8/5/2013: Olli Rehn Departs Reality Once Again

If one needs an example of out-of-touch, reality-denying and self-satisfied EU Commissioner, travel no further than Olli Rehn. Here's the latest instalment from Court's Favourite Entertainer of Things Surreal:
http://europa.eu/rapid/press-release_SPEECH-13-394_en.htm

The speech focuses on what went wrong in Cyprus.

In the speech, Mr Rehn commits gross omissions and conjures gross over-exaggerations.

Nowhere in his speech does Mr Rehn acknowledge that Cypriot banks were made insolvent overnight by the EU (including EU Commission, where Mr Rehn is in charge of Economic and Monetary affairs) mishandling of PSI in Greek government bonds.

Nowhere in his speech does Mr Rehn acknowledge that Cypriot banks were massively over-invested in 'core tier 1 capital' in the form of zero risk-weighted sovereign bonds (Greek bonds) on the basis of direct EU and Basel regulations that treated this junk as risk-free assets. Mr Rehn states that "The banking problems were aggravated by poor practices of risk management. Lacking adequate oversight, the largest Cypriot banks built up excessive risk exposures." But Cypriot banks largest risk mispricing took place on their Greek Government bond holdings and this was (a) blessed by the EU regulators and (b) made more egregious in terms of risks involved by the EU madness of Greek PSI.

Mr Rehn claims that "The problems of Cyprus built up over many years. At their origin was an oversized banking sector that thrived on attracting foreign deposits with very favourable conditions." Nowhere is Mr Rehn making a statement that the size of Cypriot banking sector was never an issue with the EU, neither at the point of Cyprus admission into the euro, nor at the accession to the EU, nor in any prudential reviews of Cypriot financial system. Mr Rehn flat out fails to relate his statement on deposits to the fact that the EU is currently pushing banks to hold higher deposits / loans ratios, not lower, and that higher deposits / loans ratio is normally seen to be a sign of banking system stability. Mr Rehn is also plain wrong on his claims about the nature of deposits in Cyprus. Chart below shows that Cypriot banks' deposits more than doubled in Q1 2008-Q1 2010 on foot of the EU-created mess in Greece and the rest of the periphery.

Source: @Steve_Hanke

And here's proof that Cypriot banks were running a shop with deposits well in excess of loans, implying low degree of risk leveraging, until Mr Rehn and his colleagues waltzed in with their botched 'rescue' efforts:

Source: Washington Post.

Olli Rehn could not be bothered to read IMF assessment of Cypriot economy from November 2011 (Article IV report) - despite him citing EU Commission June 2011 'warnings' - where IMF clearly states that the core problems faced by Cypriot banking system stem from Greece (page 14) and local commercial banks' loans, not depositors or foreign depositors. On deposits, IMF states (page 17 paragraph 21) "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." Thus, IMF directly, explicitly and incontrovertibly contradicts Mr Rehn's statement about foreign deposits having been extended on "very favourable conditions".

IMF further states that when it comes to deposits, significant risk is also poised by "€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 2011were close to €3 billion (nearly 15 percent of the total), although a portion of these returned to the Cypriot parents as NRD." ECB chart below confirms this risk materialising in the wake of Mr Rehn's structured disaster in Greece:

This outflow knocked out billions out of deposits cushion that Cypriot banks needed to reduce their financing needs. And Mr Rhen - the architect in charge of this disaster - has nothing to say about it.

I can go on and on. Virtually every paragraph of Mr Rehn's statement is open to critical examination. 

That is hardly news - Mr Rehn has made so many gaffes and outright bizarre statements in the past (including his assertions at every pre-bailout junction that each peripheral country heading into bailout was fully solvent, fiscally sustainable, etc), he became not just a laughing stock of the markets, but a contrarian indicator for reality. What is of concern is that Mr Rehn is still being given the task of speaking for the Commission on Monetary and Fiscal affairs.

Olli Rehn should read something more cogent than his own speeches on what has happened in Cyprus (e.g. business.financialpost.com/2013/03/28/seeds-of-cyprus-disaster-planted-months-ago-by-eu/ and www.reuters.com/article/2013/04/02/us-eurozone-cyprus-laiki-insight-idUSBRE9310GQ20130402 or http://online.wsj.com/article/SB10001424127887323501004578386762342123182.html) and preferably do so free of charge to European taxpayers, on his own time, while up-skilling for his next job.

