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Beware of gifts near elections: Cyprus and the Eurozone

By Alexandros Apostolides

Cyprus was not on the agenda of most analysts as the next plot twist in the Eurozone Sovereign debt saga. Although the island nation has been locked out of international capital markets since May 2011, the government of President Demetris Christophias only asked for support from the Eurogroup on 25 July 2012.

It quickly became clear that the request would not be resolved swiftly. Although Cyprus requested a small amount in absolute values, it was large relative to the size of the economy, and the Cyprus government also seemed reluctant to finalize the agreement. The island’s banking sector, which was far larger that its GDP, also suffered critical losses through its exposure to Greece and the Greek PSI. In addition, the stance of northern European creditor nations was hardening, especially in Germany, where upcoming elections altered the Bailout dynamic. All this combined to delay the resolution of the bailout terms. Nevertheless, on 4 December 2012, the outgoing President Christophias announced that he would be signing a memorandum of understanding. Yet, his term of office expired on 28 February 2013 with no resolution. Facing a large repayment of debt that Cyprus could not afford, the new president, Nicos Anastasiades, flew to Brussels to finalize the agreement on 15 March.

The nature of the agreement thrust Cyprus in the global spotlight thanks to the decision to swap a part of all Cypriot deposits for shares in the country’s troubled financial institutions. The ESM/IMF was willing to fund €10bn out of the €17bn that Cyprus needed. This left the government of Cyprus having to find €7bn to recapitalise its banking sector. Junior bank bondholders were bailed-in, and the remaining €5.8bn needed was to be raised by a “shares-for-deposits” swap on all deposits in all banks, even for insured depositors. Deposits over the insured €100,000 would have 9.9% of deposits converted to shares, with insured depositors also affected with 6.75% of their deposits converted.

Cypriot Flag

The deal was immediately disowned by all when the extent of its unpopularity was known: it failed to pass the Cypriot parliament and caused outcry in the Eurozone. Even leaked IMF meeting notes indicate that executive board members regarded the deal as “unacceptable as it imposed losses on small insured depositors.” While a new deal was being hashed out, the banks remained closed and the Cypriot economy nosedived. By the 25th a new deal was reached and the banks finally opened on the 28 March, after a record twelve-day bank holiday.

The final bailout could be called a success for the Eurozone but a disaster for Cyprus. It still breaks new ground in the Eurozone saga as bank depositors were bailed-in and capital controls were implemented, but it spared insured depositors. The turmoil caused by the bank closure ensured that the amount Cyprus needed increased from €17bn to €20.6bn; an increase equal to 20% of Cypriot GDP. Unlike the original scheme, the two largest banks on the island were bailed-in. The uninsured depositors of Laiki Bank were bailed-in 100% and became shareholders of “bad” Laiki, which would have some non-performing assets. Bank of Cyprus uninsured depositors were also partially bailed-in (currently at 37.5%) and the bank absorbed the insured depositors and good assets of Laiki, as well as the very large liabilities of Laiki towards the ECB.

The Eurogroup insisted that all Greek branches of Cypriot banks were sold to Piraeus Bank in order to prevent contagion. This made Greek depositors exempt from the bail-in, increasing the contribution of Cypriot depositors. Piraeus Bank bought the branches using funds from the Hellenic Financial Stability Fund (HFSF), a Eurogroup funded body set up after the Greek Bailout. Piraeus Bank received the Cypriot branches in Greece at knockdown prices and free of their significant capitalization needs: the large amounts borrowed under the Emergency Liquidity Assistance to fund withdrawals of Greek depositors were transferred to the banking system of Cyprus, aggravating existing liquidity shortages. The deal was so advantageous for Piraeus Bank that it announced a “negative goodwill” of €3.4bn in the first quarter results of 2013. Thus, the Cyprus bailout in effect asked for Eurozone taxpayers’ money, given to Greece under its bailout, to be used in order for a private Greek bank to make large profits.

Yet for the Eurogroup the whole operation can be seen as a success: contagion was prevented, insured depositors were protected, and bond spreads remained stable. In addition, the new deal adheres to German sensitivities prior to elections. Yet the reality is that the Eurozone has emerged weaker from the Cypriot bailout: capital controls in Cyprus mean the Eurozone has violated the free movement of currency between its members, weakening the troubled periphery. The way the bail-in was bungled in practise has led to hundreds of lawsuits at Cypriot district and constitutional courts, and in other jurisdictions, that threaten to derail the resolution of the banks. In Cyprus itself businesses lost their working capital, while capital controls are killing the services sector. Since a cumulative reduction of up to 30% of GDP is probable, debt sustainability assumptions underlying the bailout are unrealistic.

Despite the pressure to make Cypriot debt sustainable, the agreement has insisted on preferential treatment for foreign law sovereign bondholders relative to Bank depositors, local law bondholders and even foreign governments. Local law debt will be restructured with a “voluntary” rollover providing longer maturity or written down through acquisition of government land. The direct loan from the Russian Federation that Cyprus had acquired also had its maturity extended and the interest rate reduced. Yet, foreign law bond holders are to be paid on time and in full. The fact that Eurozone decision makers have preferred to hurt bank depositors and foreign governments rather than attempt to restructure foreign law bonds is extraordinary: that stills seems to be a “bridge to far” for the Eurozone.

Why was the bail-in of depositors chosen as the way to restructure the Cypriot Banking sector? One thing is clear: the blame must be shared by many. The previous government of President Christofias must take the lion’s share: its recalcitrance, its excessive fiscal spending, and its lack of understanding of the mortal effects the Greek PSI had on the Cypriot banking sector were critical errors. The new government of Anastasiades also made mistakes, although its share of the blame is limited, as it was only in power for 15 days prior to the first Eurogroup agreement.

The banking sector and its regulators also failed at a Cypriot and a European level. At a local level, banking was allowed to become far larger than the ability of the island to support it, and many mistakes were made in the Bank restructuring processes. The risky trade in Greek government bonds, helped by Cypriot banks, must be investigated over the morality of the trade, and over possible illegalities. Yet the fact that the Emergency Liquidity Assistance (ELA) of Laiki Bank was allowed to rise at such high levels is in part the responsibility of the ECB that allowed the increasing injections of liquidity in a failed bank.

Part of the blame also belongs to the Eurogroup. The political pressure to make a bail-in of depositors part of the programme led to the Eurogroup’s refusal to assist the two largest banks on the island. Yet without funding for the banking sector, the stability of the economy cannot be guaranteed. Right now Bank of Cyprus might not survive even if a 60% bail-in of its depositors because of the large liabilities towards the ECB which it inherited from Laiki. This prevents the resolution in the banking system. The lack of resolution maintains capital controls and is sending the economy into deep depression, making a second bailout increasingly likely. Cyprus is currently caught in a death spiral and only direct funding for its banking system will stop it tumbling. Unfortunately this is not the end of Cyprus-related twists in the Eurozone story.

Alexander Apostolides is a Lecturer at the European University Cyprus. He is the author of the paper ‘Beware of German gifts near elections: how Cyprus got here and why it is currently more out than in the Eurozone’, which is published in Capital Markets Law Journal.

Capital Markets Law Journal is essential for all serious capital markets practitioners and for academics with an interest in this growing field around the World. It is the first periodical to focus entirely on aspects related to capital markets for lawyers and covers all of the fields within this practice area: Debt; Derivatives; Equity; High Yield Products; Securitisation; and Repackaging. With an international perspective, each issue covers articles and news relevant to the financial centres in the US, Europe and Asia.

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Image credit: Cypriot Flag. By mtrommer, via iStockphoto.

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