The Side Effects of the Cyprus Cure ET dt.

20-03-13
The proposed package shows how EU measures become the problem rather than the solution
Satyajit Das
It will be ironic if Cyprus, one of the smallest countries in Europe with little over 1 million
people and 0!" of the EU economically, were to prove a key infle#ion point in the crisis
Cyprus needs around 1$%1& billion to recapitali'e its banks (around 10 billion) and for general
government operations including debt servicing ( $%& billion euro)*hile small in nominal terms
and well within EUs resources, the amount is large relative to Cypruss +,- of 1& billion The
package proposed by EU incorporates privati'ation of state assets, increase in corporate ta#es
(from 10" to 1.!") and withholding ta#es on capital income (to .&") and restructuring of
e#isting bank or sovereign debt /ost controversially, ordinary depositors will face a ta# on
Cypriot bank deposits, amounting to a permanent write down in the nominal value of their
deposits The deposit levy will be 0$!" on less than 100,000 (the ceiling for EU account
insurance) and 11" for deposits above that amount In return, depositors will receive shares in
the relevant banks The unprecedented write down of bank deposits, e#pected to raise !& billion,
is motivated by many factors 2ne, the I/3 participation re4uires the debt level to be
sustainable The write%off of depositors reduces debt and also the si'e of the re4uired bailout
package to Cyprus to 10 billion Two, Cypriot banks have limited amounts of subordinated or
senior unsecured debt (that are cleared only after other lenders are repaid)This means a write
down of bondholders would only raise between 1 and . billion, below the re4uired amount
Three, as in the case of the +reek debt restructuring, the European Central 5ank (EC5) and
others are unwilling to take losses on their e#posure
Capital Flight
3our, restructuring Cypruss sovereign debt is risky because many bonds are governed by English
law where the right of the creditors are more protected 6ny attempt to restructure these while
insulating official creditors from losses would invite litigation 3ive, +ermany, 3inland and
7olland are increasingly concerned about losses on bailout loans +erman Chancellor 6ngela
/erkel does not want concern about actual cash losses to +erman ta#payers to affect her
prospects in the 8eptember .019 elections 8i#, +ermany wants to prevent any bailout fund
flowing to :ussian depositors, such as oligarchs or organi'ed criminals who have used Cypriot
banks to launder money The ta# on depositors is a significant e#pansion of the principal of -8I
(private sector involvement), which was applied in the case of +reece and presented by EU as a
one%off measure *hereas in +reece losses were allocated to sovereign as well as ;unior and
subordinated bank bond holders, the Cyprus measures e#tend burden%sharing to ordinary small
depositors *hatever the case for the Cyprus package, it risks grave side effects 2ne, it may
trigger capital flight from banks in +reece, -ortugal, Ireland, Italy and 8pain, based on depositor
concerns about loss of capital in any future debt restructuring If capital flight accelerates, then
the EC5, national central banks and governments will have to intervene
Crisis Will Worsen
Two, the Cyprus bail%in provision will make it difficult for European banks, especially in
vulnerable countries, to raise new deposits or issue bonds Three, the Cyprus arrangements
undermine the credibility of EC5 and EU and measures announced last year to combat the crisis,
which have underpinned the recent relative stability 6fter Cyprus, it will be difficult for
countries like Italy and 8pain to ask for EU and EC5 assistance, if re4uired, knowing that if a
future debt restructuring is necessary then domestic ta#payers face a loss on bank deposits The
EUs much vaunted banking union was rightly critici'ed for failing to provide funds to undertake
any re4uired recapitali'ation of banks and the lack of a consistent deposit protection scheme in
the region Cyprus highlights these shortcomings 3our, the Cyprus package highlights the
increasing reluctance of countries like +ermany and 3inland to support weaker EU members
The ability of the recently elected Cyprus government of -rime /inister <icos 6nastasiades to
pass the necessary enabling legislation is unclear, given a lack of clear parliamentary ma;ority If
Cyprus does not agree, then a default is likely and the economy may collapse very rapidly If it
agrees, the package would stave off immediate collapse but may not address Cypruss problem
6s in +reece and -ortugal, privati'ation proceeds and the revenue from increased ta#es may not
reach targets The imposition of the ta# may not raise sufficient funds 5ut it will encourage
remaining deposits to flee Cyprus 6s with +reece, there is a risk that Cyprus will need
additional assistance, entailing further write%offs in depositor=s fund Irrespective of the fate of
Cyprus, the solution adopted will e#acerbate the European debt crisis Unfortunately, in each
attempt at resolution, as shown by the proposed Cyprus package, the measures have become the
problem rather than the solution
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