30/4/2013: The latest from the island nuked by the Troika 'rescuers'

Cypriot Parliament has narrowly (29:27 votes) approved the EU 'rescue' package agreement that covers EUR 17 billion in funds, according to the majority of the media analysts. Alas, the devil of the package is in the details.

Cyprus is not (repeat - not) getting EUR 17 billion in funds. Instead the package lists the following sources of funding:
- EUR 1.2 billion to be raised via losses on junior bonds in Popular and BoC
- The “bailin” of uninsured depositors (deposits in excess of EUR 100K) and senior bondholders is set to yield €8.3 billion
- EUR 10 billion loan from the euro zone and the IMF of which the IMF will provide EUR 1 billion (http://www.imf.org/external/np/sec/pr/2013/pr13103.htm)
- EUR 1 billion from rolling over domestically-held government bonds, plus EUR 100 million from extending Russian bilateral loan
- EUR 0.4 billion from gold sales by the Cypriot central bank and EUR 0.5 billion from privatizations

Grand total is, therefore, EUR 1.2 + 8.3 + 10 + 1.1 + 0.9 = EUR 21.5 billion.

Per preliminary MOU, Cyprus 'programme' has three core pillars:

"The first pillar aims to restore the health of the financial system and minimize the contingent liabilities from the banks to the state." This includes haircuts on depositors and bondholders in the first stage - as confirmed in the today's approval vote. In later stages, this involves "a substantial reduction in the size of the banking system in relation to the economy as well as in restructuring and recapitalization of one of the banks."

“The second pillar entails an ambitious and well-paced fiscal adjustment that balances short-run cyclical concerns and long-run sustainability objectives, while protecting vulnerable groups. In addition to the fiscal consolidation already underway—estimated at about 5 percent of GDP— an additional 2 percent of GDP in measures will be implemented during the program period, including by raising the corporate income tax rate from 10 to 12 ½ percent and the tax rate on interest income from 15 to 30 percent. An additional 4½ percent of GDP in measures will be needed over the medium term to achieve a 4 percent of GDP primary surplus by 2018, which is required to put debt on a firmly downward path. There will be protection for the most vulnerable groups. The social welfare system will be reviewed to streamline administration costs, minimize the overlap of existing programs, and improve their targeting to ensure that public resources reach those in need."

The third pillar, per usual IMF waffle, involves 'structural reforms'. “To complement the fiscal consolidation efforts, the program will undertake substantial structural reforms aimed to improve the effectiveness of the public sector. The state’s capacity to collect revenues will be strengthened with the implementation of a comprehensive reform agenda to modernize and harmonize procedures, improve internal coordination, and exploit economies of scale. Public financial management reforms will include the implementation of a medium-term budget framework and the adoption of a law on fiscal responsibility. In addition, to enhance the efficiency of the economy and reduce public debt, viable state-owned enterprises will be privatized. Finally, based on an assessment of needs, the program will supplement the recent reform of the pension system with additional measures to ensure its long-run sustainability.

In short, Cyprus gets the usual Troika 'Package +' of big-bang commitments delivery of which will be measured as common not by achieved sustainability or risk metrics, but by passed legislation and enacted legal changes (paper ahead of real impact). And the '+' bit refers to the total wrecking of the Cypriot economy under the reforms of the banking sector and international financial services sector, plus tax hikes which will assure that if there is any oil / gas off-shore, Cypriots will be out with shovels and snorkelling masks to dig every hydrocarbon molecule out to repay these debts.

27/4/2013: Sunday Times : March 31, 2014

The first of three consecutive posts to update on my recent articles in press.

This is an unedited version of my Sunday Times article from March 31, 2013.

What a difference a week, let alone nine months, make. 

Nine months ago, on June 29th, 2012, the eurozone leaders pledged "to break the links between the banks and the sovereign" prompting the Irish Government to call the results of the euro summit 'seismic' and ‘game-changing’. 

Fast-forward nine months. The number of mortgages in arrears in Irish banks rose at an annualised rate of 25%, the amounts of arrears have been growing at 65%. The number of all mortgages either in arrears, or temporarily restructured and not in arrears, or in repossessions is up 23% per annum. 

