Comments on the PIMCO report for Cyprus

Since the PIMCO report on the Banking System of Cyprus became public information, I've actually noticed much less comments regarding it than when it was still considered confidential. The reason might simply be that it is always much more difficult to speculate on something which is available to everyone than something which is supposed to be a secret. Thus, given the lack of comments on the subject, what follows is my take on the report.

The first thing you notice in the report is that PIMCO did an excellent job in identifying the major features of the Cyprus banking system. The most important of these features are:

1. The prevalence of asset-based lending practices

In essence, Cypriot banks lent out money only if you had some strong collateral to back your loan (in most cases real estate), with less attention given to whether the client had the ability to actually meet payments. If the borrowers got into trouble, they could always sell their property to repay their loans; as real estate prices increased for a very long time, this practice rarely yielded losses for the banks. Most importantly, borrowers who were not able to repay could always pledge more collateral and actually increase the amount of they borrowed.

2. Extended foreclosure and legal resolution timeline

Simply put, if a borrower could not repay his loan, then the whole procedure of obtaining the collateral and making a forced sale of the property ranged between 10 to 12 years. Add this to the previous feature and the reader may easily see that a borrower had no difficulty in pledging more collateral and obtaining more credit as there is almost zero downside on his part. This in its turn artificially increases loans and leads to the concentration of bad loans to few people (see land developers, hoteliers, etc).

3. Different provisioning methodology, impairment recognition and interest income practices

Notably, a fully-secured loan was not considered a non-performing one which makes the value of NPLs depend on the (subjective) valuation of the collateral. In addition, unpaid interest income was also considered to be income as a result of the historically appreciating property prices which made the probability of future losses very few (as also discussed in feature 1).

In addition to these, a high reliance on the the international banking operations for income and non-residents for funding was also reported. These features resulted in high cure rates for NPLs as well as high re-default rates (since extra collateral means a "cured" NPL but does not mean that the borrower's ability to repay has increased) and subsequently in high probabilities of borrower default but low loss-given-default rates due to over-collateralization.

The methodology of the exercise, will not be the subject of this article, yet, just simply comment that even though there has been much speculation, PIMCO does not appear to do anything different than standard procedure. The same holds for the base scenario which does not appear unrealistic given the European Commission (EC) forecast in Autumn 2012. Actually, compared to the -2.3%, -1.7% and -0.7% EC forecast for 2013, 2014 and 2015 respectively, the -3%, -0.6% and 0.8% is cumulatively much rosier. The same holds for the unemployment rate forecast.

The finding which most strikes out in the report is that Cyprus banks were unable to meet their capital needs even in the base scenario. In fact, not only would they need additional capital to meet regulatory needs but they would also end up with negative capital in 2015, making an additional case against the validity of the EBA stress test exercises in 2011. Again, I note that this is simply the base scenario. In the adverse scenario, the capital needs increase by more than 3 billion euros for the whole system.

The PIMCO numbers are supposedly the ones on which the decision on the percentage of the deposits haircut of the Bank of Cyprus  relied on. The 3.9 billion shortfall for the bank was very close to the 3.8bn obtained from the haircut. The problem, however, lies somewhere else: as stated in page 8 of the report "Greek loans represented approximately 40% of the defaulted balances. Moreover, in the adverse scenario [..] Greek loans represent 43% of total expected losses on Cyprus and Greek loans". In numbers, out of the total of 6.6 billion expected losses on loans and advances, around 2.8bn were from Greece. For those who have forgotten, MoU in March 2013 also included the forced sale of the banks' subsidiaries in Greece. This means that the banks were cut off from any potential losses in Greece thus lowering their capital needs. Even if we round the number of the PIMCO report to 2bn euros, the capital needs in the adverse scenario reduce to about 1.9 bn, without even taking into account the reduction in risk-weighted-assets which would further decrease needs.

Hence, the question which arises from the PIMCO report is: since the forecasts were made using the Greek branches as well, why was the amount employed in the haircut the same? In fact, since the Bank of Cyprus actually required a further re-capitalisation of close to 1 bn a few days ago, how low have the PIMCO estimates been? The only major difference which could make the actual outcome worse than the predicted is the fact that unemployment was 16% in 2013 rather than 13.8% in the forecast, while the house price forecast was much more pessimistic than the actual result. The change in the NPL definition does not matter at all, as PIMCO, in page 15, defines a non-performing loan as one which is 90 days past due, regardless of its collateral amount. The good Laiki couldn't have impaired the balance sheet by that much either since most of the losses were absorbed by the bad bank. Even in the worst case scenario of BoC obtaining all loans from Laiki, the exclusion of the Greek branches leaves capital needs for the domestic Laiki at less than 1bn. Strangely, the liquidation of Laiki was said to decrease Cyprus's needs by 4.2 billion which is in contrast to the PIMCO report in which the bank required 3.9 billion in total (including the Greek branches).

Concluding, the big question mark here is not if PIMCO over-estimated the capital needs of the banks, but why its numbers when it came to the Cyprus evolution of loans were so far off. If the BoC actually needed 4.8 bn (3.8bn of the haircut plus 1bn from the re-capitalisation) to pass the October stress tests why was the number less than 2 billion (excluding the Greek branches) in the PIMCO report? 

The PIMCO report, even though it did a great job in identifying and analysing the state of the Cyprus banking system did a very peculiar job in forecasting its capital needs. Truth be told, numbers and reports don't really add up.

Policy and Self-Fulfilling Prophecies

I've been raging about confidence for a while now. Since any other form of stimulus is either unproductive (e.g. monetary policy due to the ZLB) or infeasible (e.g. QE or government spending), the only way we could actually see growth in the region is via an increase in confidence, which basically means an improvement in our current expectations about the future. Simply put, if I am going to either spend or invest more, I have to know that I will continue to have a job in the near future or that the overall situation in the economy will be better than now.

The problem is that many of us (especially journalists) take a particular liking to bad news; it appears that they sell more than good ones and that is why we tend to emphasize on that (disclaimer: I may have fallen into that trap myself at times). This wouldn't necessarily be hurtful to the economy if we did not live in a world where we somehow create it ourselves. In physics, bad news about a specific group of atoms would not cause all other atoms to stop obeying natural laws. In economics though, bad news about some may cause others to react badly as well.

