Destruction of the Economy in Cyprus

One small Cyprus story this morning by Landon Thomas Jr., "Some Savers in Cyprus May Lose 60 Percent," buried on page B7 of the New York Times Busines section belies its importance. Deposits above 100,000 euros at the nation's largest bank, the Bank of Cyprus, will be confiscated to the tune of 60% to 77.5%. According to Thomas,

Over the past week, government officials have been saying that depositor losses would not exceed 40 percent — even though bankers and lawyers involved in the negotiations have been warning for some time that the final figure would need to be higher if the bank was to re emerge as a viable entity. 

Under the terms of the transaction, large depositors would have 77.5 percent of their savings turned into different forms of equity. 37.5 percent would be direct equity, in the bank with the rest coming in the form of securities that may convert into shares at a certain period. The remaining 22.5 percent would be a frozen, non-interest-bearing deposit that they would be able to access in the future. 

As a result of this arrangement, the bank’s largest depositors will initially become its major shareholders. 

If the bank does well, depositors would be able to sell their stock. But even in the best case, in which the bank thrives on the back of a quickly recovering economy — a long shot most economists believe — the loss is likely to exceed 60 percent and could well be much more than that. 

Lawyers and bankers who have analyzed the transaction believe the ultimate loss to the depositor could be anywhere between 60 and 77.5 percent.

To get a sense of the implications of this latest development check out today's must-read post by Yves Smith on naked capitalism, "Destruction of Cyprus Economy Proceeding Ahead of Schedule,"  which concludes as follows:

Now remember, Laiki and Bank of Cyprus were the core of the payments system in Cyprus. And it would be very difficult for a business of meaningful size not to have over €100,000 in deposits. If you freeze a significant majority of the commercial balances, how can you operate? How can these businesses even survive and pay each other? By e-mail, Antonis Polemitis of Ledra Capital teased out the implications:

If the Reuters story is correct, for the purposes of liquidity on Tuesday morning, that is a 100% haircut. 

If that is what they do, I am not sure how Cyprus can engage in economic activity on Tuesday without going to barter or scrips. 

I mean, that basically will mean 100% of the large deposits (all the business accounts) at Laiki and BoC are lost or not available as of next week. The Laiki wipe out may have been survivable. If you wipe (for liquidity purposes at least), both Laiki and BoC, then we are not talking about whether or not GDP drops X%, we are talking about ‘how do you actually engage in commerce?’ 

If they do this, there is little chance it can last more than a month — the economy will simply fail at even basic functions…

And if the plan has been accurately reported and plays out as Polemitis fears, it will undermine the “Cyprus is a special case” narrative. This Eurozone fiasco is making Geithner look good. The former Treasury secretary used the need to keep the confidence fairy alive as the excuse for any and every sop to the banks, from coddling miscreant executives to foaming the runway with mortgage borrowers to stealth bailouts. But the Eurocrats have completely ignored the impact of undermining confidence in the banking system. The fact that Cyprus has a decent-sized population of English retirees means that the British media will report on the Cyprus meltdown, which will be a stark contrast with Greece, where the economic devastation has not gotten the coverage it warrants. Grim accounts of the destruction wrought by the tender ministrations of the Troika should strengthen the position of the growing Euroskeptic sentiment in Italy, borne out by the success of Berlusconi and Grillo in the recent elections. Playing into the hands of Italian refuseniks should be the last thing Brussels and Berlin want. The cost of getting tough with Cyprus is likely to be far greater than they anticipate.

It's hard to find fault with this analysis, unless some sort of exception is made for business accounts, which is probably illegal (but capital controls in the eurozone were supposed to be illegal too). Bersani can't form a government in Italy. The next month should be a momentous one for Europe. Get those sell orders in.

