Friday, 27 December 2013

New Year's Change of Mind: Was the Cyprus Haircut more equal than we think?

2013's most startling development was probably the Cyprus deposit haircut, an unprecedented event which caused numerous reactions around the world. In March, the Eurogroup came up with Plan A, i.e. to haircut all existing depositors, regardless of institution or the amount of money in their accounts, at a flat rate of 6.75%; a decision which the Cypriot Parliament rejected. After 2 long weeks of bank "holidays" and intense negotiations, the plan changed to the dissolution of Laiki Bank and the haircut of all deposits above 100,000 euros in the Bank of Cyprus (the final amount of the unsecured deposit haircut was 47.5% as agreed in late July).

My reaction to the first plan was that it was unfair: a person with 10,000 in his bank account would suffer more than a person with €10 million in his after a 6.75% cut. The second plan still seemed unfair but had the advantage that depositors in other banks would not be hurt and that the "little guy" would remain an unscathed. Obviously, the "big boys" still get hurt, which means less investment and less growth, equaling more unemployment. Yet, there is actually much more good in this than was first considered.

First of all, the ones which got hurt more in the crisis were not CEO's or other businessmen; it was paid employees. Have a look at the following table compiled by the Economic Policy Institute:
As the reader may observe, in 2011-2012 average worker compensation shrunk by 1.6% while average CEO compensation increased by more than 14% during the same time-frame. What this indicates is that high-income earners do not get hurt by much during a recession. The average paid employee does. The simple reason is that the worker goes out first and the businessman continues to operate; most importantly it is the latter who makes the decision not the former. Even when a recession begins to fade out the businessman can exploit the situation and earn much more than before since wages are much stickier than profits (as also seen in the 2013 results of US firms).

The trouble with Plan A, i.e. the haircut on both secured and unsecured deposits is that the former (i.e. secured depositors) are more prone to the use of their wealth than the latter. As Simon Kuznets has shown back in the early 50's, the higher the income, the less percentage of your income you spend (for a discussion of austerity and income see this). This means that most of the money a low- or middle-income worker earns will end up back in the economy in the form of consumption. On the contrary, the money a high-income person earns are employed differently: if you take away from him, his consumption will not be reduced by as much for the simple reason that he will just save less. Since the economy is mainly driven by consumption (it comprises of the largest part of GDP) if it decreases, GDP will also be decreased.

A question which may arise concerns the banks' ability to lend if we experience dis-savings. The thing is that it will not matter by that much. Remember that if one spends, another will pocket the proceeds, thus the money ends up in the bank anyhow, i.e. the bank will not lose any funds. Second, even though the bank has less deposits now, it has much greater equity which allows it to lend out more funds to boost the economy either directly or indirectly.

This is what has happened in Cyprus since March: those with big, unsecured deposits, found themselves at a loss. Recent IMF estimations, after the second examination of the island's program development, showed that private consumption has fallen by just 2.8% year-to-year, much less than the severe contraction in Greece or other periphery countries, even though the unemployment rate has reached 17% (the 3rd highest in the Eurozone). Since private consumption has not fallen by much, GDP contraction was less than expected. Most importantly, what the less-than-expected decrease in consumption means is that Cyprus has a better chance of experiencing growth faster than other countries is recession; since demand does not fall, employers have less incentives to fire people and businessmen have greater incentives to invest.

There is a caveat in this though: the haircut exacerbated the already declining confidence in the banking sector, meaning that individuals prefer to keep their money under the proverbial (in this case even literal) mattress than deposit it. This can be easily seen in the data, with total deposits following a downwards trend since March, forcing the banks to request liquidity from the ECB. Yet, as the IMF points out, this exit of deposits appears to have reached its peak, with the overall amount in the system stabilizing in October. NPL's are still a major cause of headache in the island, yet an increase in consumption, in addition to the banks' increased ability of issuing of new loans due to higher equity ratios means that better days are ahead.

Summing up, the haircut on unsecured deposits is much more equal than first considered. It hurts those with larger wealth, who spend much less of their income (as a percentage) than those who are on the other side of the spectrum. This means that consumption is less affected by the haircut than by austerity measures: compare Greece and the succession of harsh austerity measures and tax hikes imposed which resulted in a 5-year depression to Cyprus where the haircut was accompanied by mild austerity measures (mostly in 2011 and 2012, with a few ones in 2013). The difference is extraordinary. Yet, as mentioned before, the haircut's caveat is the exacerbation of the already fragile trust towards the banking system, which is the cause of decreased liquidity; yet, if the ECB can ascertain that it will live up to the task of providing "whatever it takes" to the banks, it might be that the haircut is not a terrible idea at all.

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