Think for example what happens when austerity measures on the public sector are imposed: although it may be right that some workers in some countries are overpaid, lowering their wages in a recession comes at a cost. As civil servants lower consumption, the private sector sees its demand fall and reduces investment, causing unemployment to rise. Then, until we adjust to the situation, the economy moves in cycles of reduced demand and investment, causing unemployment to rise and incomes to fall. In the Eurozone, we are now experiencing the time where most of the adjustment has already taken place and even though demand is weak and investment is low, we are much better off (expectations-wise) than a year ago.

Yet, some still point out to the bad things; while, for example, the outflow of deposits from Cyprus appears to be stabilizing with the overall amount registering ups and downs in the past couple of months (compared to huge decreases before), some focus on the downs. The problem of over-focusing on the bad news is that it creates another cycle of uncertainty, one which, on its own, can cause more damage than policies can. You see, if I am bombarded with constant emphasis on how bad the economy is doing (it's not doing good by the way but it does certainly fare better than last year) then I will be more than skeptical to invest or spend. The cycle, as described in the previous paragraph, is indicative of what will happen when confidence falls; the issue here is that over-exposure to "bad" news means that these will turn out to be true if people believe them to be. It is the equivalent of fiat money: it works just because you trust it, nothing more and nothing less.

This kind of over-emphasis can actually derail many of the countries already in a bail-out agreement. Biased information about Greece is what made Greeks believe that they are faring worse than expected, pushing the vicious cycle of austerity deeper into the economy. Now that they are faring much better, biased information and vastly exaggerated opinions are still appearing on popular websites. While I am certainly not a fan of irrational optimism (remember I was one of the first to note that the Cypriot economy was badly in need of a rescue package in 2012 and that Spain is not really out of its trouble) I do think that we should really think before we offer an opinion, especially if it is bound to affect millions.

The bottom line is simple: be very careful of the information you use to make decisions. Emphasis on what could go wrong never really helped anyone; and neither  it will in the future

P.S. As far as forecasts are concerned here are my own (obviously biased) ones: Greece will need no more loans after 2014, but she will most probably not exit the bailout programme by year-end as the Greek PM has predicted. Cyprus will have a tough year but it may actually show us some quarter-to-quarter growth in late 2014. Spain will be rather stable with a slight increase in GDP compared to last year but the big question is what will happen in Italy and whether Slovenia will opt for a bail-out. On the latter two we just wait and see.

Road Plans for Privatizations

Probably the most discussed issue in bail-out agreements is that state-owned organizations in the countries receiving the Troika money should be privatized. The issue was first presented in Greece, where the country had to present a plan to fully privatize, among others, the state-owned post-office  (ELTA) and the water and sewage (EYDAP) companies. The same has been asked for Cyprus, and in order to avoid a bail-out, Slovenia is planning to privatize many of her companies in 2014.

There have been many arguments against these actions, most of them pondering about the job security of the companies' employees once they have been privatized or whether natural monopolies (such as EYDAP) should be privatized. Yet, even though these questions are obviously of great importance (especially since they both affect the welfare of the citizens), the biggest question comes when the decision for a sell-off has been made: at what price should these companies be sold off so that the state will not lose any money as a result of the distressed sale?

For example, consider the following (very simplistic) scenario: a state-owned company is currently (year 0) earning 200m per annum and is expected to earn the same ad infinitum. If the discounting rate is, say, 2.5% the price for that organization would be 8 billion (200/0.025). Yet, if the earnings are now depressed because of a recession (as is the case in most countries forced to sell-off their state-owned companies) or next year (year 1), due to increased marketing efforts or less competition increase to 230m a year, with the discount rate at 2.75% and are expected to remain at that level for years to come, then the company is worth 8.363 billion, which if brought to year 0 is 8. 16 billion, resulting in a loss of 160 million for the state (obviously depending on the amount of shares it sells).

In order to avoid this situation, the state will have to take specific measures, meaning that it should impose a clause which will entitle it to any profits over and above a threshold which will be considered as hurting state finances. For example, let's assume that the threshold is set at 4%, meaning that a fluctuation in permanent earnings under 8 million in the example of the previous paragraph, will cause no claim of funds from the state and that the state sells off 40% of the firm including management. Yet, if profits in year 1 rise to 220 million, then the discounted value is at 214 million (220/1.0275) and the excess of 6 million should be paid to the state, over and above the required dividends of the 60%.

What happens if things go bad one might ask. In the case where permanent decreases in earnings are made, then these will be offset by any future proceeds until one exceeds the other by some extent at which both are satisfied with. An additional issue which often arises is who should purchase these companies. My take is that their employees should have the first take in purchasing these shares, either directly through personal accounts or indirectly through provident/pension funds. This is mostly a sign of trust: if an organization's employees do not trust that their company is worth something, then nobody else will. In addition, these companies should be made publicly traded in the country's exchanges, allowing the markets to reflect their own valuation in the stock price, indicating whether the increase in profits has been considered as a permanent or a temporary situation.

Summing up, it is imperative to safeguard the state's interests when it comes to selling off assets. The fact that the timing of the sale occurs in a recession means that the price will be less than what it is really worth and the state will stand to lose a significant amount of money. Under the proposal described above (even though many details still have to be spelled out), the state will be sure that it leaves no money at the table, while at the same time the interests of the buyer are only harmed by little.

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.

We could have seen this coming. Or couldn't we?

A Black Swan in "Petra tou Romiou" in Cyprus. Photo by XristonPn

The handling of Cyprus's troubles will go down as one of the worst in economic history. Not only is one systemic bank forced to liquidation but the other has been treated as such (and will probably end up as such) since the infamous Eurogroup announcement on March 16th. Then, as the world was trying to accept the results, many began defending the handling of the situation, calling it necessary, moral and fair.