Cyprus Temporary Capital Controls Likely To Last a Long Time

Cyprus' capital controls, only to last for one week, will now be in effect for at least a month. This from a story today by Andrew Higgins and Liz Alderman, "Long Lines as Banks Reopen in Cyprus After Freeze":

Not since the introduction of the euro in January 1999 has a European country blocked bank depositors from having full access to their own cash. Under European Union treaties, such restrictions are normally forbidden. But the European Commission, the union’s administrative arm, issued a statement Thursday morning that the Cyprus controls were legal — though urging that they be rescinded as soon as possible. Originally, the controls were to be in place for one week. But on Thursday, the Cypriot foreign minister, Ioannis Kasoulides, said that restrictions on financial transactions would not be lifted for a month.

A naked capitalism cross post from VoxEU today by Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics, argues that the example of Iceland proves that temporary capital controls should, for all intents, be considered permanent:

Another European country was forced to implement `temporary’ capital controls in its crisis – Iceland, as discussed here on Vox (Danielsson and Arnason 2011). 

The Icelandic government, its central bank and the IMF considered the controls necessary because so many foreigners, and the occasional wealthy Icelander, had lost faith in the economy and only wanted to take their money out. While such individuals were considered misguided, their exit would have had disastrous consequences. Hence it was thought necessary to `temporarily’ prevent capital outflows. 

The authorities said at the time the controls would be temporary and limited in scope – lasting a few weeks or, at worst, a month or two. Half a decade later, the capital controls are still in place and getting more and more restrictive. 

This was the second time Iceland had implemented `temporary’ capital controls. The first time it did so, in the 1930s, led to the controls being in place until 1993. This is in line with the historical evidence; once capital controls are imposed, they are really hard to abolish, and a temporary arrangement usually ends up being permanent.

Reporting from Nicosia, Landon Thomas Jr. says the prevailing wisdom appears to be holding. Cyprus is a one-off and will not spread:

“People have lost all their money,” screamed a young financier Wednesday night, as he knocked back drink after drink at a local nightclub — which, despite the earsplitting din of Greek rap music, was half empty. “To me, that feels like war.” 

But on a global scale, investors have refused to panic, other than unloading the risky bonds of second-tier banks in Spain and Italy. 

And while the bond yields of Italian government debt have spiked in recent days, a signal of investor wariness, and the euro has traded down against the dollar, the view, for now, is that even though Europe’s handling of the crisis has been a mess, broader contagion has largely been avoided. 

“This does not worry us at all — Cyprus is just not systemic,” said a senior executive at a large sovereign wealth fund based in the Middle East, who was not authorized to speak publicly. 

Even Cypriot government bonds that are due to reach maturity this June are holding up fairly well, trading at 88 cents, not far from their recent high of 94 cents earlier this week, though a 12 percent discount from their face value.

But Floyd Norris in a High & Low Finance column that appears side by side with Thomas' piece sees signs of a spreading instability:

The fact the hot money stayed even after it became clear the Cypriot banks were in trouble — in large part because of all the Greek bonds they owned — is a testament to the false security the euro provided even after the Greek crisis erupted. That security has faded, at least a little. The cost of credit-default swaps on European banks has been rising since Cyprus got into trouble, suggesting the market thinks bank defaults have grown more likely. That cost continued to rise after the latest plan was announced. It does not help that European leaders seem unable to decide whether the Cypriot deal would set a precedent if banks in other countries get into trouble. It does, whatever they say, or at least it could. 

A few months ago, Europe was supposed to be on the way to a banking union, an arrangement that it was hoped would prevent what has now happened in Cyprus. What happens to those plans will be an indication of whether Europe can continue to hold the euro zone together. 

It may help that Cyprus is so insignificant. Its economy is about one-tenth the size of Ireland’s, which itself is among the smaller economies in the euro zone. It is even smaller than Vermont’s, which is smaller than that of any other state. We can only shudder at what might happen if banks in a big euro zone country got into a lot of trouble.

The next small eurozone country headed to the troika for a bailout, according to naked capitalism's Yves Smith, is Slovenia.

Capital Controls in Cyprus, Bank Lines Not as Long as Expected

Banks opened today in Cyprus. There were lines but not as long as some anticipated. The S&P 500 established a new record, 1569.19, breaking the old one set in October of 2007. I'd say it's time to start selling.

