Satyajit Das: Effects of bailout will be felt far beyond Cyprus

Economic View: After Cyprus, it will be politically more difficult for countries to ask for EU and ECB assistance
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The Independent Online

It would be ironic if Cyprus, one of the smallest countries in Europe with little over a million people and about 0.5 per cent of the total EU economy, were to prove a key inflexion point in the crisis.

Cyprus needs about €10bn (£8.6bn) to recapitalise its banks and a further €7bn to €8bn for general government operations including debt servicing. While small in nominal terms and well within the EU's resources, the amount is large relative to Cyprus's GDP of €18bn.

The package proposed by the EU incorporates: privatisation of state assets; an increase in corporate taxes from 10 per cent to 12.5 per cent; withholding tax on capital income at 28 per cent; and restructuring of existing bank or sovereign debt.

Most controversially, ordinary consumers will face a "tax" on Cypriot bank deposits, amounting to a permanent writedown in the nominal value of their deposits. The deposit levy will be 6.75 per cent on deposits of less than €100,000 (the ceiling for EU deposit insurance) and 9.9 per cent on deposits above that amount. In return, depositors will receive shares in the relevant banks.

The unprecedented writedown of bank deposits, expected to raise about €5.8bn, is motivated by a number of factors:

l International Monetary Fund (IMF) participation requires the debt level to be sustainable. The writedowns cut debt and reduce the size of the required EU bailout to €10bn.

l Cypriot banks have only limited amounts of subordinated or senior unsecured debt. That means a writedown of bondholders would raise less than €2bn, well below the required amount.

l As was the case in the 2012 Greek debt restructuring, the European Central Bank (ECB) and other official lenders are unwilling to take losses on their exposure, requiring the depositors to take a haircut.

l Restructuring the sovereign debt of Cyprus is risky because many of the bonds are governed by English law. Any attempt to restructure these while insulating official creditors from losses would invite litigation.

l Germany, Finland and the Netherlands are increasingly concerned about losses on bailout loans. The German Chancellor, Angela Merkel, does not want concern about actual cash losses to German taxpayers to affect her prospects in the September elections.

l Germany wants to prevent any bailout fund flowing to Russian depositors such as oligarchs or organised criminals who have used Cypriot banks to launder money.

Whatever the case in favour of the Cyprus package, it risks significant side-effects.

First, it may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain, based on depositor concerns about a similar loss of capital in any future bailout.

If depositors withdraw funds in significant amounts and capital flight accelerates, the ECB, national central banks and governments will have to intervene, funding affected banks and potentially restricting withdrawals and funds transfers.

Second, the Cyprus deposit tax will make it increasingly difficult for European banks, especially in vulnerable countries, to raise new deposits or issue bonds.

Third, the Cyprus arrangements undermine the credibility of the ECB, the EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability.

After Cyprus, it will be politically difficult for countries such as Italy and Spain to ask for EU and ECB assistance, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits.

The EU's much-vaunted banking union was rightly criticised for failing to provide sufficient funds to undertake any required re-capitalisation of banks as well as the lack of a consistent deposit protection scheme across the eurozone. Cyprus highlights these shortcomings.

Fourth, the Cyprus package highlights the increasing reluctance of stronger eurozone economies to support weaker members.

Within Cyprus, the ability of the recently elected government of President Nicos Anastasiades to pass the necessary enabling legislation is unclear, given its lack of a clear parliamentary majority and especially after Mr Anastasiades pledged that he would "never" accept a haircut of deposits as a condition for a bailout.

If Cyprus does not agree, a default is likely and the economy may collapse very rapidly. Businesses would face bankruptcy, many banks would fail and most Cypriots would lose their savings.

Irrespective of the fate of Cyprus, the solution adopted will exacerbate the eurozone crisis. Unfortunately, with each attempt at a resolution, as shown by the proposed Cyprus package, the measures have become the problem rather than a solution.

Satyajit Das is a former banker and author of "Extreme Money" and "Traders Guns & Money"