The basic premise of the "defense" is that people should have seen this coming and take the appropriate measures to counter it. Yet, what all of them fail to see is that nobody had ever warned about such things before. The most notable article on this was Peter Spiegel's one concerning a confidential memorandum on a haircut which would be "involving more foreign depositors and bond holders". Yet, this was not the outcome of some economic or political forecast of any kind. This was the result of a journalist doing his job (and doing it very well), at a time where nobody expected such decisions. There were some other articles which appeared in the press by the time the Eurogroup decision had been reached but these were the whole deal: a debate by Charles Goodhart of LSE arguing against bail-ins, an article in Bruegel which compared the similarities between a Cyprus and a Danish bail-in, a Reuters article presenting the possibilities for the Eurogroup meeting, another SSRN paper proposing measures to prevent such a bail-in, one on the NYT questioning whether such proposals might actually be feasible and one by yours truly explaining why a deposits haircut was a terrible idea. Note that the earliest of this articles (the NYT one) was just published on January 10th, with all the rest (except the SSRN paper which was again in late January) published a couple of days before the haircut.

Again, this was not the result of any economic analysis which predicted such an outcome. At most, it was an examination of what might happen, based on media reports which were more volatile than most speculative trades. Any person who calls himself an investor would not dare decide on such information, much less a depositor who has almost no idea what to do even if he understands this information, especially if most of his money are already tied up in time deposits. In all the aforementioned articles (other than the Peter Spiegel one), nothing specific on who would participate in such a haircut appeared. (Just notice the difference between the two Eurogroup decisions: the first was a levy on all depositors in all banks while the second was a levy on uninsured depositors in the two large banks). What happened next was what Nassim Nicolas Taleb would describe as a Black Swan: 

1. The event is a surprise (to the observer).
2. The event has a major effect.
3. After the first recorded instance of the event, it is rationalized by hindsight, as if it could have been expected; that is, the relevant data were available but unaccounted for in risk mitigation programs. The same is true for the personal perception by individuals.

We cannot fully understand the effects of the decision on Cyprus yet, thus although point 2 may be out of our reach at the moment, yet, point 3 is what we should be focusing on. A notable example is Jean Pisani-Ferry who stated the following after the first Eurogroup decision was made:

All those who say Cyprus tax is robbery, have a look. No reward w/out risk. Savers could have deposited in Germany.bit.ly/15aaw7v
— Jean Pisani-Ferry (@BruegelPisani) March 16, 2013

The link provides a summary of the accounts a Russian bank was (is?) providing in Cyprus, with their respective interest rates. Yet, it appears that no earlier statements had been made on Cyprus, either warning about the eminent collapse or of the increasing interest rates, which by the way were always high even before Cyprus's entry in the EU or the Eurozone. As for the seriousness of the argument that savers should have deposited in Germany it appears that although there may be many pensioners with more than €100,000 in a bank (which may be nothing more than saving €100 per month for several years), the idea of sending their money abroad is almost incomprehensible if they never had a background in investments and especially if they use that money in their everyday lives, or they are tied in time deposits.

People have taken the chain of events in Cyprus even further as Barnejek now proposes that abolishing deposit insurance would be good for the bank health. Again, we have a failure to understand what we can forecast and what we cannot. In a discussion after my asking what we should do if a similar crisis occurred in the 2030's and we had no deposit insurance the argument was that we shouldn't worry about a future crisis. Abolishing deposit insurance would supposedly make banks stronger and people would be more careful on their choice of bank. Nevertheless, I would like to remind the reader that we tend to forget fast and the "this time it's different" motto will be heard again when the economy is booming. Who would be willing to go through 200+ pages of annual reports to understand whether a bank is good or not or even if one would be willing to do so how many of us have what it takes to really see through these? If we all could then Warren Buffett wouldn't be the only billionaire investor.

Then, the argument about making banks stronger would perhaps hold for some time after the recession, although it is the case that banks have very strong balance sheets when the economy shifts from recession to growth (Minksy had mentioned this back in the 1980's on what he called the financial instability hypothesis). Then as times are good, banks fund more loans of less and less quality, resulting in trouble again (again, Minsky is the originator of these theories). Then, when it hits the fan, and they lose money or are at the brink of doing so, people start paying attention to what their bank had been doing before and complain that we should have seen this before (just remember the Madoff scheme which lasted more than 40 years-in which case people could actually foresee trouble.). If we have no deposit insurance then as soon as news of financial distress hit the market (regardless of being justified or not) a bank run will occur destroying the bank through a huge outflow of liquidity. Thus, if (or after) trust is replaced by suspicion, any rumour that a bank is not financially well will in fact destroy it. A better alternative, the creation of a fund similar to the FDIC, has not promoted thus far. (Roger Lowenstein provides a short history of the Deposits Insurance Scheme in the US here).

In addition to the above, it has been suggested that the bail-in wasn't something new and if we kept our eyes open we could have seen it in a 2010 proposal. Well, first of all, a proposal for a directive is not the same as a directive. Just because 1 million Americans asked for the construction of a Death Star does not mean they are going to get it. If the documents which leaked 2-3 weeks before the event were classified as confidential then how was that public information? There was an outflow of deposits from the Cypriot banking system yet, this was more out of concern and reaction to rumours (which also proves the point made in the previous paragraph) than of predicting the outcome.

In retrospect everything appears to be easy, yet were where the voices of concern from Cypriot authorities when the Bank of Cyprus or Laiki Bank invested in Greek bonds? How about from Bundesbank officials when German banks did the same? (Yes, German banks got rid of much of those bonds later although it is doubtful whether this was done through BuBa pressure) As a former member of the BoC board states the decision to invest in them was considered good and profitable for the bank at the time. It would be unrealistic to believe that directors (and especially the CEO) of a bank would choose a terrible investment on purpose as this is not to their best personal interest: the bonuses they received were based on bank performance meaning that if the bank was doing bad then they received nothing. Nevertheless, it would also be unrealistic to assume that these choices were not terrible or that the directors used good risk management rules (as German banks did at the time). Yet, could they have seen the PSI before? Not a chance.

It is not just that there was no precedent in Europe. Those bonds were at their worst rated as A3, paid a significant amount of interest and were considered zero risk by everyone. Many (including yours truly) would like to see a post dated prior to 2009, stating that Greece, or any other country in the EU for that matter, would face so much trouble that a bond haircut would occur and that the risk premium was high. Yet, I have serious doubts on whether anyone was able to do it (and first of all, I admit that I could not see such a thing happen in a million years).

