Thursday, 21 March 2013

72 Hours to Decide the Fate of Cyprus: Will it Go Down Like Lehman Brothers?

The financial crisis in Cyprus is presently at a critical juncture. Having rejected a tax on bank deposits early this week, the government needs to come up with another option for financing, or face a liquidity crisis in the next 72 hours that renders the country effectively bankrupt.

From here there are several things that could happen, of which I list three in the order of relative likelihood that I would assign them.

     1.) The Russian government contributes to a bailout

The reason for proposing the bank levy initially was that the EU and IMF are unwilling to completely bailout Cyprus themselves. The EU and IMF funding is structured as loans. Despite the fact that the extra sum required is small compared to bailouts in other Eurozone countries, the Cypriot economy cannot support any greater level of debt than is currently being planned. What is needed is more 'equity' rather than debt, either from a direct fiscal transfer, or an internal source such as a bank levy. 

A fiscal transfer would be untenable to the EU, and Germany in particular, for two reasons. Firstly, this would set up a 'moral hazard' problem, such that other countries lose the incentive to be financially responsible. The impetus for austerity measures in Greece and elsewhere would be severely weakened. Secondly, a key beneficiary of the transfer would be Russian depositors, who were outspoken opponents of the bank levy as originally proposed. A bailout that transfers EU funds directly to wealthy Russians is rather unpalatable, both ethically and politically.

This leaves the Russians themselves the most likely participants in a bailout agreement. It is their own citizens that stand to lose out from default, and the Russian leaders have already shown their solidarity with the depositors, even if they are using Cyprus as a tax haven.

     2.) A bank levy is reinstated on large deposits

Having observed the outcry at taxing deposits universally, the Cypriot leaders probably wish they had limited it to large deposits in the first place. It is far more politically palatable to place a windfall tax on the wealthy than on the poor. They even amended the proposed bank levy before the vote in parliament, but by that time it was too late as it had already lost all support. However, since Cyprus is so low on outside options, a resurrection of a tax on larger deposits is a real possibility.

     3.) Default

There are many commentators arguing that default will not be allowed to occur, and EU authorities will relent and cave in to a larger bailout. In my view, default is a very real possibility. I outlined above why the EU is unlikely to provide a direct fiscal transfer; such a transfer is beyond the remit of the IMF and anything less than an equity injection will leave the Cypriot banks insolvent. This means the European Central Bank will cease providing them with cash, and they will be bankrupt.

In this case the likely consequence would be a Cypriot exit from the Euro. The mechanics of how this might be conducted were closely examined in case it were needed in Greece. The banking system would be put on hiatus while the currency is switched to Cypriot Pounds. Bank assets and liabilities, including customers' deposits, would be re-denominated. The new Pounds would instantly depreciate against all the major currencies. Simultaneously the government would probably default on its external debts, either directly (by ceasing payments) or indirectly (by denominating the debts in Pounds and printing money, leading to hyper-inflation.) In short a lot of people would lose a lot of money, and they would end up wishing they had accepted the bank tax originally proposed.

From the perspective of the rest of the Eurozone, the great big unknown in this situation is the knock-on effects. 

A very good parallel here is the Lehman Brothers bankruptcy at the peak of the credit crunch in 2008. This was allowed to happen by the US authorities on precisely the 'moral hazard' grounds that make the EU reluctant to completely bail out Cyprus. The Lehman bankruptcy had devastating consequences, which were unanticipated largely due to the opaqueness and intrinsic complexity of connections in the financial system. Small details, like where assets were parked overnight, went on to have major ramifications as it led to different bankruptcy laws being applied. With a national economy we are faced with a whole different set of opaque connections, complex dynamics and ambiguous legal territory.

The EU leaders know all this, and yet may still allow it to happen. If nothing else (and assuming the Euro survives the contagion), a Cypriot exit would provide a test case for how a bigger Eurozone nation might later conduct an exit.

My thoughts go out to the leaders currently negotiating the future of a nation. I hope you bring us back from the edge.