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Cyprus is running out of options

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Thanassis Stavrakis/AP

(Read caption) Bank of Cyprus customers use the ATM as the bank remains closed for the second day in central Athens on Wednesday. There is simply no option for Cyprus apart from a deal which wouldn't result in losses for depositors that would be multiple times larger than the one negatotiated, Karlsson writes.

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Two things in combination have, barring extreme altruism or stupidity from other countries, made losses for depositors in Cyprus of some kind almost inevitable (apart from maybe the Russian solution discussed in the end of this post).

First, Cyprus created an extremely oversized banking sector, with balance sheets multiple times its annual GDP, by becoming a haven for Russian oligarchs and other foreigners. This was made possible in part because it had low tax rates, but more importantly because it didn't ask any.questions of how their depositors got their money, enabling so-called "money-laundering".

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Second, EU leaders thought that it would be a good idea to "solve" the fiscal problems of Greece by making private bond-holders "agree" to a "voluntary" write-down of the value of its debt- The problem is that one institution's debt is another's asset, and with Cypriotic banks heavily invested in Greek debt due to Cyprus' close ties to Greece, this meant that Cypriotic banks made heavy losses. In short, the "solution" to the Greek problem caused the Cypriot problem we're now discussing.

As a result, Cyprus' banks lost sums of money  that were enormous relative to the small size of Cyprus' economy. It seems in fact that the losses were nearly as large as the size of Cyprus' annual GDP. It's as if America's bank required a capital injection of $15 trillion. 

There is simply no way that Cyprus can pay for this on their own. It's government's debt has, quite rightly, been designated junk status so the government can't borrow the money on its own. There are basically only three ways to solve this:

1) Other countries lend Cyprus the money
2) Cyprus decides to formally "haircut" the value of deposits one way or another.
3) Cyprus  reintroduces the Cypriotic pound, and decrees that some arbitrary conversion rate between euros and cypriotic pounds be made, and prints the money to pay for it.

The now rejected deal meant basically two thirds of option number 1 and one third of option number 2. So contrary to the widespread perception that depositors were "sacrificed", it actually meant that Germany and others decided to reduce their pain by two thirds compared to what would have happened otherwise.

While Germany and others have rightly signalled that it is up to the Cypriots to decide the relative distribution of the burden, they would be wrong to make any concessions whatsoever regarding the fact that at least this must be raised. Arguably, they were far too generous to begin with.

The fact is that because Cyprus can't borrow any money on its own, it has no bargaining power at all. If there is no deal, it will be Cyprus who will see its banking system collapse, while the damage to the rest of Europe will be neglible. The alternative, if Cyprus remains in the euro area, is a three times bigger dose of option 2).  We would then be talking about a reduction in deposit value of  at least 20-30%, compared to the 6.75% to 9.9% proposed in the initial deal.

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But what if it exits the euro and reintroduces the Cypriotic pound? Well, that wouldn't solve the problem directly if Cyprus follows international law because the deposits are in euros and a reintroduced Cypriotic pound would fall catastrophically in value, especially if the purpose is to monetasize the bank bailout by money printing, causing the debt to quadruple in value in terms of Cypriotic pounds.

But what if they say that the accounts should be converted into Cypriotic pounds according to some arbitrary obviously overvalued exchange rate? Well, then it might be possible to formally finance it. But since the new Cypriotic pound would plummet in value by at least 30.-40% against the euro, this means that the value of deposits would be reduced by 30-40%.

And as that would also likely mean a lot of legal problems, that could possibly mean that Cyprus would be kicked out of the EU, causing them to also lose their access to the EU market and all the subsidies from the EU budget.

So, there is simply no option for Cyprus apart from a deal which wouldn't result in losses for depositors that would be multiple times larger than the one negatotiated. Except for perhaps that other EU countries either out of extreme altruism or ignorance of their strong bargaining position caves in , something that would be very unwise for them. And judging by the intial signals from Germany that insight seems to be present.

The only remaining possible solution would be if the Russian state, out of a desire to bail out its oligarchs, step in with the money. If so, then Cyprus and the Russian oligarchs will be happy, but regular Russian taxpayers will rightly feel that they've been ripped off.