We should all be very careful in promoting policies which are based on "we could have seen this" arguments, since most of the times we wouldn't be in a bad situation if we could have really seen it coming. This is not providing an excuse for everything though: the Greek, Italian and Portuguese governments had been overspending for at least the past 10 years and Spain and Cyprus were in a housing bubble which was doomed to burst sooner or later. Nevertheless, the timing of such bursting, including its outcome are mostly unknown as I have argued before. Prevention should not be confused with vague forecasts of disasters. "This time it's different" has about the same validity as the "we could have seen this coming" premise and any policy based on our ability (or willingness) to see the future is doomed to fail.

The Economic Consequences of a CY-Exit

Ever since the latest Cyprus fiasco, many have been wondering whether a country exiting the Eurozone could be a possibility. The fact is that the Eurozone cannot evacuate a country as it will set a precedent (not that setting a precedent seems to bother them a lot, given that lately we have learned that every deposit over €100,000 is not safe). For the sake of argument we can assume that the Eurozone leaders can understand that if one country exits then it is only a matter of time before more leave; thus it is to their better interest to keep every country in the monetary union.

In addition to the assumption that leaders do understand the consequences of their actions, we will also assume that the exiting the Eurozone will allow the exiting country to remain in the EU which means that forcing it out will not forbade it from the common market (details on the subject will be discussed later).

To make things more specific, Cyprus will serve the cause of a case study. 

We know that Cyprus has an 87% debt-to-GDP ratio, a ratio slightly more than the EU average of 81%. As stated in a previous post, Cyprus currently has €9bn of her debt held by domestic creditors. Thus, even under the English law (which does not allow for any changes in the bond structure) if more than 75% of creditors are in agreement then the bond terms can by altered. One can only assume that the Cyprus Central Bank can excess some kind of pressure to the state creditors making them agree on longer duration and lower interest rates (from the creditors' point of view this would not be a bad deal; the alternative would be default and losing all the invested funds). Thus, if this can happen in Cyprus then it is not irrational to assume that it can happen in every other EU nation.

Re-structuring the domestic debt means less expense for the government for the next 10-20 years; the excess could be employed to boost the economy. Then, according to Alex Apostolides an additional €3.9bn would be remain (the rest was bank recapitalization needs which after the fall of Laiki bank are no longer needed), in addition to approximately €5-6bn of ELA money. Then the matter of which issue has more seniority arises. According to Megan Green:

@alexapostolides So defaulting on ELA same as defaulting on anyone else unless want to stay in euro (in which case it's de facto senior)
— Megan Greene (@economistmeg) April 7, 2013

Thus, in the case of an exit, ELA debt and any other European debt (such as Target2 balances) would be equal to every other issue. Then, if Cyprus (or any other country for that matter) chooses to partially default on debt repayments the ECB cannot do anything more than seize assets (which I doubt since it is not senior to any other debt and no actual assets are being on mortgage when a bond is issued-unlike bank loans). Under those terms the ECB would be forced to re-structure any loans it has made to Cyprus (again, the other alternative would be default).

Then we move to the trickier parts of the equation and first of all how will the new currency be introduced. An award-winning paper on Euro-exit states that at the time of the exit, the new currency and the euro should be at a 1-to-1 parity and that euros should be allowed for small transactions for a further 6 months. The first issue that has to be made clear here is that in the case of a euro exit, the new currency and the euro cannot co-exist for more than a week. Many have been arguing for parallel currencies yet, as history has shown and common economic sense dictates, this will cause much trouble.

The reason is simple: assume that on the first day the new currency will have a 1-to-1 parity with the euro. Nevertheless, the new currency will suffer a severe devaluation within the first hours (minutes?) of trading. Thus, if we assume a 40% devaluation as the most popular scenarios do, it would make 1 unit of the new currency equal to €0.60, which would mean that prices would have to be altered again as it would mean that now what cost €1 should cost 1.4 units of the new currency, just to make up for the exchange rate losses. Making matters even worse, the rate would not be at all stable during the transition period. 

A possible solution would be either to peg the new currency to the euro at 1-to-1 parity. However, this would never hold as the George Soros pointed out to the Bank of England in the 1990's. In addition, the willingness of Brussels to do that for a "traitor" is highly questionable. The only remaining alternative is a short transition period and capital controls through it. In order for the transition period to go without any severe effects on the economy (the two-week bank "holiday" is expected to cost approximately 2% to the country's GDP) it has to be fast and swift, with capital controls loosening significantly after it (unlike the very slow steps taken now). 

The only real problem faced by any nation who wishes to exit the Eurozone is inflation. The award-winning paper suggested that:

"The exiting country would immediately announce a regime of inflation targeting, adopt a set of tough fiscal rules, monitored by a body of independent experts, outlaw wage indexation, and announce the issue of inflation-linked government bonds.It also recommends that government should redenominate its debt in the new national currency and make clear its intention to renegotiate the terms of this debt."

The only trouble with the above is that inflation targeting does not assist in the short-run, where the economy will face harsh problems through increased energy prices. In addition, all of the proposed measures are more for the sake of credibility than actual good (in the short-run that is). Although inflation would be needed as a means to boost the economy, too much of it will prove to be disastrous, especially with regards to imports (it has been suggested that deposits will lose their value. This is not an issue per se for residents as everything will be evaluated in the new currency. This is only an issue with hyperinflation and increased import prices).

Economic theory (and practice) indicates that there are the following determinants of an exchange rate:
1. Domestic Money Supply/Inflation and Interest Rates
2. Import demand and Export Demand
3. Productivity (with respect to other countries)
4. Current Account balance and the Trade Balance
5. Domestic Reserves in Gold and other currencies

Another issue which cannot be measured is investor/speculator sentiment. For example, although the US has employed three rounds of monetary expansion (commonly known as QE) the euro continues to depreciate against the dollar because of the Eurozone uncertainty. We will return to that later.