The capital controls in Cyprus include the following: funds cannot be electronically transferred to another country; a maximum of 3,000 euros in cash can be taken out of the country; allowable ATM withdrawals have been increased to 300 euros a day from 100 euros; credit and debit card charges are limited to 5,000 euros a person a month; banks will accept payroll checks as deposits but will not cash them. This info can all be found in Liz Alderman's story, "Cyprus Sets Up Tight Controls as Banks Prepare to Reopen," from this morning.

Imagine the same restrictions in the United States. There would be an armed insurrection.

The EU is coming under fire. As Alderman says,

Under European Union treaties, restricting the free movement of capital is forbidden. Critics say that what is happening in Cyprus shows that union rules will be flouted when the International Monetary Fund, the European Central Bank and European Union leaders find it convenient to do so.

By imposing capital controls, European and Cypriot officials have effectively created two classes of euro: cash that can be freely spent, and cash that is locked up by capital controls, effectively diminishing its value.

“It has to be acknowledged that this is something entirely new,” said Nicolas Véron, a senior fellow at Bruegel, a research group in Brussels, and a visiting fellow at the Peterson Institute for International Economics in Washington. “This will shape expectations in other countries, and the issue is whether capital controls can be avoided in future episodes.”

Borrowing rates for Italy and Spain increased yesterday.

Cyprus: "The Money is Going to Stay There for a Very Long Time"

Banks are scheduled to open tomorrow in Cyprus and rules outlining how people can access their money are still being promulgated. This is from today's story, "In Cyprus, Big Losses Expected on Deposits," by Landon Thomas Jr.:

The government is also struggling to come up with some form of capital controls in a bid to prevent too much money from draining from the banks and leaving the country. Given that more than 30 percent of the Bank of Cyprus’s 14 billion euros in long-term deposits belongs to foreigners — mostly Russians and Greeks — who would not hesitate to take their money out of the country, the restrictions on those funds are likely to be onerous, bankers say. 

“That money is going to stay there for a very long time,” said one person who has been involved in the discussions, but who requested anonymity because he was not authorized to speak publicly.

Beyond the challenge of dealing with the large depositors is the question of what to do with about 27 billion euros in deposits in accounts under 100,000 euros that now carry the Cypriot government’s full backing, following last weekend’s reversal of the decision to tax those deposits, too. That figure alone exceeds Cyprus’s annual gross domestic product of 18 billion euros. 

If the banks reopen on Thursday, as planned, Cyprus’s shellshocked citizens will have access to their insured deposits for the first time in more than a week. With their bills and fears mounting, it is widely expected that many will immediately seek to remove these funds from the banks. 

For now, officials say, it is likely that uninsured depositors will face stiff restrictions when it comes to withdrawing money from an automated teller machine or sending money abroad. But if a depositor at Bank of Cyprus wanted to transfer funds to, say, Hellenic Bank, a smaller institution that is in better shape, the controls would be less severe because that money would remain within the Cypriot banking system. Such arcane mechanisms are now being thrashed out in Brussels and Frankfurt.

With more time to consider the bailout an assessment has gone from bad to worse. The low end of the haircut, 30%, for uninsured depositors at the Bank of Cyprus has given way to the high end, 40%, because the bailout estimate of a 3% contraction of Cyprus' economy is being reassessed as too modest; now, according to Thomas' story, economists are predicting a shrinkage of 5%-10% within a year.

Andrew Higgins and Liz Alderman have a good "how we got here" story today, "Europeans Planted Seeds of Crisis in Cyprus." The Eurogroup's decision in October 2011 to make private-sector investors take a 50% write-down on Greek government bonds doomed Laiki Bank. Higgins and Alderman conclude their story with seven paragraphs that pretty much sum up the whole story heretofore. And the gist of it is that the eurozone is finished:

After the Greek write-down, Cyprus compounded its problems by dithering on whether to seek a bailout from the European Union. At first, it appealed to Russia, which provided a 2.5 billion-euro loan in December 2011. But this money quickly ran out, and when Cyprus did finally go cap-in-hand to its European partners for a lifeline, it received a rude shock: Germany, already gearing up for an election this year, wanted not just budget cuts and other conventional austerity measures but a complete overhaul of Cyprus’s economic model, built around financial services for foreigners seeking ways to dodge taxes and, Berlin suspected, launder dirty money. 

