Finance & economics | The Cypriot deal

Second time unlucky

The new plan is better than the first. That isn’t saying much

AFTER a week in which a first, ill-planned Cypriot bail-out unravelled amid consternation at the notion of swiping some of the country’s guaranteed deposits, a second rescue deal for the island was reached in the early hours of March 25th. The plan, which “bailed in” creditors of Cyprus’s two biggest banks but spared insured deposits, was an improvement on its predecessor. But as The Economist went to press, the banks were still shut, the economy was braced for disaster and capital controls were in place for the first time in the euro zone’s history. A triumph it is not.

Initial market relief that Cyprus had not been forced out of the euro quickly turned sour as Jeroen Dijsselbloem, the Dutch head of the Eurogroup of finance ministers, went off-script. Instead of depicting the Cypriot deal as a one-off, the usual trope, he said that the bail-in of bank creditors, including uninsured depositors if necessary, should become a template. Although he hastily retracted the comments as markets took fright—European bank shares fell sharply—Mr Dijsselbloem had merely revealed in public what northern European creditor nations say in private. They are fed up with funnelling cash to peripheral countries (see chart 1); they would like the idea of recapitalising banks directly through the euro area’s rescue fund to remain just that, an idea.

The second deal left the loan amount from the euro area and the IMF at €10 billion ($13 billion) but changed the terms of what Cyprus must do to tackle its banking crisis. The new deal abandoned the raid on savings envisaged a week earlier, which had made a mockery of the European deposit-guarantee threshold of €100,000 by levying a swingeing one-off tax on accounts with less than this amount, as well as imposing a steeper levy on uninsured deposits. Instead, the Cypriots agreed to wind up Laiki, the island’s second-biggest bank. Its bad loans will be dumped into a “bad bank”, which will also get €4.2 billion of uninsured deposits that are unlikely to survive the experience; Laiki’s bondholders, senior as well as junior, will be wiped out, too.

What remains, including Laiki’s insured depositors, will go to Bank of Cyprus, which will itself be restructured and recapitalised by writing down bonds and turning uninsured deposits into equity. Those deposits, estimated at close to €10 billion, will be frozen pending a haircut to be determined by the bank’s recapitalisation needs; losses on them will not be as severe as at Laiki but could still reach 40%.

For the Cypriots this was a package served with humble pie. It was broadly in line with a solution first advocated by the IMF and backed by the Germans before the original bail-out deal was done, but rejected back then by Nicos Anastasiades, the country’s president. Frantic attempts to get Russia, the source of many of the banks’ big deposits, to help proved fruitless. An ultimatum from the European Central Bank that it would cut off its emergency funding to Cyprus’s big lenders after March 25th if no agreement had been reached by then left the Cypriots with little leverage. Thanks to laws passed in Nicosia just before the second meeting in Brussels, Mr Anastasiades did not have to put the revised deal to a parliamentary vote.

The official lenders may see the second deal as a good night’s work. They had not had to follow through on their barely veiled threat to eject Cyprus from the euro, with all the damage that might do to the credibility of the single currency. They had charted a new course for the euro area in dealing with tottering banks: bail-in by creditors rather than bail-out by taxpayers. And the outcome was more acceptable to suspicious voters in creditor countries, since none of the rescue money will go to the big banks in Cyprus. That should make it easier for the Germans in particular to get the financing passed by the Bundestag.

But the Cypriot fix may yet come back to haunt its makers. The imposition of capital controls, using wide-ranging powers passed by Cypriot MPs on March 22nd, is a particularly worrying development. Although controls are banned under European Union law, there is a get-out clause for up to six months in exceptional circumstances. Mr Anastasiades insisted that the restrictions would be “very temporary”, but history suggests they will stay for longer than expected. They remain in place in Iceland, for example, over four years after being introduced. If capital controls do stay in place for some time, Cyprus will be in the monetary union only in name. A Cypriot euro, trussed within the island’s borders, will not be the same as a euro in the rest of the zone.

And, whatever Mr Dijsselbloem may protest he really meant, the Cypriot bail-in serves notice on creditors of weak banks throughout the euro area. Wholesale money will be tempted to move out of them as soon as possible. Although retail deposits are stickier, bank runs are now more likely if a bail-out looms. Cyprus is not the only country stuffed with deposits (see chart 2). European policymakers are underestimating the extent to which events in Cyprus may yet destabilise the rest of the euro area, says Jacques Cailloux of Nomura.

Cypriots have cause to lament that its rescuers have made a desert and called it peace. The tiny economy has suffered a massive blow. Earlier forecasts by the European Commission that its economy would shrink by 5% over the next two years were bad enough; a shrinkage of close to 20% is now plausible. That will render debt-sustainability forecasts null and void. Cyprus’s bail-out may have saved the blushes of its rescuers, but they may soon have to deliver another one.

This article appeared in the Finance & economics section of the print edition under the headline "Second time unlucky"

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