The following data are before Cyprus's entry in the Eurozone (in 2008) and shall assist us in determining the needs of the country for a stable currency (click on the image for enlargement):

Source

The above graph indicates the exchange rate between USD and CYP (the reason for not choosing EUR/CYP is of less history and the fact that energy prices are quoted in dollars). The exchange band of the currencies fluctuated from a low of $1.44 per CYP (in late 2000, after Cyprus's stock market bubble crashed) and $2.5414 (in late 2007, perhaps due to the sub-prime lending crisis). In the meantime, Cyprus's other indicators were:

 

 In contrast to the views of many, it appears that from 2001 until 2007, when the CYP/USD rate was increased by 76%, money supply rose by 191% and foreign reserves by 112% (at their all time high). Inflation was rising during the period, with an approximate increase of 21.4% (or approximately 3% per year).

In addition, the current account was not doing any better either. The data show that as it reached its all-time low (by then) in 2001, the exchange rate did not resume its fall (it moved within the same band for about a year), and the year-end CYP/USD rate was actually increased. In addition, CYP continued its appreciation (reaching the all-time high) regardless of the fact that its current account reached new depths in 2007.

The Import/Export data do not show any significant difference over time either. Their average was pretty much zero until 2004, when the Trade Balance fell continuously until 2007. Yet, however, the CYP increased in value.

Oil prices are always important in an economy.Yet, although oil price rose from 1996 to late 2000 by 70% and the exchange rate fell to approximately $1.50, thus forcing the price of oil to rise more than 130%, real GDP rose by approximately 0.94% per quarter.

The last part of economic theory is interest rates: if interest rates are high, the investors/speculators will want to hold on to the currency; if they are low they do not wish to hold any of it. Yet, as interest rates are higher in a country, higher inflation appears and growth is supposed to be less than it could potentially be if the rates had been lower. 

Having an extremely high interest rate in 1999 did nothing to stop currency deterioration. As the reader may recall, the lowest point of the USD/CYP pair was in late 2000, just before the interest rate was lowered. As interest rates dropped to an average of 3.5% (which again is very high compared to other nations), the currency started appreciating.

In comparison, Cyprus today (as of 2012Q3) stands at:

- minus 990m on the current account (48% less than 2007 but 10% more than 2006 although the full year total will probably be less than 2006)

-341m of reserves (less than any period since 1995)

-101m of forex reserves (again an all-time low)

-563m in gold (an all-time high due to the increased price of gold)

-Deposit rates at about 3-3.5% for term deposits

-The least Balance of Trade (-1bn) it had over the past 8 years (since 2005)

-A slowing inflation (up just 1.2% in 2012 and expected to be near zero in 2013)

The only problems in Cyprus's position are foreign reserves and general reserves. The catch here is what Paul Krugman has been stating and many (including many Cypriots) ignore: 

-Income from tourism in 2012: €1.927bn or approximately 11% of GDP. (The income was actually higher in 2001 when the CYP was in place)

Such an influx of money (which will be even more if the depreciating currency brings more tourists than 2012) will increase the country's foreign reserves and help stabilize her currency. That is the reason why a euro exit should occur either before the summer season or just after it (if the island can survive until then that is). A devaluation of the new currency would in fact assist Cyprus to gain more tourists thus increasing that income.

The main cause of worry for the Cypriots should be oil prices. Yet, as the graphs have shown, rising oil prices is not the end of the world. Real estate, tourism and business services (which comprise approximately 60% of GDP) would be benefited from a devaluation of the currency, which means that more money would be pouring in Cyprus than before. This will again help stabilize the currency thus making prices less susceptible to oil shocks.

In addition, the other worry would be that of money supply. At its highest, M1 supply in Cyprus was approximately 36% of real GDP. Thus, according to data on 2012Q2, the amount of money supply would have to be roughly the same as it was in 2007 to compensate for that (i.e. €4.5bn). The amount of money used to recapitalize banks would not affect M1 as bank reserves are not included in its definition (nor are they included in the M2 definition). (This justification obviously assumes that money needed for recapitalization purposes will be treated as cash/reserves by the banks and not directly used for lending purposes).

A few paragraphs above, there was mention of investor/speculator sentiment. Imagine this: a country exits the Eurozone. Which that country is, does not really matter since once a country is out everybody else will start thinking about their own exit. Consequence: the euro depreciates. Sharply. With fears of a euro break-up, speculators will start shorting the currency driving its price down. Simultaneously, the CYP will itself depreciate, yet not such a fast pace as the euro, leaving it stronger than assumed. In addition, the USD will itself depreciate with regards to the CYP as the effects of the three rounds of QE will once again be visible. What economists seem to be forgetting in their analyses is that an exchange pair does not really count on just one currency but on both: if both deteriorate the same then the exchange rate is unaltered. 

Should the new CYP parity be 1-to-1 with the euro? Not in my opinion. The island would be better off in setting the parity a 0.5CYP to a euro to compensate for any potential currency depreciation. In addition, having the above-suggested parity would need less money supply to support it, making it both easier to create in shorter notice and simultaneously having the reverse effects of exchange rate overshooting in the short run (i.e. currency appreciation instead of depreciation).

Hugo Dixon presented the idea that Cyprus could lose competitiveness if the CYP depreciated because foreign labour will no longer be cheap. Yet, in a country with the largest increase in unemployment over the past year this will not be an issue. If cheap foreign labour force turned expensive it could easily be replaced with cheap domestic labour (unemployment is currently at 15% and rising). As for the current account having a deficit of 5% of GDP, the country never really had a strong current account balance (the least current account deficit was back in 1999 and it was approximately 4.95%).

What can be seen above is that if Cyprus wants to exit the Eurozone it is to its benefit. Although I would not strongly suggest that it does, the island has a very strong negotiating position now: it can request (or threaten) a euro-exit. Most commentators fail to see that if the country exits (or any country exits for that matter) consequences will be severe both for those who left as well as for those who are left behind. Cyprus has nothing to lose at the moment: she is facing at least a 15% decline in GDP in 2013 with no idea when growth will return. If she exits then a significant decline in GDP will also occur. The benefit though, is that it can control both its monetary as well as its fiscal policy which is much more than those which will be left in the Euro can brag about. 

