The European Institute – Washington, DC
Perspectives - Cyprus: The Mouse That Roared At the Euro Zone “Troika”
By J. Paul Horne, Independent International Market Economist, Paris
The political miscalculation of “Troika” leaders (of the European Commission EC, the
European Central Bank ECB, and the IMF) has been dramatized by the Cypriot mouse that roared
“No” to what amounted to illegal confiscation of insured savings as the price for bailing out Cyprus.
When the Parliament in Nicosia unanimously rejected last week the bailout conditions posed by the
Troika, it was embarrassingly forced to withdraw these conditions.
It then approved early this morning (Monday, March 25) in Brussels, a plan acceptable to Cypriot
leaders but not subject to approval by the Cypriot Parliament. (Ironically, the German, Finnish and
Dutch legislatures may have to vote to authorize the European Stability Mechanism (ESM) to approve
loans to Cyprus in April.)
Today’s bailout means tiny Cyprus (its € 25 billion GDP is 0.19% of the Euro zone’s € 13 trillion GDP –
and Cypriot share will be significantly smaller after its banking sector is down-sized), will remain in
the Euro zone, which it joined in May 2004. The bailout also means that the Cyprus’ over-extended
banking system will be dramatically restructured and that Cyprus will have to endure an austerity
program. Another consequence is that Cyprus will no longer be one of the Euro zone’s principal tax
havens.
Key elements of the bailout include: A one-time tax of up to 40% on uninsured bank deposits (those
over EUR 100,000) and capital controls. Doubtful bank assets from Cypriot banks will be segregated
into a “bad bank.” The largest bank, the Bank of Cyprus, will take over the viable assets of the second
largest, the Cyprus Popular Bank, which is 84% government-owned and will be closed. Senior
bondholders will also contribute to recapitalization of the Bank of Cyprus. The banking system will be
closed “until further notice.” The ECB is expected to insure euro liquidity to the Cypriot banks once
they are restructured. IMF loans will be accompanied by an economic austerity program.
The bailout relieved markets at their opening on Monday, with Asian and European equity markets
rising modestly, after sinking last week. Euro bond yields are easing and the EUR is edging up against
the USD.
The € 10 billion bailout of Cyprus, the fifth Euro country to be bailed out by the Troika, will prevent
the island’s banking system from collapsing and perhaps forcing Cyprus out of the euro. Disturbingly,
a “CyprExit” from the Euro zone had been hinted at, irresponsibly, by Euro zone finance officials
during the bailout negotiations, presumably because they thought Cyprus’ tiny size meant it was not
vital to the integrity of the Euro zone. It is worth noting that from the Cypriot view the bungled
negotiations were not due to the lack of time: Cyprus requested the EC to bail out its banking system
last July.
No matter how tiny, however, the Cyprus affair is an acutely embarrassing reminder that the euro
currency remains vulnerable to banking and sovereign debt problems, even though important
2 – Cyprus : The Mouse That Roared
progress has been made in Euro zone governance and regulation since the Euro crisis began in late
2009.
Far larger problem countries include Italy, still without a government since its general elections on
Feb. 24-25; Spain, still plunged in recession with a 26% unemployment rate; and even France, which
is the core of the Euro system with Germany, but whose fiscal situation if worsening with its
increasingly uncompetitive economy stuck in recession .
Moreover, key parts of the Cyprus bailout raise basic questions about the Euro system. These include
the possibility that insured deposits might be taxed to bail out failing banks, an eventuality not lost
on depositors in weak banks in other Euro countries. The imposition of capital controls by a Euro
zone state in crisis violates one of the principles underpinning the European Union.
The ECB’s inability to intervene directly to save “bad” banks is a reminder that the planned banking
union and Single Supervisory Mechanism managed by the ECB must be accelerated. It is equally clear
that Euro zone banks’ core capital remains far too reliant on sovereign debt issued by deficit-prone
and debt-ridden Euro governments. And Cyprus illustrates, once again, how the Euro zone’s survival
depends on “virtuous”, but increasingly grumpy, north Euro zone taxpayers paying to bail out errant
“Club Med” members.
Ironically, all of these problems were highlighted by IMF’s first-ever Financial System Stability
Assessment (FSSA) of the European Union on the eve of the Cypriot crisis. The 60-page FSSA was
approved by the IMF Executive Board and published, with considerable fanfare, on Friday, March 15,
the day before the Troika’s representatives agreed, early Sunday morning, on their politically illconsidered conditions for resolving Cyprus’ pesky banking crisis.