Deposits held in Irish ‘covered’ banks have fallen 13.9% between June 2012 and January 2013. In three months through January 2013 average levels of Irish residents' private sector deposits was down 2.34% on three months through June 2012, clocking annualised rate of decline of 4%. Over the same period of time, loans to Irish private sector fell 1.54% (annualised drop of 2.7%).

Smoothing out some of the monthly volatility, average ratio of private sector loans to deposits in the repaired Irish banking system rose from 145.8% in April-June 2012 to 147.0% in three months through January 2013.

Put simply, in the nine months since June 29th last year, the urgency of implementing the eurozone leaders' 'seismic' decisions on direct recapitalization of the banks and on examining Irish financial sector programme performance has been rising. 

Yet, this week, in the wake of yet another crisis this time decimating the economy of Cyprus, a number of EU officials have clearly stated that the euro area main mechanism for funding any future bailouts - the European Stability Mechanism fund - will not be used for direct and/or retrospective recapitalization of the banks. The willingness to act is still wanting in Europe.

First, chief of the euro area finance ministers group, Jeroen Djisselbloem, opined  that the ESM should never be used for direct capital supports to failing banks. Mr Djisselbloem went on to add that Cypriot deal, imposing forced bail-in of depositors and bondholders, is the template for future banks restructuring programmes. This pretty much rules out use of ESM to retroactively recapitalize Iriosh banks and take the burden of our past banks’ supports measures off the shoulders of the Irish taxpayers.

On foot of Mr Djisselbloem's comments, the EU Commission stated that it too hopes that direct recapitalisation of the banks via ESM will be avoided. In addition, the EU Internal Markets Commissioner Michel Barnier, while denying Mr Djisselbloem's claim that Cypriot 'deal' will serve as a future template for dealing with the banking crises, said that "Under the current legislation for bank resolution . . . it is not excluded that deposits over €100,000 could be instruments eligible for bail-in". Finnish Prime Minister Jyrki Katainen weighed in with his own assertion that the ESM should not be used to deal with the banking crises, especially in the case of legacy banks debts assumed. Klaus Regling, the head of the ESM, made a realistic assessment of the viability of the June 29, 2012 promises by stating that using ESM to directly recapitlise troubled banks will be politically impossible to achieve.  German officials defined their position in forthcoming talks on ESM future as being consistent with excluding legacy banks debts from ESM scope.

All of this must have been a shocker to the Irish Government that presided over the Cypriot bailout deal structuring which has shut the door on our hopes for Europe to come through on June 2012 commitments. After last weekend, uniqueness of Ireland is surpassed by the uniqueness of Greece where sovereign bonds were thrown into the fire and Cyprus where depositors and bondholders were savaged and not a single cent of Troika money was allocated to support the banks recapitalisations. 

The slavish conformity to the EU diktat that prompted the Irish Government to support disastrous application of the Troika programmes in Greece and Cyprus is now bearing its bitter fruit.

Which means that three years into what is termed by the Troika to be a 'successful adjustment programme', Ireland is now facing an old question: absent legacy banks debts restructuring, can we sustain the current fiscal path to debt stabilisation and avoid sovereign insolvency down the road?

Let’s look at the banking sector side of the problem.

Latest reports from the Irish banks show lower losses for 2012 compared to 2011, prompting many analysts and the Government to issue upbeat statements about the allegedly abating banking crisis. Such claims betray short foresight of our bankers and policymakers. Even according to the Central Bank stress tests from 2011, Irish banks are not expected to face the bulk of mortgages-related losses until 2015-2018. Latest data from CSO clearly shows that residential property prices across the nation were down for three months in a row through February. Prices have now fallen almost 23% since the original PCAR assessments were made. Even at the current levels, prices are still supported to the upside by the banks' inability to foreclose on defaulting mortgagees. Meanwhile, there are EUR45.3 billion worth of mortgages that are either in repossessions, in arrears or restructured and performing for now. Taken together, these facts mean that at current rates of decline in property values from PCAR valuations, we are already at the top of the envelope when it comes to banks ability to cover  potential mortgages losses. Add to this the effect of increasing supply of distressed properties into the market and it is hard to see how current prices can remain flat or rise through 2014-2015. 

