The Trouble with Tailor-Made Euro Fixes
The Cyprus solution drew on normal bankruptcy procedures. Applying this elsewhere could reduce uncertainty.
Europe’s Cyprus settlement brings to mind the old joke of committees reinventing the wheel.
After weeks of meetings and angst, the members of the eurozone have settled on something for Cyprus that looks very much like a typical bankruptcy. Comical as it might seem to work so hard to arrive at a widely known, well-established process, this result may yet provide relief from past disruptive patterns.
Because Europe through this crisis so far has strived to tailor settlements for each new challenge, it has always left people in doubt about each outcome, particularly as to where the pain would fall. The extreme uncertainty involved has created bouts of destructive market turmoil that heightened the risk of failure. Perhaps now, by finally settling on what is, after all, long-standing practice, Europe at last may have fastened onto an outline for future challenges that, if it cannot banish all the pain of resolution, will at least relieve a measure of uncertainty.
Though the deal still requires some clarification, its fundamentals are clear enough. In order for the government in Cyprus to receive European rescue funds, it will effectively have to collapse its financial system. The bond and shareholders of its two largest banks will lose all. Depositors will get the protection of insurance up to the first €100,000. Amounts above that will lose somewhere between 30 and 40 percent. The smaller insured deposits and viable assets of the island’s second largest bank, the Popular Bank of Cyprus, also known as the Laiki Bank, will migrate to the Bank of Cyprus, an infusion of liquidity and assets that should make it viable. Meanwhile, the Laiki Bank will be dissolved. The plan expects to raise €5.8 billion from the banks in this way, the majority, €4.2 billion, from Laiki Bank’s larger deposits.
It is a classic “good bank-bad bank” model of resolution. The more authorities can get out of Laiki’s depositors, the smaller loss they will impose on large depositors at the Bank of Cyprus. In return, the government will receive €10 billion in rescue funds from Europe, and the rump of Cyprus’ financial system will remain eligible for the usual support of the European Central Bank (ECB).
This approach contrasts with past European settlements, which relied more on taxpayer funds and savaged bond holders and depositors less. It is little wonder, then, that stock markets retreated initially when the plan was announced and also responded badly to remarks by Netherlands finance minister Jeroen Dijsselbloem that this practice should become the Zone’s default approach to ailing lenders. Standard bankruptcy solutions always go hard on stockholders. But otherwise, the solution calmed market fears. The euro, which had fallen more than 5 percent against the dollar during the uncertainties preceding the settlement, stabilized, albeit at its low level. The rates that Spain and Italy had to pay for credit, which had jumped under the initial uncertainties, fell back to levels that prevailed before the crisis, as did those of other vulnerable members of the eurozone.
While this approach offers a welcome predictability, it is not without drawbacks. One is the likelihood of capital controls. Depositors in Cyprus banks, having lost, will naturally want to withdraw what remains of their assets and place that them in safer locations. Finance Minister Dijsselbloem’s remarks may convince depositors in other vulnerable nations to do the same thing. To block this disruptive flow, Cyprus and other peripheral countries may well have to impose capital controls to limit the amount depositors can withdraw or send out of the country.
Such restrictions may only need be temporary, until people’s most intense fears dissipate. But even if they last for only a brief period, such restrictions will prevent the movement of funds to where they can best be used and so further stymie growth. The controls will also penalize depositors even more by enabling financial institutions to hold onto funds while paying a lower interest rate than they might otherwise. Worse still, capital controls in some member nations would raise questions about the universal nature of the euro, for euro deposits in places without controls will offer more value than those in places with controls.
However the details get worked out, especially on the question of capital movements, there can be no mistaking that Cyprus will suffer horribly. There are, of course, all the austerity strictures Europe will impose on government policy as a condition for the €10 billion in aid. These, with very little variation, have been a consistent part of the otherwise very different European rescues during the past four years. But more, this settlement, particularly its resemblance to bankruptcy, will utterly destroy Cyprus’ economic model.
The island’s economy was always a shaky deal and invited destruction. Cyprus, largely through the Laiki Bank, had actively presented itself as a place for Russian oligarchs to bank and conduct their other business. To facilitate, the government in Cyprus established a thorough tax treaty with Moscow. Russia also supported the arrangement in 2011 by extending a €2.5 billion loan to the island nation. The flow of oligarch deposits, amounting by some estimates to €28 billion in an economy of less than €20 billion, dangerously inflated the size of the financial sector.
For a while, the excesses of capital created a remarkable prosperity, as did the oligarchs’ luxury living, fostering a jobs boom in finance, obviously, but also in expensive goods imports, tourism and the hospitality industry. Some have speculated that the special burden placed by the settlement on Laiki deposits aims at these oligarchs. Certainly, that was the initial response of Moscow. Russian Prime Minister Dmitry Medvedev referred to the settlement as “stealing.” But in the end Vladimir Putin signaled his acceptance by extending the official loan for five years and reducing its interest rate from 4.5 to 2.5 percent.
A collapse in Cyprus, hard as it will be on the Cypriots, will do little to make matters much worse in the eurozone generally. Even Cyprus’ inflated economy amounted to less than 1 percent of the eurozone as a whole. Meanwhile, for all the drawbacks of capital flight and credit controls, this Cyprus solution, by drawing on standard bankruptcy practice, offers some hope that Europe will handle future financial challenges better than in the past. By abandoning the tendency to create new procedures at each turn and instead relying on this familiar approach (not as a rigid template but as a guide) Europe will avoid the unnecessary uncertainties of the past.
The continent is far from done with this crisis. But the relative calm offered by better understood, more predictable procedures would raise the prospects of success and make the job of the authorities easier.
Mr. Ezrati is senior economist and market strategist for Lord, Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo. He writes frequently on economics and finance. His new book, Thirty Tomorrows, linking globalization to aging demographics, is forthcoming from Thomas Dunne Books of Saint Martin’s Press.
Wikimedia Commons/Marvin Addison. CC BY-SA 2.0/i>