Taxing Insured Deposits
The most egregious Troika demand was a one-time tax of 6.5% on savings deposits in Cypriot banks
insured by the government up to EUR 100,000; and a 9.9% levy on uninsured savings over that
amount. It should be noted that Cyprus’ President Nico Anastasiades, elected on Feb. 25 as head of a
new Center-Right government, approved the proposal to tax the government-insured deposits. But it
was the Troika’s flagrant repudiation of the EU-wide principle of insuring small savers’ deposits that
infuriated Cypriot parliamentarians , who unanimously rejected the Troika’s conditions early last
week.
Within 48 hours, the red-faced Troika made it clear they were ready to revise their bailout
conditions. Today’s final agreement avoids taxing insured deposits, although it will severely penalize
the more speculative, uninsured deposits. These are said by Moody’s to include € 20 billion in
deposits by Russian, plus those of other tax-evasive non-resident individuals and corporate entities.
(The Russian government refused to help a second time, having lent Cyprus € 2.5 billion in 2011. It is
thought that Moscow finds Cyprus useful as an off-shore tax haven; a potential source of off-shore
natural gas and oil (a sensitive issue for Istanbul which insists that any gas and oil also belongs to
Turkish Cyprus); a window on to the bitter Greek-Turkish rivalry in Cyprus, and as a base near
Moscow’s Syrian ally.)
The Troika’s initial demands made it appear as if the EC had forgotten its years of travail with deposit
guarantee schemes (DGS) designed to avoid the catastrophic bank failures of just a few years ago,
notably in Ireland and Iceland. In discussing the initial proposal to tax insured deposits, Jeroen
Dijsselbloem, the 46-year-old Dutch finance minister (since late last year) and new President of the
Eurogroup (the Euro zone’s 17 finance ministers), told the European Parliament on March 21:
“Whether we are incompetent or not, I’ll leave up to you to judge.”
3 – Cyprus : The Mouse That Roared
Competence is an important consideration in the on-going Euro crisis. The Irish and Icelandic bank
failures, plus the Euro sovereign debt crisis, had forced the European Commission in July 2010 to
revise its Directive on Deposit Guarantee Schemes (DGS) to harmonize and simplify protection of
saving deposits, provide for a faster payout, and improve financing of such plans. Today, national
DGS in virtually all EU countries will reimburse up to EUR 100,000 (or the equivalent in non-EUR
currencies) in savings deposits in a failing bank.
A new flare-up of the debt crisis in summer 2012 then forced Euro political leaders to agree on a Euro
zone banking union, which was to have included a single deposit guarantee scheme for all Euro zone
banks. Although all EU member states agreed that a Euro-wide DGS was essential to such a
fundamental banking reform, the surrender of sovereign control of national banking systems, and
taxpayers’ liability implicit in a Euro-wide DGS, were too much for German political leaders, facing a
tough Federal election due in September, as well as other northern countries responsible for
guaranteeing deposits in peripheral Euro states.
As a result, the Euro-wide DGS was shelved as an immediate component of the new Euro banking
union. (The City of London financial center has a perpetual allergy to regulatory constraints and the
British government refuses to agree to an EU-wide DGS.)
As the IMF’s FSSA emphasized, deposit guarantee schemes are essential to the Euro system because
they prevent depositor runs that can quickly cause banks to fail. Thus, the Troika’s initial proposal of
a tax on Cyprus’ insured deposits looked suspiciously, and mystifyingly, like reneging on the
fundamental sanctity of insured deposits. The move also raises questions about what the Troika
might do in the next chapter of the Euro crisis.
Capital Controls
Similarly, Cyprus’ new bailout agreement calls for capital controls with strict limits on individual and
corporate movements of assets and changes of accounts, as well as strict rationing of cash
withdrawals from ATMs. Investors elsewhere in shaky Euro zone countries may well be asking
themselves if capital controls could be imposed if and when their government runs into trouble.
If the question were limited only to marginal economies such as Cyprus and Greece, it might not be
of great concern to markets. But the Troika’s actions suggest that basic protections in the Euro
system, such as deposit insurance and free capital movement, might be at risk. Since tax authorities
in Paris and Rome are targeting high net worth individuals and foreign companies, French and Italian
residents and corporate entities must be concerned. A French survey, published this past weekend,
found that 40% of respondents thought the Socialist government of President Francois Hollande
might tax savings.
