How big is Cyprus’ economy? 

GDP of €18.0bn as of 2011 (latest official figure)

 

Why does Cyprus need a bailout? Did Cyprus have an irresponsible/spendthrift Government?

No, it is its banks that are the problem. Cyprus’ Debt/GDP ratio stood at 49% in 2008 and rose to 71% by 2011 as a result of the crisis and the sizeable deficits of the last three years. However, the Cypriot Government had a budget surplus of 3.5% in 2007 and 0.9% in 2008 and, despite suffering a -1.9% recession in 2009, the Cypriot economy quickly recovered with real GDP growth of 1.3% and 0.5% in 2010 and 2011 respectively.

 

So how big is its banking sector?

Here is the issue. A growth strategy based on becoming an offshore financial center with favorable tax rates and deposit rates attracted deposits and boosted the balance-sheet of Cypriot banks, which reached north of 700% of the island’s GDP in 2011. Therefore Cyprus rapidly became the small island with an outsized banking system that it is now.

 

But were they running their banks like in Iceland, Ireland and Spain?

Truth is, no. The Cypriot banks were in many ways arguably healthier. They had very little dependence on wholesale funding (ie loans from other banks or Mortgage-Backed Securities etc), which chocked off the Icelandic banks at the start of the financial crisis. Loans to deposits ratios in the Cypriot banks stood at less than or around 100% compared to 200-300% seen in Iceland and Ireland. Moreover, the Cypriot economy did not suffer a real estate bubble comparable to the Irish or the Spanish one.

 

So what was the issue?

In a nutshell, Greece happened and this is a prime example of the eurozone domino effect. The two main Cypriot banks, Bank of Cyprus and Laiki Bank, had a substantial presence in Greece, almost as large as their Cypriot operations. Fierce competition between the two in the 2000s led particularly the latter to an aggressive lending policy in Greece, resulting to them having now Non-Performing Loan levels of 21% and 40% respectively based on their 9m 2012 in their Greek operations. Moreover, they had a substantial impact from the restructuring of Greek government debt, digesting €1.7bn and €1.9bn capital hits respectively. This, in combination with an increasingly worsening domestic economic situation and troubled commercial loans in their Russian and other former eastern bloc subsidiaries substantially eroded the capital base of the Cypriot banks.

 

After conducting a stress test on behalf of the Cypriot Government and the Central Bank of Cyprus, the investment firm PIMCO reportedly estimated that Cyprus’ banking system needs between €6bn and €10bn of new capital on baseline and downside scenario respectively due to the banks’ potential losses (approx. 55% of GDP in the downside case). The exceptionally high estimates led to the report not being officially published. Moreover, the Cypriots hired also Blackrock Solutions (which was involved in the Irish and Greek stress tests) to get a second estimate for the potential losses.

 

So how much money does Cyprus need and where are they going to find it?

According to the publicly available information so far, the total need seems to be c.€16-17bn, which was the number initially rumoured throughout the last few months. This amount is meant to cover the bank recapitalisations (€6-10bn, depending on the final decision) as well as the financing needs of Cyprus over the next few years, assuming no market access for the country, which seemed to be the case given its >7% yields.

 

What changed on the 16th of March was the composition of the package. In light of the size of the Cypriot economy, a loan of roughly 100% of GDP would make the country’s debt unsustainable. Therefore the bailout loan was capped at €10bn, with the aim of Cyprus reaching a debt/GDP ratio of 100% by 2020 as per the 16th of March Eurogroup statement.

 

The remainder of the funds, would be sourced primarily by a levy on bank deposits which would raise €5.8bn. Based on the initial proposal, 9.9% of deposits above €100,000 and 6.75% of deposits under €100,000 would be converted into shares in the respective banking institution they were deposited (what most people in the label as a “haircut”). The most controversial aspect of this move is that it violated 1) the deposit insurance of amounts up to €100,000 which holds across the EU and 2) it obviously undermined faith in the banking system as deposits are considered the safest and most senior of liabilities in banks’ capital structures.

 

What is happening now?

After the parliament’s rejection of the initial € 10bn bailout proposal on Tuesday the 19th of March, in light of the public’s fury over the € 5.8bn levy on deposits, the Cypriots inspected a number of alternatives:

 

1)      Russian rescue: a new loan by Russia. Russia would be given in return for its help either access to Cyprus’s prospective gas reserves or a purchase and subsequent recapitalization of one of the Cypriot banks. There were rumors about a possible marriage between Gazprombank (the Russian gas giant’s financial arm) and Laiki, the second biggest and highly compromised bank of the island; However, the loan would eventually push the Cypriot debt over the level deemed sustainable by IMF and this was not acceptable to the Troika. After visit by the Cypriot Minister of Finance and discussion between Putin and Anastasiades there was no conclusive alternative on the table.

 

2)      Returning to the Cypriot lira: If the Cypriot authorities fail to raise extra funds in a way that satisfies the Troika by Monday the 25th of March, the ECB has given an ultimatum saying the Cypriot banks will no longer be eligible for Emergency Liquidity Assistance (ELA). This would effectively force the country to leave the euro and a number of Cypriot politicians openly considered the idea.

 

3)      Revisit the “haircut” proposal, with adjustments to protect small depositors

 

Indeed the third option is the one that’s being followed and on which the Cypriot Government, the Troika and the Eurogroup are working on this weekend. According to the latest information, Laiki Bank will be split into a good bank/bad bank structure, while only Bank of Cyprus’ deposits above 100,000 would suffer a 25% “haircut”/equity conversion. Laiki’s good bank will likely be merged with Bank of Cyprus. The banks’ Greek operations were sold on Friday to Greece’s Piraeus Bank, reducing also the size of the institutions substantially.

 

The question is: if the Bank of Cyprus is recapitalized by the write-off of liabilities (the deposits) and Laiki Bank is split into a good/bad bank with no need for direct cash injections in the banking system, could the Cypriots tap the market without resorting to the €10bn bailout? The main driver for the indebtedness is the bank recaps, but if this is achieved in a non-cash manner, there is no new debt for the Government! The ECB should be content providing unlimited liquidity as the banks would be sufficietly recapitalized and the Government would still have a sustainable debt position today, with no need for an IMF memorandum (whereas with the extra €10bn it will only go back to sustainable levels by 2020). Food for thought…

 

The bottom line, though, is that it is sad to see the eurozone falling again victim to the vicious cycle between bank and Sovereign solvency, an issue that the decision on the banking union was meant to solve. Hopefully, as the banking union gets fully operational in 2013-14 systemic instability caused by such episodes will be substantially reduced.


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