Once again a small and lethargic economy at the edge of Europe threatens to upend progress made on resolving the eurozone crisis. Burdened by an overleveraged and outsized banking system, Cyprus took the unprecedented step of announcing on March 16 a levy on bank deposits in order to secure a bailout from the troika (IMF, European Commission and European Central Bank). The terms of the bailout have not yet been finalised and the course of events are evolving quickly. Below we flesh out our immediate response to this weekend's developments and attempt to answer some of the key questions which have arisen.
What Are The Specific Bailout Terms ?
Despite announcing the bailout terms over the weekend, the details still seem to be up for discussion, with rumours that the levy on deposits could yet be adjusted to protect low earners. As it stands Cyprus has agreed in principle to generate EUR5.8bn from the deposit base, which has reduced the size of bailout needed to around EUR10bn. The initial announcement indicated that a levy of 9.9% would be charged on deposits over EUR100,000 and 6.75% on those under that amount. Parliament is due to vote on the bailout terms and it is likely that the specifics of the levy will change.
Why Is Cyprus 'Exceptional'?
European policymakers have been quick to stress that the terms of the bailout (namely the deposit levy) are unique owing to the exceptional circumstances of the Cypriot crisis. First, the sheer size of the banking sector - several times the national output - would render a full bailout unsustainable even under an optimistic scenario of rapid economic recovery. Second, the relatively low share of senior unsecured debt in the banking system has meant that the burden of adjustment cannot be forced onto bondholders (as was the case in Greece) with policymakers instead eyeing the large stock of deposits (around EUR70bn).
In addition to the above idiosyncrasies identified by European policymakers, we highlight two further unique circumstances. First, Cyprus' position as an offshore financial centre in the Mediterranean has given rise to a large inflow of foreign deposits (around 30% of the entire stock), with lingering allegations that some of these foreign inflows could be connected to illegal activity. Nevertheless, the potential taxation of foreign deposits has motivated an immediate response from foreign governments with the UK, in particular, pledging to cover the deposits of military personnel serving in the country. Second, whereas previous eurozone bailouts have involved the three official creditors in the troika, the Cypriot bailout has a de facto fourth actor - Russia, which accounts for a large chunk of the foreign owned deposits. The presence of Russia, which has funnelled a lot of money into Cyprus via the natural resources industry, creates the potential for conflict in bailout negotiations, which could adversely affect Russian depositors and companies. Meanwhile, for European policymakers, bailing out foreign depositors - especially those from Russia - is clearly unpalatable.
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What Role Has The ECB Played?
The European Central Bank (ECB) appears to have played a key role in the negotiations over the weekend, with the threat of withdrawing funding from Cyprus' second largest bank Laiki greatly reducing the government's bargaining power. Given that Laiki is in such a parlous state that it no longer qualifies for Emergency Liquidity Assistance (ELA), the ECB has been under pressure to eliminate the risk of moral hazard. However, as has been the case through the last three years of the eurozone crisis, the central bank has periodically found ways to bend the rules and get around its overly restrictive mandate. As such, it is uncertain whether the ECB would have followed through on its threat to pull funding, particularly considering the possibility of triggering further financial turmoil and eroding the goodwill built up in the market since ECB President Mario Draghi's pivotal 'we will do whatever it takes' speech in July 2012.
The ECBs assertive positioning raises interesting questions about how it would administer bond purchases through the recently devised Outright Monetary Transactions (OMTs). We have been wary of the OMT facility given the uncertainty over its deployment and whether the ECB would choose to withhold funding if reform targets were not met, at the risk of triggering a funding crisis. Ultimately, the ECB may have felt emboldened to threaten Cyprus owing to its small size and lack of leverage, but may not be quite so gung ho if Spain or Italy was on the receiving end of state support.
What Role Has Germany Played?
As Europe's implicit paymaster, Germany continues to lead the pack of creditor nations stumping up the cash for eurozone bailouts. Throughout the eurozone crisis Germany has been reluctant to write blank cheques for fear of encouraging fiscal laxity and mitigating pressure to reform. Pushing the burden of responsibility on to Cyprus and limiting the contribution of German taxpayers would be a significant coup for Chancellor Angela Merkel and her government ahead of the September general elections. Moreover, Germany's recalcitrant demands further highlight the growing rift between northern and southern Member States, which has become synonymous with the creditor-debtor relationship that is increasingly defining intra-EU relationships. Germany has been demonised in the Greek media for its insistence on wrenching austerity, with early indications that it led the pack of creditor nations in calling for a tax on Cypriot deposits further compounding the sense of an increasingly one-side relationship between the North and South.
The first key hurdle will be a parliamentary vote on the terms of the bailout, which was initially scheduled for March 17. Complicating the vote is the fact that no party has an absolute majority in parliament. President Nicos Anastasiades' Democratic Rally (DISY) party has 20 of the 56 total seats, and are counting on eight votes from their coalition partner, the centrist Democratic Party (DIKO). DIKO had a ninth member, but he sits in parliament as an independent after splitting with his party over one year ago, and is thought to be opposed to the bank levy. In sum, the passage of the bill will rely on unanimity within the coalition parties. A single dissenter would sink the vote, while even with the 'optimistic' scenario playing out (28 for, 28 opposed), the government would require further support to pass the measure. The Progressive Party of Working People (AKEL)'s 19 voting members, and the socialist Movement for Social Democracy (EDEK)'s 5 members will almost certainly oppose the levy, meaning that passage could come down to support from one of the three remaining members, from the pro-EU Evroko party, or the lone Green party member.
Aside from the parliamentary math, there are also rumours that the vote will be postponed, potentially until the end of the week. The vote cannot be pushed back by more than a day or two since this would require the freeze on bank transfers to extend beyond the March 18 bank holiday. The implicit uncertainty this would create and the impairment to financial transactions would cripple economic activity and risks sparking riots.
What Does This Mean For the Broader Eurozone?
Once again the eurozone has ventured into unchartered territory. Although bank deposit levies are not completely without precedent (Italy introduced a tax on deposits in 1992 ), the size of the charge and the potential to override the EU-wide deposit guarantee scheme are major developments with far-reaching implications. Even if the government were able to shift more of the burden onto larger deposits, the mere announcement of the government's intentions could trigger a mass withdrawal of funds in the coming weeks. A pledge by President Nicos Anastasiades to compensate savers for any losses with bank shares and reward savers who kept money in their banks for two years with securities tied to national gas revenues, may not be a sufficient enticement.
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Depositors across the eurozone will also be on tenterhooks. There remains enormous uncertainty surrounding Spain and Italy and the potential for further state bailouts. If Cyprus sets the precedent of taxing deposits, it risks igniting capital flight across southern Europe, which in turn could restart the polarisation of funding markets seen in 2012 which threatened to pull apart the eurozone.
The Cypriot bailout could ultimately mark another inflexion point for burden sharing which has shifted from banks to governments, to future taxpayers, to bondholders, and now potentially to current taxpayers and pensioners. We stress that while Cyprus appears to be an exceptional case, once such a precedent has been set, it is entirely feasible that similar policies could be rolled out in future bailouts.