If one country chooses to exit the Eurozone, either with the others' consent or without, the rest will have to live forever with the ghost of uncertainty lurking above them. Any austerity measures taken until now will appear to in vain. Which country will be the next? Will Italy, without a government and eager to relieve its citizens from the perils of austerity exit next? Will Greece? Or will mighty Germany decide to give up the throne of the Queen of Europe? Uncertainty will reign and the euro rate will collapse. Bond spreads will rise and the ECB will have to either use the OMT it has proudly presented in summer or watch it all fall like a tower of cards.

There is also another issue: whoever exits first, gains the most. Less depreciation, less uncertainty, less bond yields and more time to control its finances if (or until) someone else also leaves. As Megan Greece comments, in another example of a half-baked union "There is no mechanism through which Cyprus could be pushed out of the European Union in retaliation." In addition, there should be no country willing to kick another out of the EU just because they wish to exit the Eurozone since they can understand that their time may come soon enough. 

Thus, it can be safe to assume that Cyprus will not be etched out of the EU if it decides to return to the pound. The consequences of that are not as harsh as most people believe; yet they are not to be taken lightly. However, the island has more to lose if it remains in the Euro than if it exits in both the medium- as well as the long-run and it would be wise to use the exit scenario as a bargaining card.

Contagion, Capital Controls and Too Big To Fail: Outcomes of the Cyprus agreement

Corralito Protests in Buenos Aires

Just when I thought that nothing more would have to be said about the Cyprus experiment, a literature over capital controls, whether Cyprus should leave the Eurozone and if potential contagion is something to be feared in the future arose. Economists have been evaluating every one of the aforementioned issues and just as they always do, they could not agree on anything.

Capital controls have been in Cyprus for four days now and apart from the mess at the banks as a result of the 12-day "holiday" no significant flight of capital occurred (and no bank run, to the delight of everyone, even journalists). Although the ECB does not publish real-time Target2 balances, it appears that the capital controls have done their job (if one excludes the stupid decision to close down all banks and leave branches in Russia and Romania open). Probably every article online condones the measures taken by the Cypriot government, yet, some of them agree that there was no other option. Fellow blogger Protesilaos Stavrou commented that if controls persist even after the first tranche is paid by the Troika, then the whole programme was a fiasco; a statement I partially agree with.

Abolishing capital controls cannot happen over a day. The strict regulations applicable now should be transformed to more lax ones over time, with the aim of completely abolishing them until the end of the year (at the very extreme). Why the end of the year? Simply because anything that lasts more than 9 months should be considered as permanent no matter what the authorities may claim. Receiving the first tranche from the Troika does not really mean anything unless the ECB is willing to increase the ELA funding for the Cypriot banks, whose reputation has sunk over course of this deal. If €10 or €20bn of deposits exit the island will the ECB be ready to accommodate the lack of liquidity? 

Many compare Cyprus with Iceland. I beg to differ. First of all, Iceland was not part of the Euro-Area, which means that it had to create its own liquidity. If the ECB agrees to provide ELA funding for the Cypriot banks which may need it (so far only the Bank of Cyprus appears to be in need), then Cyprus can abolish the controls (again, over time) without any more harm to its reputation or economy. In addition, Cyprus banks only account for 10% of GDP and the economy receives a strong boost of foreign money in the form of the 2.5 million tourists who visit the island every year; not be rude to Iceland but we have to admit that their tourism is much less than that. Even without that amount of tourism, Iceland, having imposed capital controls for about 5 years now, exhibited a 3.1% growth in GDP in 2011 with an unemployment rate of less than 5% in mid-2012. Thus, although most economists discern capital controls they have really benefited the country's economic performance. Having capital controls is not bad per se; it's how long you keep them and how harsh they are that makes the difference.

Let's move on to contagion issues. A New York Times article stated that the Bank of Cyprus is no bigger than Indy Mac Bankcorp, a savings and loans institution in the US, which failed five years ago and needed a bail-out. The author misses a little detail though: the US has a GDP of $15 trillion while Cyprus's is about 1,000 times lower. Thus, Indy Mac was approximately 0.0018% of GDP (it had $27bn in assets), while the Bank of Cyprus is approximately 1.5 times as big as the Cypriot GDP. The difference between the two was that Indy Mac was NOT too big to fail. As stated before, there would be no severe contagion in any monetary terms from Laiki bank failing. Neither Bank of Cyprus for that matter. What made the two banks systemic was there strong presence in Greece. After selling that for the cheaper price they could get, they now pose no danger to the European economy (bad move for the Cypriots). 

What makes a difference though, are the psychological effects this issue has had. The banking union, planned for 2014, now appears to be a vague dream; no predictability of institutions exists in any form. If someone thinks that the situation is not so bad and people still trust their banks then why should Wolfgang Schauble have to tell us that the savings in euro are safe? Ordinary citizens have no other viable option in the EU but to place their savings in a bank account. Yet, the less-than-100k accounts do not amount to much. For example, in Laiki bank, only €4bn out of a total of  €20bn will be saved, i.e. 80% of deposits belong to large depositors. These are the people who have the ability and knowledge to transfer funds from one country to another at the click of a button. It is, unfortunately or not, the big depositors that the EU has to reassure to the small ones. In addition, it is not just depositors that have to be persuaded. It is also emerging economies or other countries who use the euro as a reserve currency. The Economist observes that countries in the developing world are drastically reducing their reserves in the Euro, with reserves being at their lowest in a decade. The Euro is as strong as its weakest link and we do not even know who that link is.

Uncertainty is running wild in the Union, as the Eurogroup does not appear to understand the decisions it is making. Another outcome of the Cyprus experiment is that a brand new Too-Big-To-Fail bank has emerged in Greece. Pireaus Bank, after securing €16.2bn of loans at the ridiculously low price of €524 million, has become probably the largest bank in Greece controlling 28% of loans and 27% of deposits. With no agenda on being pessimistic isn't market concentration in the banking industry a big issue, especially in an economy in recession? Time will tell. Yet, it now appears that Greece is being dominated by 3-4 banks, which is almost never good for competition and always never good for the economy if they face trouble. If the Eurogroup decided to reduce the Cypriot banking sector the EU average by making one bank default and make the other less systemic why isn't it doing the same in Greece? Oh, I forgot: we are only looking for solutions AFTER the problem has hit us over the head with a baseball bat. 