“They did not want the Cypriot model to exist as it did — they wanted Cyprus to stop being a financial center,” said Pambos Papageorgiou, a former central bank board member who is now a member of parliament and on its finance committee. “It was very brutal, like warfare.” 

Mr. Papageorgiou complained that the European Union had shown “the opposite of solidarity” in its dealings with one of its weakest and most vulnerable members. 

In the three years since Europe’s rolling debt crisis first exploded in Greece, governments and citizens in the hardest-hit nations have fumed that decisions made in Brussels pay little heed to their interests and are dictated instead by the economic concerns and election cycles of Germany. Whether in Athens, Dublin, Rome, Madrid or Nicosia, people increasingly ask whether the European Union serves their own aspirations or those of remote institutions dominated by others, particularly Germans. 

Such questions have grown to a furious pitch in Cyprus, where terms set early Monday for a 10 billion-euro bailout will deepen an already painful recession and send unemployment — now at 15 percent — soaring. They require the dismantling of Laiki Bank, with the loss of around 2,500 jobs, and a significant reduction in the country’s role as an offshore financial center. 

“We are looking at a very grim future for Cyprus,” said Michael Olympios, chairman of the Cyprus Investor Association, a lobbying group. “Even firm believers in European project like myself see now that it was a bad idea and that we should have at least stayed out of the euro.” 

As jobs disappear and the economy contracts, Mr. Olympios said, faith in Europe will wither. “I used to be a believer. Not anymore.”

The eurozone will continue on for some time of course. But this is the beginning of the end. Bigger is not always better. The idea has finally sunk in.

Dijsselbloem's Deal with Anastasiades

A deal is reported to have been struck between the Eurogroup, led by Jeroen Dijsselbloem of the Netherlands, and Cyprus President Nicos Anastasiades. Here's how it breaks down, according to a cross post by Cyprus.com this morning on naked capitalism:

1. Laiki is resolved via good bank / bad bank, with uninsured depositors (4.2B) most likely losing everything (along with shareholders and bond holders). 
2. Bank of Cyprus will have a bail-in of uninsured depositors, with them losing between 30-40% most likely. Shareholders and bond holders will be wiped out. 
3. Troika will lend 10B to the Cyprus government, solely for fiscal purposes and based on a memorandum to be determined. None of the troika funds will be used for the bank bailout.
4. Insured depositors will be protected (sub 100K euros). 
5. The 9B of ELA [Emergency Liquidity Assistance] at Laiki will be transferred to Bank of Cyprus. This is the single most bizarre and unfair part of the agreement. It has not been discussed why the Bank of Cyprus creditors should be paying for the ELA of Laiki and no reporter pressed with a follow-up question. 
6. Note that for the most part the bailout is NOT hitting the Russian depositors that hard but will hit local Cyprus depositors hard. Russian depositors were not largely at Bank of Cyprus.

Gone is the specific demand that Cyprus raise 5.8 billion euros since none of the 10 billion euros the Troika is lending is going to a bank bailout. There is some question whether the deal needs to be approved by Cyprus' Parliament. Dijsselbloem is quoted in today's New York Times saying that it can implemented immediately. But naked capitalism raises the possibility that this is not the case:

I have been operating on the assumption ... that the deal negotiated in the early AM in Brussels was set because it relied on the bailout provisions already passed by the Cypriot parliament and did not require additional approvals. And of course, one of the biggest tricks in deal land is to act like something is done even if the remaining “technical” details aren’t technical but are actually substantive and could be used to stymie consummation of the transaction. 

