In memory of Dr. Andreas Höfert

Cyprus – more than a little stone in the shoe

Still digesting the negative results of the Italian elections, European leaders are facing another risk to the euro: Cyprus. You would think that such a tiny country shouldn’t really matter in the grand scheme of things, let alone reignite the euro crisis. And in fact, money is not an issue, but rules, principles and precedents certainly are. Once again we have a case which shows that the euro crisis is much more about politics than about economics.

Cyprus joined the EU in 2004 and the euro in 2008. With a population of slightly more than 1 million people and a GDP of 17.5 billion euros (0.2% of the overall Eurozone GDP) it is the second-smallest Eurozone member. Until recently it also managed to fly under the radar of market participants with a public debt-to-GDP ratio averaging slightly below 60% between 1995 and 2007 and a public deficit-to-GDP ratio also well within the Maastricht criteria until 2007. The divided island generally only made it into the headlines in connection with its own geopolitical situation.

This all changed with the financial crisis. Cyprus’ debt-to-GDP ratio began to surge in 2008 and is currently estimated at somewhere between 90% and 95%. Even this would not be considered too serious as it roughly corresponds to that of France. Things really started to get bad for Cyprus after the private-sector involvement (PSI) in Greece’s debt haircut in 2012. The three largest Cypriot banks’ aggregate loan exposure to Greece equaled 107% of Cyprus’ GDP, and these banks fully participated in the Greek government debt restructuring, leaving them largely undercapitalized.

Moody’s has estimated that recapitalizing the Cypriot banks would take at least 10 billion euros, bringing the country’s debt-to-GDP ratio to an unsustainable level significantly above 150%. In addition to this 10 billion to recapitalize the banks, Cyprus needs at least another 7 billion to cover debt redemptions within the next two years as well as its current deficit. The country is scheduled to redeem 1.4 billion euros of international bonds on 3 June and 700 million euros of domestic bonds on 4 July. Ten billion euros, or even 17 billion, might not seem like a lot, especially compared to the second Greek rescue package of 130 billion. However, even forgetting the bailout fatigue of Northern Europe, it is still a political headache.

There are basically two ways to deal with the problem. Either ask Cyprus to recapitalize its banks on its own like Ireland did, or ask the Cypriot banks’ creditors and depositors to do their part in the recapitalization. Both solutions bring very high contagion risks.

A “traditional,” i.e. government-funded, recapitalization would most likely result in Cyprus being over-indebted. This would increase investors’ expectations of a Greece-style PSI debt restructuring despite European leaders’ promises that Greece would be the exception. A restructuring like this would open a Pandora’s box, probably leading back to higher interest rates in other peripheral countries and jeopardizing a full return to the bond markets for Ireland and Portugal.

Many media reports have also cast doubts upon the origin of Cypriot banks’ large deposits, implying some money laundering activities for Russian clients, which prompted European politicians to suggest that creditors should take losses and even depositors should help to recapitalize those banks. This would set a major precedent that could lead to immediate deposit flows out of peripheral and into core countries, especially out of those peripheral banks which are still at risk. This could in turn recommence the creeping bank run in the periphery, which European leaders made great efforts to stop last year, ultimately announcing their intention to create a European banking union.

Finally, one could think about postponing the issue, using some European Stability Mechanism funds for the Cypriot government and leaving the banks undercapitalized for the time being. However, this could be seen as an opportunity for the depositors to withdraw their money before it’s too late and thus further exacerbate the financial distress of the Cypriot banks. Moreover, German Chancellor Angela Merkel would surely find Cyprus an annoying stone in her shoe as she walks along the campaign trail. Hence, in my view this situation will have to be solved – and likely in a very complex and opaque way – sooner rather than later, and once again not because of economics but because of politics.