This is has been a great week for euro-skeptics. A Euro-exit appears to be less distant know that ever before. The question is who will take the first step. The outcome of Italy's elections will dominate the Euro-Area over the next few weeks, while all of us will keep an eye in France, whose fiscal deficit was still very high in 2012. If the austerity cycle resumes then we are all in big trouble; especially Germany.

Troika Wrong? Estimates of the Cyprus Debt

Source: IIF publication "Cyprus:Just the Facts"

According to an IIF publication of about a week ago, Cyprus had about €15.6bn of government debt, or about 87% of GDP. Of it, €6.6bn were held by non-residents, leaving about €9bn to residents. Of the €6.6bn of non-resident claims, €3.9bn were held by official creditors (mostly the €2.5bn loan from Russia and another €1.1bn from the EIB and the Council of Europe Development Bank). The rest (or €2.7bn) represent medium- and long-term bonds. It also appears that these are almost exclusively Euro Medium Term Notes (EMTN) issued under British Law.

Of the remaining €8.4bn debt, €1.4bn represent medium- and long-term bonds and €1.9bn represent bank recapitalization bonds for Laiki bank in May 2012. Of the whole €7bn held by domestic creditors one-third or about €2.35bn of them is short-term.

When first reading about the Cypriot bail-out (bail-in would indeed be a better term) I thought the amount would be approximately €10bn for both financing government debt as well as recapitalizing the banks. However, it appears that under the last deal "achieved" by the Eurogroup €10bn are to be given just for government needs and not for recapitalization. 

Now, let us add the numbers presented above: €3.9bn of short-term, non-resident claims in addition to €1.9bn for the Laiki recapitalization and €2.35bn held by residents. This adds up to €8.15bn. Yet, hold on for a second: if we exclude the €1.9bn for Laiki, (which will not be of use since the bank is to be liquidated) then the amount is about €6.25bn. Then, the question becomes on whether the short-term claims could have been rolled-over. Russia has explicitly stated that it would be willing to do so, yet we will not even consider that scenario for now. We will just consider the fact that residents would, which decreases the amount to €3.9bn.

It appears that the Troika is not considering rolling-over loans: it is just thinking about changing the identity of the creditors, from residents to the EU or the IMF. 

Under the Troika scenario of €8.15bn, the Cypriot state has to produce minimal deficits in every year to come, even with private consumption and GDP contracting. The hole is government finances is about 4% or approximately €720m. Under the Troika scenario just two years of the same amount of deficit would force the Cypriots to ask for more money (improving government finances when GDP is shrinking is a midsummer day's dream. Greece can indicate more details on that), thus perpetuating the situation.

Even if Russia would not roll-over its loan (which it probably would), it would meant that the EU would not have to give more than €10bn to Cyprus. As the bank recapitalization costs are now less than €6bn, the whole €17bn package seems way in excess. Why government officials, with every inside information available to them could not see this is beyond my understanding.

Cyprus, the next day

Yesterday, the Cypriot Parliament passed 9 bills in its intention to reduce the recapitalization funds the island needs as part of its restructuring process (for a review of the legislation this earlier post sums it up).

Two decisions have been the talk of the town (the Union is a better term): the imposition of capital controls (as Pawel Morksi commented, neither of us has ever seen such a thing in the Western World during our lifetime) and the decision to split Laiki bank into a good bank/bad bank scheme. As far as capital controls are concerned there is nothing to be critical about: had Cyprus not imposed these measures then we would have witnessed the first bank run in the 21st century; and either the ELA would have to pump €20bn in the system to save the country, or they would have to go bankrupt with both insured and uninsured depositors losing their money. It may not look good, but it is the only decision that will save the banks' deposit base.

With regards to the Laiki restructuring, there are some clear advantages and some issues which appear somewhat vague. As far as the advantages go, after this decision the Cypriot state will not be liable for the €1.8bn assistance which the bank "received" about a year ago. This amount is approximately 10% of the country's GDP. In addition, the recapitalization needs should be significantly reduced since the bad assets will not be counted as part of the whole procedure. Given this, some have stated that the whole assistance package has now been reduced to approximately half of what it originally was. This makes the Cypriot public debt sustainable and in addition no further austerity measures have to be taken in order to secure income.

In addition to these, there is also the huge advantage of having avoided the deposits haircut. Exotix’s Gabriel Sterne, presented the following graph on Twitter yesterday, shows that a haircut decision (as promoted by Troika last week) would mean a 20% contraction of GDP.

Yet, a haircut on uninsured deposits is not completely out of the table. It is very likely that uninsured depositors at the Bank of Cyprus will also receive a 20% haircut, for the bank's recapitalization needs. The drawback of such decisions is that they affect provident funds, pension funds, charities and other NGO's. The Cypriot Parliament committed yesterday to look into such issues, although given the island's financial position it would be difficult to compensate large depositors' losses in full. Some estimates place the final loss taken by uninsured depositors to about 20-40% of their funds (based on previous examples like this one). However, this avoids depositors in Coop's or other banks operating in Cyprus having to pay for the two banks' needs, safeguarding a significant amount of deposits. (latest developments indicate that a 4% tax on all uninsured deposits will be levied in order to cover the losses of provident funds, charities, etc from the separation of Laiki's operations)

On the bad side, what appears to be rather odd is the intention of merging the "good" bank with the Bank of Cyprus. This means that a huge bank will be created, one which will contain more than 50% of the island's deposits. Talk about too big to fail! Why the "good" Laiki bank does not continue with its operations independently is beyond my understanding. Adding to the stream of irrational decisions is the one to sell off the Cypriot banks Greek subsidiaries for approximately €1.5bn of which the Cypriot state will have to pay €0.5bn. I cannot help but wonder who was the genius behind this decision. This is not just inane is it exceedingly stupid. The Greek subsidiaries took all the damage from NPL's in the Greek economy over the past 3 years and just about when the potential for growth is at the door, they slam the door right at its face! In addition, this is exactly what made Cyprus systemic. Decreased recapitalization needs is what (in my opinion) caused this decision yet people should look just a few steps ahead when planning. It does not make sense to sell off your assets in a recession, when growth is to follow in the next couple of years.

