Friday, 11 January 2013

Should the EU bail-out Cyprus?

Cyprus Ministry of Finance. Source: Wikimedia Commons
From what I have seen, I was the first blogger to bring attention (on July 28th!) on the worsening situation in Cyprus and the imminent bailout. Media sources have had their reports before that of course but they were largely focused on Greece and the probabilities of a Grexit. Now, it is more than evident that Cyprus is having liquidity issues, largely due to their banks' exposure to Greece (both in sovereign debt as well as private loans). Now, as usual, many media sources have expressed their own views on whether the EU should lend the island money to overcome its difficulties. For example, the Wall Street Journal states that a line has to be drawn and Cyprus should be let to default.

It's always easy to hit the little guy isn't it?

For me, the rationale behind the statement "draw the line" is not very clear. Draw the line where? Let small economies collapse because their effect on the economy will not be as large as the effects of a Greek default? It is the same irrational rationale which has forced the US government to bail-out AIG, Bank of America, General Motors and about 15 other large institutions (for details on the TARP program read here). The message: do not worry if you are large; we shall do anything to save you. Yet if you are small, bankruptcy is your only option. Hmm that doesn't sound very democratic does it?

On the other hand shall we pay €18 billion to a country where the debt-to-GDP ratio is expected to rise over 130-140%? The answer is it depends. First of all the amount is ridiculous. 18 billion is approximately 100% of Cyprus's GDP! (for the calculation have a look at this) It is impossible for a nation to require that much money. Even if they did, the amount could easily come from the ECB's printing machine. Value of euros produced by the EU just in 2012: €184 billion. Cyprus requires less than 10% of that even at the utmost extreme scenario, which again is highly irrational.

Let us take things from the start. Cypriot banks stupidly put more than 50% of their equity in Greek government bonds. Then came the infamous Greek PSI. Had there not been for that, Cypriot banks would not have lost approximately €4 billion's worth of bonds, and they would not have been at the situation they are currently facing. Still one might add, that to the previously mentioned amount of €18 billion, the Troika delegates have calculated about €10 billion for bank recapitalization, and the rest for debt repayment and government needs. Let us examine them one by one.

First, letting the banks collapse should be out of the question. Bank default would cost much more than what it would take for them to recapitalize, even at the extreme scenario of €10 billion. Now let's examine this differently. The island current faces a debt-to-GDP ration of approximately 75% and has a deficit of about 4% of GDP. The latter figure is expected to be reduced to 2.5-3% in 2013 and even further by 2014. This would mean that essentially from 2015 onwards the Cypriot debt will start moving downwards. The issue is what happens until 2015.

What I would propose is in fact very simple. In addition it would only cost around €3 billion. From what I have been reading, Cypriot banks have issued about €1.2 billion in CoCo bonds (for a definition read this). So if they transform these bonds in ordinary shares, their equity base will be significantly strengthened, and they will surely need much less help in finding the necessary capital for them to continue functioning. In addition, another €3 billion should be lent to the Cypriot banks, conditional on the term that they should lend it back to the state to fund its needs. Given that the hole in the banks' balance sheets is about €2.5-3 billion, they would more than cover it with the €4.2 billion influx received, even given that the low ratings Cyprus has received from the ratings agencies. It is highly unlikely that the island would need more than €3 billion for the next year (or even the year after), provided of course that it can roll-over its current debt; which will have no trouble doing given that most of its lays in the hands of Cypriot banks and pension funds. 

In addition, given that Greece is on the verge of a crisis-reversal in 2013, banks would start receiving profits in either 2013 or 2014 from their exposure there, which they could use to directly fund the Cypriot state by 2015. Even if the huge influx of capital due to the gas depositories in the area does not occur, then by a combination of very few austerity measures and an increase in consumption (which will occur if banks influx just a percentage of that €4.2 billion back to the system) the future would be much brighter for the island than any other scenarios. What makes this plan even better is that the EU only has to lend the island about €3 billion, which is essentially nothing to them. Oh, and it can do so by directly funding the banks through the EFSF/ESM funds instead of just having €300 billion sitting around. 

The alternative presents a much darker situation: if Cyprus obtains a loan is excess of €10 billion, then another memorandum and a debt haircut are inevitable. This is not so difficult to see; we have the Greek experiment to indicate that these issues are not so incomprehensible and difficult to forecast as people who are just bored to think two moves ahead may believe. More so, it is their job to do so. (talking about the Cypriot and Irish minister here, who did not veto decisions which were aimed against their countries in two different Eurogroups. As Constantin Gurdigev has commented, their actions resemble the Stockholm Syndrome)

If they are denied of help then the Cypriots have two options: either default and stay in the Union, or exit the Union and avoid default. As forecasts state that there is enough natural gas in deposits near Cyprus to support probably half of Europe, politicians would not risk letting them leave the Union. Yet, Cypriot politicians might actually be too afraid for such a radical solution. These are the odds to which the game is played: the little guy, more often than not succumbs to the will of the big guy, so the latter obtains continuous small profits from their relationship. It is the same rationale with stock market: bets which bring small profits very often when the market seems to be listening to whims of investors. Occasionally though, the market decides it has had enough of them and takes a large fall. What do you think happens to the big guy then?

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