25/3/2013: Cyprus 'deal' - notes from the impact crater

What are the true 'innovations' of the Cypriot 'bailout' deal?

1. At this junction one must face the realisation that European 'leadership' vacuum has reached alarming proportions. Cyprus was pushed to the brink, literally hours away from ELA cut-off, with a deliberate and mechanical precision. This is hardly consistent with any spirit of subsidiarity and/or cooperation that the EU was allegedly built on. In a further affirmation of the mess that is EU policy-making, the markets must now be aware that the EU has no defined approach to dealing with debtors and creditors, nor with issues of assets or liabilities. In other words, five years into the crisis and numerous 'white papers' later, with acronym soup of various 'solutions' and new 'institutions' thicker than pasta fagioli - there is still no clarity, no legal or institutional commitment, no formula, no predictability, but rather politically-motivated swinging from one extreme (no bail-ins in Ireland) to the other (all bailed-in in Cyprus).
2. We now have bailed in uninsured bank deposits within the so-called 'open' economy with 'common currency' and 'common market' based on rules and laws. In other words, unlike in Ireland, Portugal and Greece, the EU has crossed another line.
3. We now have bailed in senior bank bondholders (and the sky did not fall)
4. We now have capital controls within 'common currency' area and within the 'common market' - kind of equivalent to Louisiana declaring its dollars purely domestic to Louisiana. 
5. Bail-ins under the Cypriot deal are non-transparent and not defined, showing that the entire package was put together is a half-brained fashion at the last minute. Surely this, if not the first but very much the most exemplary indicator of the complete mess in policymaking. It further reinforces the view of PSI measures - both in Greece and in Cyprus - as being politically motivated, rather than systemically and legally structured.
6. The fact that the Cypriot banking system will now be completely shut out of the funding markets reinforces my view that unwinding the 'emergency' measures deployed by the ECB during the crisis will be: a) risky, b) costly and c) protracted. As the result, the monetary policy risks missing the window for optimal interest rates reaction and either over-reaching on the inflationary side or over-tightening to the detriment to future growth. either way, peripheral countries will be the likely victims.

Overall, from the EU-wide point of view, Cypriot 'deal':

• Does not reduce the risk of contagion or re-amplification of the crisis in other peripheral states;
• Does not create or even enable a break between sovereign and bank crises; 
• Adds to the overall quantum of policy uncertainty; 
• Raises even more doubts as to the functionality of the cornerstone crisis-related institutions (ESM and OMT); and
• Acts to strengthen the hand of eurosceptic, nationalist and populist political movements and parties in the Euro area 'periphery'.

25/3/2013: Debt, Demand & Deposits: Cyprus 2013

Der Spiegel has a handy graphic detailing the extent and the depth of the Financial Services sector in Cyprus...

[link]

The above lumps together couple of things that should, really, be addressed:

1. Cyprus' financing needs only cover banks recapitalisations to the deposits base as provided by the end-of-January 2013 figures. Since then at least EUR3-5 billion and more likely even more fled the country. And selection bias suggests that larger depositors (potentially with more political connections) were more likely to avail of 'systemic' exemptions to withdrawals in recent days.
2. As termed deposits mature, more will leave, unless the Government imposes involuntary lock-in for depositors with termed contracts.
3. Cyprus' financing needs above do not include non-CB and non-deposit funding for the banks that is going to mature in months to come and has to be replaced by some other source of funds (presumably we can assume that ECB / ELA will step in, but I don't see how that arrangement in the medium term can be pleasing to the ECB).
4. The deposits above do not break out MFI deposits, corporate deposits and personal deposits. It is one thing to bail-in personal accounts and yet altogether another matter to bail-in corporations and other banks (the former are subject to more strict capital controls than the latter two).

These are material risks to the sustainability of the Cypriot 'bailout' programme.

25/3/2013: Bankrupted Cyprus, aka 'The Rescue'

While European 'leaders' celebrate the breakthrough 'bailout' agreement with Cyprus, let's get back to Planet Reality, folks. The 'deal' is based on a EUR10bn loan to the Cypriot Government for which the taxpayers will be on the hook.

EUR10bn = 56.2% of the country 2013 forecast GDP.

And now, let's begin counting the proverbial chickens:

1. IMF forecast for GDP - used above - is based on nominal GDP growth over the fiscal year 2013 of 0.33%. Even by IMF 'rosy' standards this is way off the mark, as other (EU Commission and Cypriot own) forecasts envisioned GDP contracting between 0.5% and 1.3% in 2013.
2. IMF forecast is based on pre-bailout assumptions with the banking sector returns to the economy being at the levels consistent with full functioning of the Cypriot financial services sector.
3. Even outside the above points, IMF forecast through 2017 saw Government debt/GDP ratio in Cyprus rising to 106.11%, prior to the current 'deal' on foot of forecast GDP growth of 2.87% per annum on average between 2013 and 2017.