An pertinent issue to affect the local economy is the shortage of liquidity. Imposing capital controls will mean that exchanges will be limited for an undefined amount of time, which will harm the already fragile local economy. As another article stated "For Cyprus, the single currency would be dead in all but name". Yet, as already mentioned, there is no option but imposing them. The drainage of capital due to Laiki's liquidation will also mean a shortage of funds in the economy, not the mention increased unemployment as an outcome of the Laiki merge. More than half of Laiki's employees or approximately 2,000 people will be jobless in the course of the next few years. This will inevitably push the island further into a recessionary cycle and destroy it's reputation as a financial center (what is left of that reputation anyhow).

Nevertheless, the most important aspect of last week's decision is that Cyprus did not set a precedent. They managed to stand up to what the inane decision of the Eurogroup had imposed on them and by protecting their insured deposits they have protected the whole of Europe's as well. The following years will not be easy on the island. Recession, thanks to the efforts of Germany and all those who did not oppose its politics and tactics, will reign over people who had no idea of what was going on in the political salons of Europe. The same people who will bear the burden of their leaders'  decisions, those who will be unemployed and hungry, those who will be homeless and even hopeless. People not just in Cyprus, but everywhere in a European Union tormented by austerity and unwilling to deviate from obsessions of a previous century.

P.S. Waiting for the Eurostat data on 2013's first quarter... Recession in Germany appears to be a good bet. We will wait and see.

A Review of the Legislation Passed in Cyprus

Source. www.philenews.com

Although I unfortunately could not get my hands on the actual bill proposed and passed at the Cypriot Parliament yesterday, a description of the measures is the following:

1. Creation of a National Solidarity Fund whose purpose is the funding or financial support of banking institutions, assisting and supporting their recapitalization or promote and contribute to the Republic's funding. The Fund's income will be derived from natural gas revenues or bonds or other securities the Fund will issue and sell.

2. Power to the Minister of Finance or the Central Bank Governor to impose restrictive measures in banking transactions in case of emergency. These measures up to now are (the provision for the increase of these measures exists in the legislation):

• Maximum amount of monthly withdrawal €10,000
• Term Deposits are forbidden from premature ending
• Obligatory renewal of all term deposits ending over the next period (unspecified)
• Restriction in the creation of new banking accounts
• Current accounts to be transformed into notice accounts
• No-cash transactions to be limited
• Cashing of cheques and interbank transactions to be limited
• Limitation of the public's transactions with the banks

3. Division of Laiki (Popular) Bank to a good bank/bad bank scheme. All depositors who possess up to €100,000 in the bank will be insured. The percentage of the uninsured deposits to be lost is yet to be formally announced. Good assets and liabilities from Laiki Bank will be merged with the ones of the Bank of Cyprus PLC (the island's largest banking institution). A liquidator will be assigned in order to collect non-performing loans by Laiki.

All other laws passed yesterday by the Cyprus Parliament were Amendments to previous legislation, giving more power to the Central Bank to monitor, obtain information and intervene in banking institutions with the purpose of promoting recovery plans, providing for the creation of an integrated recovery framework and increasing early intervention measures.

How Pulling the Plug on ELA makes Cyprus Systemic

A bank run in 1933

We cannot possibly know whether Germany (or the ECB for that matter) had threatened to pull the plug on Cyprus`s Laiki Bank Emergency Liquidity Assistance (ELA) if the island did not accept the deal. Yesterday, joyful Cypriots who gathered outside the Parliament house, saw 36 MP`s voting against the referendum which imposed a one-off tax on deposits in Cyprus. Today, German Finance Minister Wolfgang Schauble warned that the ECB will pull the plug on the both Cypriot banks.

 

Two words for that: Non-credible threat

 

Here`s why:

 

Schauble comments that "(..)we are much more stable in the eurozone - we took measures to protect ourselves from the risks of contagion ... but I don't want to have any of this.". It appears that he has not taken a good look at the situation in Greece nowadays. Bank of Cyprus has €7bn of deposits in Greece (01/09/2012), while Laiki bank has another €7bn (31/12/2011) and Hellenic bank approximately €600m (31/12/2012)*. In total, the Cypriot banks control about €15bn in deposits in Greece, or approximately 11,8% of domestic deposits in the country (approximately €127bn).

If the ECB pulls the plug on Laiki Bank, the whole Cypriot banking system will collapse in a matter of days, taking the Greek subsidiaries with it. This will mean that the Greek government will have to compensate deposits up to €100,000, which even in a an extremely optimistic scenario will be approximately  €7,5bn, money it does not have. Thus, the collapse of Cyprus will trigger a severe deterioration of the Greek banking system, which in turn will trigger the ever greater deterioration of the Greek economy. If the Greek state does not afford to pay insured depositors it will mean that it will have to either allow them to default or do the unthinkable: a deposits haircut for those who have more than  €100,000 in deposits. Yet, this will trigger a bank run, and people will return to the keeping their money under the proverbial matress.

In addition, if Greece is systemic as stated (and if it wasn`t it now is due to the inane decisions to influx taxpayers` money instead of allowing the ECB to print money) its collapse cannot be afforded. If we reach the bank run stage, then Italian and Spanish depositors will run to banks in order to save what they an, allowing for the first large-scale bank run in the West since the 1930`s. The amount of money needed by the ECB to avoid Greek collapse will be far greater than the amount currently required for the Cypriot banks to continue their operations.

Skeptics might argue that if the Greek state has announced that it can absorbe the Cypriot banks` subsidiaries in Greece, it can do it even if they collapse. I beg to differ: there is a difference between a controlled passing of operations to the Greek banks (a procedure which may take a significant amount of time) and the sudden collapse of a bank. In the controlled situation it is highly unlikely that depositors will panic, and an even less chance of a bank run. In the uncontrolled one, panic, dispair and bank run will be the major ingredients in an explosive situation. We have all seen scenes of enraged Greek employees violently protesting for salary cuts. One can only imagine how the scene will change if they are to face a personal bankruptcy.

Wolfgang Schauble should be extremely careful about his comments. He is risking a credibility which cannot be regained easily once lost. Statements of this kind do not put markets at ease. They create more uncertainty and fear as people realize what the truth is really like.

*Data taken from Bank of Cyprus, Laiki Bank and Hellenic Bank annual quarterly reports