


How to Grow Now


So, what does Cyprus do now? It still has a highly educated workforce and would need to find something to do (quickly!) with it to avoid major brain drain and permanent diminution of its prospects.


1. Find a way to eliminate the capital controls as quickly as possible. Not much else is going to happen with capital controls in place.


2. Preserve as much of the financial services business as possible. This solution does at least allow a window for that to happen.


3. Push more aggressively on tourism related improvements – in particular, casinos should prove interesting given its geographic location (no country really ever replaced the hole left when Beirut lost that role in the 1970s)


4. Promote higher education. We have links to the University of Nicosia so are biased, but Cyprus has a surprisingly advanced private university system. With a few small tweaks to legislation to support it, it could be a significant growth driver.


5. Professional services outsourcing. The workforce is highly skilled, but still probably 50% less expensive than London and Western Europe.


6. Oil & gas: Important and meaningful, but as we saw with this week's renewal of the Israeli-Turkish alliance, this is not going to be a walk in the park. We will need some serious coverage from a serious power if this will be extractable.


7. [longer-term] Start building software/tech capabilities. It is a good fit for a small, highly educated nation, though Cyprus has no pre-existing capabilities here, per se.


None of the above will be easy, but Cyprus did perform miracles economically after the Turkish invasion in 1974. This is the chance to aim for an Act 2 in this regard. And, cliched as it is, its greatest asset is its people.


It is time to dig deep and start again…