It will get much worse before it gets better

Cyprus risks living through years of economic malaise as it copes with the consequences of downsizing its banking sector and last week’s political maneuvers. Although the bailout deal with the European Union attempts to tackle bank issues in a better way, the shattering of the island’s economic model will come at a cost which may dwarf the plunge in Greece’s gross domestic product so far. This is not good news for Greece even though the deal may help silence some voices seeking to imitate the example of the Cypriot Parliament’s rejection of the initial EU plan a week or so ago.

There is no doubt the broad outline of the Cyprus bailout signals a departure from previous rescue plans. This is because the resolution and recapitalization costs of the banks will not be borne by taxpayers but their shareholders, junior and senior bondholders and uninsured depositors. This is clearly an attempt to disentangle the banking crisis from its sovereign debt counterpart. Another way would have been to recapitalize the Cypriot banks directly using the European Stability Mechanism (ESM) but this runs against the will of Northern Europe not to throw money into the island’s banking system.

In previous bailouts, the recapitalization was financed by loans taken by the state to be repaid by future taxes and expected privatization proceeds. In Greece, the costs were assumed by taxpayers via the loan from the European Financial Stability Facility and the ESM. The total resolution and recapitalization costs are estimated at 50 billion euros, meaning taxpayers will have to pay more than 1 billion euros annually for interest expenses alone. Many think this type of bailout agreement is not good because it ties banks and the state together.

On the other hand, some argue taxing even uninsured deposits – an important component of the resolution plan for Cypriot banks – is not a good idea. The latter argue this tax or levy on uninsured depositors above 100,000 euros may be successful in raising a good deal of money but ignores property rights. According to them, this levy, in fact a deposit-for equity-swap, will eventually hurt the credibility of the EU’s bank deposit guarantee system. It should be noted the approach chosen in Cyprus is quite the opposite of what happened in Ireland a few years back when the state extended a full deposit guarantee in a successful bid to stop a bank run.

Nevertheless, the impact of overhauling the banking sector on the economy will be severe. The financial sector and related services account for more than 40 percent of the island’s output. The sector could shrink by more than half after the agreement with the EU, last week’s developments, which hurt the island’s status as an offshore financial center, and the draconian capital controls put in place to deal with deposit outflows. Readers are reminded that the island’s second largest-bank, Laiki (as Cyprus Popular Bank is known), is to be split into a good and a bad bank, with the Bank of Cyprus, the country’s largest, merging with the good bank. Uninsured deposits may suffer considerable losses depending on the recapitalization needs of the Bank of Cyprus and the recovery of assets placed with the bad bank.

So, even if one assumes the negative effect will be limited to the financial services – an overly optimistic assumption – it should be large enough to deal a blow to the Cypriot economy. Unless another sector fills the gap or/and development aid is provided, the economy could shrink by 20 percent, as in Greece, or more, albeit in a shorter period of time. The steep recession will further boost nonperforming loans, testing the banks’ capital adequacy ratio. Moreover, given the state’s considerable revenues collected from international financial services, the budget gap should widen fast, perhaps prompting the troika to demand more austerity measures to contain it. The expected large drop in economic activity should also drive the public debt-to-GDP ratio much higher than the 140 percent projected following the 10-billion-euro loan agreed with the EU. This ratio will likely be deemed unsustainable and require some form of public debt restructuring.

This is a huge price to pay for failing to recognize and deal early on with the oversized banking sector and be more prudent in government spending. Remember that Cyprus had been in talks with the EU since last summer for a bailout package while the island lost access to international markets almost two years ago. The economic situation clearly worsened last week after the Parliament rejected the EU plan, prompting the European Central Bank to threaten to cut off liquidity to local banks unless there was a bailout deal. According to many analysts and bankers, Cyprus would have been better off if it had signed the earlier EU proposal modified somehow to protect insured depositors. It could still have lost tens of billions of euro in deposit outflows but a lot of non-EU money would have stayed for various reasons. By closing the banks and initiating capital controls, Cyprus signed its own death warrant as an offshore financial center.

Undoubtedly, the dire economic situation in Cyprus is not good news for the Greek economy. Tens of thousands of Greeks work in Cyprus, there are strong trade ties, while some market participants think events such as the deposit levy and the capital controls may discourage people and companies from bringing their money back to Greece from the island and elsewhere, freezing or slowing down the return of deposits seen since last summer.

On the other hand, developments in Cyprus may discredit some voices that have been demanding Greece rejects the bailout agreement, encouraged by the Cypriot Parliament’s rejection of the initial EU proposal for a tax deposit. All in all, Greece stands to lose more from Cyprus’s drama.

Subscribe to our Newsletters

Enter your information below to receive our weekly newsletters with the latest insights, opinion pieces and current events straight to your inbox.

By signing up you are agreeing to our Terms of Service and Privacy Policy.