The only thing worse than Cyprus accepting the rotten bailout program that European policy makers agreed on late last week was Cyprus rejecting it. Yesterday, the parliament voted decisively against the terms of the bailout, with 36 members opposing it, the ruling party abstaining and not a single vote in favor.
Policy makers will have to come up with a new plan, and they had better hope the European Central Bank buys them enough time to do so before Cyprus’s financial system melts down.
A bank holiday was declared until Tuesday to prevent panicked savers from withdrawing their deposits from banks when they learned over the weekend that a levy may be imposed on deposits as part of a bailout program.
If depositors were worried about losing their savings before, they should be even more worried now. Last week, the ECB threatened to cut off emergency liquidity assistance to Cyprus’s two main banks in the absence of a bailout program. This would result in the immediate collapse of both banks, and they would default on their debt and most, if not all, of the 30 billion euros ($39 billion) in deposits they hold.
Faced with a bank run and the collapse of its largest financial institutions, Cyprus would only be able to rescue its banks and its economy by printing money and leaving the euro.
Luckily, this needn’t happen. A much more likely outcome is that the ECB will first impose capital controls. The euro area is founded on the principle of freedom of goods, labor and capital, but Article 65 of the Treaty on the Functioning of the European Union stipulates that capital controls are allowed when “justified on grounds of public policy or public security.” We have already seen capital controls this week in Cyprus, with the bank holiday and transfers frozen.
Once banks reopen — scheduled for tomorrow but probably postponed until next week — we can expect deposit flight from Cypriot banks. A bank run is no problem as long as the ECB continues to finance it by plugging the gap with continued emergency liquidity assistance. After parliament’s rejection of the bailout deal, the ECB announced yesterday that it would offer Cyprus liquidity within “existing rules,” a strong indication that it will back down from its earlier threat to take the punch bowl away and shut down emergency funding to banks.
Capital controls and the ECB’s emergency financing can buy time for Cyprus, but the tiny island will still need at least 17 billion euros in bailout funding. So far, the 10 billion euros that the International Monetary Fund, the European Union and the ECB offered in the original deal are still on the table, but Cyprus needs to find an additional 7 billion euros. There are four potential sources.
The best option would be for the government to accept that wealthy Russian depositors have already been well and truly scared off from Cypriot banks, given developments over the past few days, and impose a big enough levy on uninsured deposits to avoid having to tax insured deposits. The government remains stubbornly protective of the country’s status as a tax haven, so this option seems unlikely, though not impossible.
Cyprus could try to piece together 7 billion euros from other sources. The nation could force losses on unsecured senior bank bondholders, but for the two biggest banks this would generate less than 200 million euros in savings. Yesterday, Mario Mavrides, a member of parliament, admitted the government was considering raiding pension funds, as was done in Ireland to help finance its bailout program. This would bring in less than 500 million euros.
Cyprus could also discount the net present value of future revenue from gas reserves lying off its coast. These reserves are notoriously difficult to value, and delays in establishing the infrastructure to capture and transfer them are inevitable.
A third option would be for Cyprus to go back to the troika of lenders — the IMF, ECB and EU — for more money. It would probably reject such a request for the same reason it originally did: A 17 billion-euro bailout would cause Cyprus’s public debt burden to balloon to unsustainable levels, even more so now because gross domestic product is set to contract further, given deposit and capital flight.
The final option is for Cyprus to negotiate aid from Russia. Finance Minister Michael Sarris traveled to Moscow yesterday to meet with President Vladimir Putin. A plain vanilla loan from Russia could cause the troika to withdraw their support for Cyprus for the same reason the troika won’t offer the extra funds themselves: It would make Cyprus’ debt unsustainable. Russia could offer money in exchange for rights. There has been speculation that OAO Gazprom (GAZP) may offer to recapitalize Cyprus’s banks in exchange for ownership of gas fields and factories near and on the island. The EU has opposed Russia increasing its foothold in the region, but having botched the original bailout deal so appallingly, euro-area policy makers may have lost their right to have an opinion on this.
Cyprus’s path forward is highly uncertain, and even though the island is tiny, it stands to set an important precedent in the euro area. This goes not only for how policy makers structure the bailout, but also for how Cyprus responds to it. The government has surprised investors by being the first to stand up to the troika of lenders by rejecting the proposed bailout. I doubt it will be the last.