One potentially useful aspect of the bailout involves Greece’s Piraeus Bank’s absorption of the Greek
units of the Bank of Cyprus and the Cyprus Popular Bank (also called the Laiki Bank), once they are
restructured and recapitalized. This will make the Piraeus Bank one of Greece’s largest banks and
contributes to the consolidation of the Greek banking system, as well as reducing Cypriot exposure to
Greek sovereign debt issues.
But the Troika’s erratic moves to resolve the Cypriot crisis leaves the markets basically unhappy.
Moody’s Investors Service commented in a note reported by Bloomberg today: “Policy makers’
recent decisions raise the risk of deposit outflows, capital flight, increased bank and sovereign
funding costs and broader financial-market dislocation throughout the euro area in the future.”
4 – Cyprus : The Mouse That Roared
The IMFs Assessment
Despite the Troika’s embarrassing lapsus last week, the IMF’s first assessment of overall financial
stability in the European Union was relatively positive, considering the magnitude of the Euro debt
crisis since late 2009 and the dire predictions of the euro’s demise.
Much has been achieved to address the recent financial crisis in Europe, the IMF wrote in the FSSA,
noting new Euro institutions, such as the ESM (which will be allowed, in principle, to recapitalize
banks directly); the new European System of Financial Supervision (EFSF), and the planned Single
Supervisory Mechanism (the SSM, to be managed by the ECB) for the new banking union, which we
have described in other reports.
The FSSA also lists the ECB’s numerous “unconventional measures” since 2007 to protect financial
stability in the Euro zone. It also pointed out that “virtually all EU governments have started fiscal
adjustment programs with varying degrees of success.
The IMF praises EU banks which have raised “considerable new capital” under the guidance of the
new European Banking Authority (EBA) although “pockets of weak banks remain” – Cyprus being the
latest example. Banking restructuring is, however, too slow with the number of credit institutions
dropping a paltry 5% since 2007. Only 60 banks have been deeply restructured. Moreover, many EU
banks are still excessively dependent on wholesale funding and/or are too exposed to illiquid or
impaired assets.
National government support has been excessive, the IMF warned, and, as we have seen, can trigger
an adverse loop between banks and governments. Burden sharing with creditors, i.e. “haircuts” for
bondholders, has been rare, although Greece forced creditors to take losses, as will uninsured
depositors in Cyprus.
But Cyprus was a perfectly timed example of what the IMF’s FSSA warned are serious vulnerabilities
that remain in the EU, and require intensified efforts across a wide front. These include:
1. Bank balance sheet repair. Progress toward strong capital buffers needs to be secured and
disclosures enhanced. To reinforce the process, selective asset quality reviews should be
conducted by national authorities, coordinated at the EU level.
2. Fast and sustained progress toward an effective Single Supervisory Mechanism (SSM) by the
ECB and the planned banking union is imperative. The IMF warns that the ECB must build
“supervisory expertise of the highest quality” and have “resources commensurate with its
supervisory tasks.” These are essential to anchor financial stability in the Euro zone and for
ongoing crisis management. The European Stability Mechanism (ESM) must start to directly
recapitalize Euro banks as soon as the SSM becomes effective.
3. There must be a stronger EU-wide financial oversight framework. Enhanced coordination
across various supranational agencies is essential to achieve policy consistency, especially at
the national level.
The IMF warns: “Financial stability has not been assured.”
Recent assessments of individual EU member states show vulnerability to stresses and dislocations in
wholesale funding markets; a loss of market confidence in sovereign debt; further downward
movements in asset price, and downward shocks to growth. These vulnerabilities are exacerbated by
the high degree of concentration in the banking sector, regulatory and policy uncertainty and the
major gaps in the policy framework that still need to be filled.
5 – Cyprus : The Mouse That Roared
From our point of view, the Cyprus affair illustrates how careless, early-in-the-morning crisis
management can escalate an otherwise manageable mini-crisis into one that shakes markets and,
worst of all, reduces confidence in the Troika’s ability to resolve such problems while continuously
improving governance of the Euro zone.
J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris
where he was chief international economist for Smith Barney for 24 years. He retired as a Managing
Director of Salomon Smith Barney/Citigroup in 2001 but remains active with the National Association
for Business Economics, the Global Interdependence Center and the Société d’Economie Politique in
Paris.
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This article was published in the Institute’s journal, “European Affairs”, which can also be seen at:
http://european.institute.org/.