Now, with the deal:

1. Shrinkage of the financial services sector will be immediate and deep;
2. Deficit financing of any capital investment by the Cypriot Government will cease;
3. New debt is going to be loaded onto the country;
4. Reduced savings and exits by larger depositors will mean reduced revenues for the economy, etc

Much of this was outlined in my previous post on debt sustainability in Cyprus (http://trueeconomics.blogspot.ie/2013/03/2432013-are-cypriot-debt-dynamics-worse.html)

Now, let's do simple exercise. Add EUR10bn to Cypriot debt pile and get scenario of Cyprus (post-crisis with no growth effects).

Then, adjust GDP growth from 2013 through 2017 to yield average rate of economic growth of -0.18% annually (note, this is much more benign than Greek forecasts for the first 5 years of the crisis which are equal to -2.94% annually on average). This yields scenario of Cyprus (post-crisis with growth effects).

The above two scenarios are compared in the chart below against Greek forecasts by the IMF and the pre-'bailout' forecast by the IMF for Cyprus:

This is what the EU leadership is currently celebrating - a wholesale, outright bankrupting of the entire country. Well done, lads!

24/3/2013: Few Cypriot Myths & Few Billions in Losses

Ever wondered why would the IMF (and reportedly the EU Commission) reject the proposed (Plan B) Cypriot Government raid on state pensions funds? Oh... ok... IMF review from November 2011:

Naughty, naughty little Cyprus...

And the very same IMF note also sheds some light on those 'oligarchs' deposits that are so vast, the entire EU is apparently chocking on chicken breasts at Herman von Frompuy's dinners:

"First, non-resident deposits (NRD) in Cypriot banks (excluding deposits raised  abroad by foreign affiliates) are €23 billion (125 percent of GDP), most of which are  short-term at low interest rates [note: ECB official data does not exclude foreign affiliates deposits, which are normally out of touch in levy imposition. Also note: much of bulls**t about Russian oligarchs deposits was about high interest rates allegedly collected by them on Cyprus deposits. Guess that wasn't really the case as chart below confirms: deposit rates decline sharply by nationality grouping for both corporates and individuals... so who was exactly earning 'high returns' on Cypriot deposits? oh, well... Cypriots...].

"These could prove unstable in the event of  further confidence shocks. [In other words, Cyprus requires very stringent capital controls if it is to avoid instantaneous bankruptcy even with ELA continuing]

"This risk is partly mitigated by the 70 percent liquid asset requirement against the €12 billion in NRD in foreign currency), and the 20 percent requirement for the €11 billion in euro-denominated NRD). [Wow, so apparently 'oligarchs' deposits carry massive safety cushions, whilst 'ordinary' depositors are not...]

"Second, €17 billion in deposits collected in the Greek branches of the three largest Cypriot-owned banks could be subject to outflows in response to difficult conditions in Greece. Outflows in the first half of 2011 were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD. [Now, there was more of Greek money than 'oligarchs'?]

Now, couple more revealing charts:

Clearly, structuring PSI the EU authorities & IMF knew the above factoid, right? Just as they knew the following (which clearly highlights the fact that any substantial hit on Cypriot banks would have immediately spelled insolvency of the entire economy):

24/3/2013: Are Cypriot Debt Dynamics Worse than Greek?

A nice chart via Pictet (link) on the size of the banking sector in Cyprus and its dynamics since 2006:

Now, do notice, reducing the above to 300-330% of GDP as required by the Troika in Plan A (and so far not disputed by the Cypriot Government) will imply lowering liabilities by EUR66.6 billion. Overall, banking margins in Cyprus are running at around 1.2% net of funding costs, we can roughly raise that to double to include wages and other costs spillovers, which implies that EUR66.6bn deleveraging of liabilities should take out of the Cypriot GDP somewhere around EUR1.5bn annually or 9% of GDP. Auxilliary services, e.g. legal, accounting and associated expatriate community benefits that arise in relation to international banking services being offered from Cyprus will also have to be scaled back. Assuming that these account for 50% of the margin returns to the economy, overall hit on Cypriot economy from deleveraging can be closer to EUR2.2bn annually or 12.7% of GDP.

Now, consider the loans package of EUR10 billion that Cyprus is set to receive if it manages to close the EUR5.8 billion gap. Absent banking sector deleveraging, this will push Cypriot Government debt/GDP ratio to over 140% of GDP. However, with reduction in GDP, the debt/GDP ratio (assuming to avoid timing considerations assumptions a one-off hit to GDP) will rise to 161%.

Now, recall that IMF and Troika 'sustainability' bound for debt/GDP ratio used to be 120%. We are now clearly beyond that absolutely abstract number even without the banking sector deleveraging. And let's take the path of debt/GDP ratio forecast by the IMF which would have seen - absent the 'rescue' package - debt/GDP ratio in Cyprus rising 106.1% of GDP by 2017. With the 'rescue' package and banking sector deleveraging, this can now be expected to rise to 174% of GDP in 2017 against Greek debt of 153% of GDP.

In short, the EU 'rescue' is going to simply wipe Cyprus off the map in economic terms. All debt 'sustainability' consideration are now out of the window.

