Cautious Optimism from Cyprus

Robust risks remain, but the deal on the island shows new confidence and flexibility from the EU's financial firefighters.

Cyprus is now receding from the headlines. But the recent financial crisis in the Mediterranean will long be remembered—both for the extraordinarily inept attempt to raid the small island nation’s insured deposits and the backtracking and finger-pointing that followed it.

The decision to “tax” insured deposits was taken during a weekend late night negotiation between Nicos Anastasiades, the country’s newly elected president, and the Troika (EU Commission, European Central Bank, and International Monetary Fund). It represented a blatant violation of the spirit, if not the letter, of a 2009 EU directive that all bank deposits below one hundred thousand euros should carry an insurance guarantee. As the saying goes, “trust, once broken, is forever lost” so the damage persists even if the proposal was stopped in its tracks by the Cypriot Parliament—a fortunate development for the eurozone’s stability.

The revised deal that was hammered out in another cliffhanger late-night negotiation is less dangerous but still carries grave consequences for Cyprus: by inflicting massive losses on uninsured depositors (those over one hundred thousand euros) and wiping out senior and subordinated bond holders, it effectively destroys the offshore-banking industry, which is the mainstay of the small island’s economy. It also makes a travesty of the claim that the government debt of Cyprus has been placed on a sustainable path, a major condition for the IMF’s participation in the rescue package. And it will, to a degree that is very difficult to assess, deter potential investors in banks across the eurozone periphery.

But despite the botched rescue attempt, and the dire prospects for the Cypriot economy, the recent chain of events ironically may bolster the eurozone.

Cyprus has shown that there is no obvious limit to the level of pain that a country will accept rather than face the chaos and disruption that would follow if it abandoned the euro. The conditions placed on Cyprus were extremely harsh and unprecedented, effectively closing down its most important industry—even though variations on the offshore-banking-sector model operate in other eurozone countries (including Luxembourg, Malta and Slovenia, whose banking sectors are proportionally as large or larger than that of Cyprus). It would have been like insisting that as part of its rescue program, Greece should close down its tourism and shipping industries all at once.

Yet at no point did the authorities in Cyprus seriously consider exiting the eurozone, adopting a devalued currency and defaulting on their government debt, measures that would undoubtedly help the small island economy adapt more rapidly to the enormous shocks it has suffered. To the contrary, while bitterly resentful of the program forced on them, the finance minister and president have explicitly rejected a Euro exit “as gambling with the country’s future.”

In step with Cyprus’ commitment, Germany and the rest of the Euro group have shown that they will go to extraordinary lengths to maintain the integrity of the monetary union. They will do so even when the country in question is tiny, amounting to a fraction of 1 percent of the block’s GDP. The rescue package for Cyprus, though insufficient to protect its banks, nevertheless amounts to 60 percent of its GDP—an extraordinary level that is proportionally larger than the bailout for Ireland or Portugal and about the size of Greece’s first package. The much agonized-over IMF rescue package for Egypt amounted to 2 percent of that country’s GDP. Moreover, the Troika loans to Cyprus supplement liquidity provisions made to Cypriot banks from the ECB (through the Central Bank of Cyprus) that may have been almost as large.

In other words, total support for Cyprus may exceed its GDP. On top of that, by allowing a massive raid on uninsured depositors, the eurozone countries showed that they were willing to risk a major diplomatic showdown with Russia, whose nationals are the main holders of such deposits.

The raid on uninsured depositors would not have been possible without the active support of the ECB, whose mandate has been recently expanded to include regulation of the zone’s most systemically important banks. The ECB’s ultimatum on Cyprus—it would withdraw liquidity support to its banks if the Troika’s program was not accepted—demonstrated to the periphery countries that, should the need arise for them to ask for help, including purchases by the ECB of their government bonds, it would come with very tough conditions. This mitigates the risk of moral hazard—the possibility that countries in the periphery will slacken their reform efforts along with a political backlash in Germany and other core countries—that would deter the ECB from carrying out its function as lender of last resort.

The ECB also allowed the Troika program to break the taboo against having senior bondholders bear losses before the taxpayer does. While this carries the risk of further accentuating the credit crunch (especially in the periphery countries), it also reduces moral hazard among those inclined to lend to the eurozone banking sector. Further, by providing more flexibility to “bail-in” creditors and depositors in the event of a bank rescue, it reduces the cost of future rescues and the likelihood of political backlash in the core countries. The net effect is probably to reassure holders of the periphery’s sovereign debt.