Cyprus bailout remains unresolved

The debate over whether Cyprus will be bailed-out of its current economic crisis rumbles on, without any clear resolution.  This is a dangerous state of affairs given that the Island will face economic collapse if it cannot bring a resolution before June of this year, when it faces a Euro 1.4 billion bond redemption.

It was June 2012 when the Island, which accounts for just 0.2% of the Eurozone’s economy, first requested help, but the route to resolution since then has been far from smooth. The reasons for the delay are a mixture of political and financial. 

One of the biggest issues is quite simply how a bailout can be structured in such a way that it does not set the Island on an inevitable path to future collapse, due to the size of the debt burden.  Little public information has been given regarding the size of the bailout required, but it is believed to be in the region of Euro 17 billion spread over 4 years, 10 of which would be used to recapitalise the Island’s ailing banks, and the remainder for other Government spending requirements.  However, it is believed that a bailout of this magnitude would push the country’s public debt burden from its current level of 84%, to a huge 140-150% of GDP in 2016 and there are real fears that this is an unsustainable level which would lead to future bankruptcy.  If this is the case, and the bailout would do nothing other than postpone the inevitable, then some would argue that there is no point accepting the help now, together with all of the strings and conditions (for example regarding privatisations and significant cut-backs in the public sector) which would inevitably be applied.

It has been suggested in recent days that part of the package that is being negotiated at present includes a write-down of private creditors’ holdings of Cypriot bonds, or a write-down of uninsured bank deposits, so that private investors/depositors share some of the financial pain and the size of the external bail-out which is needed can be reduced. Whilst on the face of it these may seem like sensible suggestions, they have been the cause of great consternation and are very controversial.  Domestic Cypriot banks hold the majority of Cypriot government bonds, and so writing those bonds down in order to raise funds to prop up the banks simply does not make sense.  On the other hand, making bank depositors take some of the pain raises concerns that it would lead to panic in other EU countries experiencing financial difficulties that they too could take similar action in the future if their financial position deteriorates.

From the Island’s perspective, a far more palatable result would be to extend the life of the bailout to give it more time to pay, as was done in the case of Greece, but it is far from clear that this would be acceptable to the Troika, and the reasons are to a large extent political.

At a time when politicians are moralising publicly about tax avoidance, it is seen as politically difficult to prop up an economy which is based to a large extent on tax avoidance (even if we assume the tax avoidance is entirely legal) and where the majority of the depositors in Cypriot banks are extremely wealthy Russians.  Whilst the Eurocrats may have sympathy with ordinary Greek families losing their life savings as a result of a Greek bank collapse, there is little sympathy for Russian oligarchs who may face a similar prospect in the event of a Cypriot collapse.  In Germany in particular, where Cyprus is routinely portrayed in the press as a haven for Russian money laundering, there are very few political votes to be won in supporting the territory, and an important election looming in September means that few German politicians are willing publicly to back a bailout for fear of an electoral backlash.

So what is the most likely outcome of the current very difficult situation?  Despite the fact that many would argue that Cyprus can be allowed to fail without the contagion spreading to other EU territories, I doubt that there are many EU countries who would want to take that risk, and so the pressure to agree a deal will be enormous.  The Germans will need to be seen to have won concessions to ensure that Cyprus becomes more open and transparent in its financial dealings in the future, to lessen the chances of it being used as a money-laundering centre.  Russia, which already lent Cyprus 2.5 billion euros in 2011, may also be persuaded to extend the repayment date for that loan from 2016 to 2022, and to put its hand in its pocket once more.  This would enable the Troika’s contribution to the bailout to be reduced, which would go some way to assuaging concerns that EU money is being used to prevent wealthy Russians from losing their cash. Cyprus, for its part, is going to have to agree to some painful measures to shore up its finances, including a sale of some state assets and the removal of key protections for public employees. If these measures could be combined with a slightly longer time frame for the EU bailout cash, keeping the debt ratios lower, then Cyprus just might be able to come out the other end of this situation intact.  But there is a lot of talking still to do and the clock is ticking.