Here's the chart:

Of course, the above analysis is crude as it ignores:

1. Potential positive effects of replacement activity and the fabled 'gas revenues' etc - which presumably were already reflected in GDP growth figures in the IMF forecasts
2. Potential negative effects of tourism, real estate sales and other services declines due to the reduced activity in the banking sector, which can raise the above adverse impact of the banking sector deleveraging to 15% of GDP. Corporation tax increases can yield further losses.
3. Timing issues for the deleveraging which is not expected to happen overnight.

Nonetheless, all in, there have to be some severe doubts as to viability of the Cypriot debt path under the Troika Plan A, let alone under the Cypriot Plan B.

22/3/2013: Cypriot Plan B - any better than Plan A?

So the reports are that Cyprus has a Plan B. And the outlines of the Plan - filtering through yesterday - are quite delusional.

The Plan consists of 3 main bits:

1. Split Laiki bank (see below) into a good and a bad bank. The 'bad' bank will take on deposits of over 100K and deposits under 100K (guaranteed by the State) will be shifted into 'good' bank. Other banks will be recapitalised but there are no specific as to how, when or to what levels of capital. This stage of the Plan aims to reduce the recapitalisation costs by about €2.3bn. The problems with this stage are massive, however. First: smaller depositors are more likely to run on the bank as they are less likely to have termed deposits and as their withdrawals (even under capital controls to be imposed - see below) will be less restricted than for larger depositors. In other words, the Plan B is likely to reduce stability of deposits and funding in the resulting 'good' bank. Second: while Cypriot banking system losses are currently crystallised, reducing uncertainty for any recapitalization, there is no guarantee that depositors flight will not undermine their balance sheets beyond capital injections repair. Thirdly: the new 'good' bank will have a balance sheet (again, see table below) saddled with massive exposure to ELA & ECB funding at ca 40% of the total liabilities. If associated assets move along with larger depositors, it is likely that ECB funding ratio to Assets is going to be close to 50%. How on earth can this be called a 'good' bank beats me.

2. Step two in the delirious process of Plan B repairs of the Cypriot banking system will be the creation of a sovereign wealth fund backed by state, church, central bank and pension funds 'assets'. Even 'future gas revenues' are thrown into the pot. Put simply, the fund will be a direct raid on state pension funds, state properties and enterprises and gold reserves. It will also contain a direct link to the collective psychosis induced by the crisis - the pipe dream of Cypriot 'Saudi Arabia of the Mediterranean' Republic. Honestly, folks, this crisis has taught us one thing: the quantity of hope-for oil & gas reserves in the country is directly proportional to the degree of economic / financial / fiscal insolvency of the nation. So, having set up a bogus and bizarre fund (with hodgepodge of assets and a rich dose of 'dreamin in the night' claims to assets) the state will issue 6-year bonds against these 'assets' to raise some €2.5bn. Now, what idiot is going to voluntarily buy into this fund is quite unclear at this stage, but presumably, with bond yields set at crippling levels, the fund will find some ready buyers.

3. Step 3: the remaining shortfall of €1bn is to be covered through a small deposit levy on deposits above 100K.


Laiki bank latest balance sheet summary is provided (via Global Macro Monitor) here:

It is a whooper… with Assets at EUR30.375bn the bank is over 178% of Cypriot GDP. Deposits are at 105% of GDP.

The question is whether this plan, even if acceptable to the EU and ECB, will prevent or even restrict the deposits flight once the Cypriot banking system opens up. The EU Commission is working with Cypriot Government on developing capital controls to stem outflow of funds. But there are serious questions as to whether such capital controls can be imposed in the country that is part of the common market.

Another pesky problem is whether the bonds issued by the fund in Step 2 above will count toward Government debt. Presumably, EU can allow any sort of fudge to be created (e.g. Nama SPV in Ireland) to avoid such recognition. If not, then whole Plan B is a random flop of a dead whale beached on Cypriot shores…

Third pesky issue is what happens if the Fund goes bust. With pension funds committed to it, will the Cypriot state simply default on all of its pensions obligations? deport its pensioners to Northern Cyprus? whack the remaining (I doubt there will be any) Russian 'oligarchs' once again? or invade Switzerland? The Cypriot Government attempted to dress up the Plan B as the means to avoiding hitting small savers and ordinary people with the bank levy. It so far seems like risky leveraging of ordinary retirees and future retirees to plug the very same hole that would have been created in their budgets by the deposits levy.


Meanwhile, here's the question for those reading this blog in Ireland: According to the ESCB Statures Article 14.3, the Governing Council of ECB can make a determination to shut off liquidity assistance to the national banking system only on foot of a 2/3rd majority vote. The ECB Council did announce such a move for Cyprus comes Monday. This implies that at least one peripheral state National Central Bank governor casted the vote against Cyprus. Would that have been our Patrick Honohan, one wonders, given the frequent propensity of Irish officials to kick other peripheral states in order to gain small favours from the EU/ECB?