However, Richard Smith has found a tweet that suggests otherwise:

If this source is right, it’s still possible for the Parliament to reject the deal. Consistent with that being possible, I noticed how the recent rounds of messaging about the pact considerably downplayed how bad the hits to Cypriot borrower would be (as in it seemed to be more in sales mode than I would have expected). The early estimates (not official, just based on a look at the balance sheet and knowledge of what was on it) was that the Laiki depositors >€100,000 would be very lucky to get anything back, and the Bank of Cyprus losses for the over €100,000 depositors had been 22% to 25%, and that may not include the ELA transfer, which would presumably increase the losses considerably. 

Admittedly, at this point, the inertial course would be to approve the agreement. However, the influential Archbishop of Cyprus advocated leaving the Eurozone over the weekend. That plus a show of outrage from the population could undo what seems to be a settled deal. And that would have more immediate, unexpected ramifications.

Krugman in his column this morning welcomes the imposition of capital controls in Cyprus and provides a little historical perspective:

I am, of course, not the first person to notice the correlation between the freeing up of global capital and the proliferation of financial crises; Harvard’s Dani Rodrik began banging this drum back in the 1990s. Until recently, however, it was possible to argue that the crisis problem was restricted to poorer nations, that wealthy economies were somehow immune to being whipsawed by love-’em-and-leave-’em global investors. That was a comforting thought — but Europe’s travails demonstrate that it was wishful thinking. 

And it’s not just Europe. In the last decade America, too, experienced a huge housing bubble fed by foreign money, followed by a nasty hangover after the bubble burst. The damage was mitigated by the fact that we borrowed in our own currency, but it’s still our worst crisis since the 1930s. 

Now what? I don’t expect to see a wholesale, sudden rejection of the idea that money should be free to go wherever it wants, whenever it wants. There may well, however, be a process of erosion, as governments intervene to limit both the pace at which money comes in and the rate at which it goes out. Global capitalism is, arguably, on track to become substantially less global. 

And that’s O.K. Right now, the bad old days when it wasn’t that easy to move lots of money across borders are looking pretty good.

Predictions are that Cyprus' economy, 45% of which is in financial services, will shrink 20% to 30% in the next two years.

Damage to Cyprus Already Done

Once again the news coming out of Cyprus is not encouraging. Yesterday Cyprus' Parliament came up with a new bailout plan to present to the troika Sunday evening, though it still has to vote on one proposal to confiscate a quarter of all bank deposits above the insured amount of 100,000 euros for Laiki Bank account holders. Parts of the plan that passed, as Liz Alderman and James Kanter report today, include capital controls to prevent withdrawals and account closings as well as the shutting down of Laiki, creating a bad bank for the non-performing accounts and rolling its good accounts into the Bank of Cyprus. Parliament also voted to confiscate the pension funds of state-run companies.

I've seen reports that this might not satisfy the troika. The troika wants the legislation to apply to all Cypriot banks not just Laiki. Cypriot president Anastasiasdes jets to Brussels tomorrow to take his lumps.

The message from all of this -- banks have been closed for over a week now in Cyprus -- is that the damage has already been done. Even if the new bailout plan is accepted by the ECB, the IMF and the European Commission, Cyprus' days as a financial hub are over and capital flight from eurozone countries with vulnerable banks like Spain will likely commence posthaste. As naked capitalism opines in "Cyprus Capitulates to Eurozone (Updated)":

The imposition of capital controls has the potential to alarm depositors in periphery countries even more than deposit seizure. While the Eurocrats can try claiming that the deposit grab is a one-off, the result of Cyprus having a huge financial sector that was heavily deposit funded, it was already troubling that they didn’t go after equity or bondholders. But the imposition of capital controls effectively creates another currency without the benefit of allowing the currency to revalue.

As we’ve indicated, the big risk coming out of the cramdown of Cyprus is a resumption of the flow of deposits out of periphery countries, which had been underway last year but was arrested by the introduction of the OMT. You’d be nuts to keep your money in a Spanish bank after the brutal treatment of Cypriot depositors. Expect Swiss, German, American, and, as Dizard put it, “banco de Mattress” to be the beneficiaries.

So far U.S. markets have dismissed Cyprus as inconsequential. Let's see what the prevailing wisdom is next week. The 17-nation eurozone appears about to shrink.