All of the above suggests that before the first half of 2014 runs its course we are likely to see renewed concerns about banks capital levels starting to trickle into the media. Thereafter, the natural question will be who can shoulder any additional losses, given the entire Euro area banking system is moving toward higher capital ratios and quality overall. The answer to that is, of course, either the ESM or the Irish State.  The former is being ruled out by the euro area core member states. The latter is already nearly insolvent as is.

The headwinds to Irish debt sustainability argument do not end with the mortgages saga. 

Take a look at the economic growth dynamics. Back at the end of 2010, when Troika structured Irish ‘bailout’, our debt sustainability depended on the 2011-2015 forecast average annual growth at 2.68% for GDP.  By Budget 2013 time, these expectations were scaled back to 1.76%, yet the Troika continued to claim that our Government debt is sustainable. To attain medium-term sustainability, defined as declining debt/GDP ratios, between 2013 and 2017, IMF estimates that to stay the course Ireland will require average nominal GDP growth of 3.9% annually. To satisfy IMF sustainability assumptions, Irish economy will have to grow at 4.5% on average in 2016-2017 to compensate for slower rates of growth forecast in 2013-2015. So far, in 2011-2012 recovery we managed to achieve average growth rate in nominal GDP of just under 2.25%  - not even close to the average rates assumed by the IMF.

And the real challenge will come in 2015-2017 when we are likely to face sharp increases in mortgages-related losses. In other words, growth is expected to skyrocket just as banks and households will engage in massive mortgages defaults management exercise. 

There are additional headwinds in the workings, relating to the shifting composition of our GDP in recent years. Between 2007 and 2012, ratio of services in our total exports rose from 44.8% to 51.2%, while trade balance in services went from EUR2.75bn deficit to EUR3.1bn surplus. Trade in services is both more imports-intensive (with each EUR1 in services imports associated with EUR1.03 of services exports, as opposed to EUR1 in goods imports associated with EUR1.73 in exports) and has lower impact on our real economy. Irish tax system permits more aggressive, near-zero taxation of services trade against higher effective taxation for goods trade. This implies that while services-exporting MNCs book vastly more revenue into Ireland, most of the money flows through our economy without having any tangible relationship to either employment here or value added or any other real economic activity. In recent years, a significant share of our already anemic growth came from activities that are basically-speaking pure accounting trick with no bearing on our economy’s capacity to sustain public debt levels we have. If this trend were to continue into 2017, we can see some 5-7 percent of our GDP shifting to services-related tax arbitrage activities. 

Which, of course, would mean that the ‘sustainability’ levels of nominal growth mentioned above must be much higher in years to come to deliver real effect on our government debt mountain.

Take these headwinds together and there is a reasonable chance that Ireland will find itself at the point of yet another fiscal crisis with reigniting underlying banking and economic crises. Far from certainty, this high-impact possibility warrants some serious consideration in the halls of power. Maybe, continuing to sit on our hands and wait until the euro area acts upon its past promises is not good enough? Is it time we start building a coalition of the states willing to tackle the Northern Core States’ diktat over the ESM and banks rescue policies?

Box-out: 

Following the High Court judgment in the case involving rent review for Bewley’s Café on Dublin’s once swanky now increasingly dilapidated Grafton Street, one of the premier commercial real estate brokerages issued a note to its clients touching upon the expected or potential fallout from the case. The note mentions the stress the case might be causing many landlords sitting on ‘upward only rent review’ contracts and goes on to decry the possibility that with the Court’s decision in some cases rents might now revert to open market valuations. One does not need a better proof than this that Irish domestic sectors are nowhere near regaining any serious competitiveness. Instead of embracing self-correcting supply-demand reflecting market pricing, Irish domestic enterprises still seek protection and circumvention of the market forces to extract rents out of their customers. That’s one hell of a ‘the best small country to do business in’ culture, folks.

27/4/2013: ECR latest league table for ECE

Handy sovereign risk summary via ECR for Eastern and Central Europe. Note changes over time:

Interestingly, Cyprus - default event took place - is still ranked higher than a number of non-default states. Another interesting bit: Latvia, Hungary, Romania are ranked in 4th tier - low quality sovereign risks, all are EU countries, while Croatia is barely above Cyprus and Bulgaria is below - one is accession state another is the member of the EU. For much talk about 'heterogeneity' not being a problem, with differences between the US states evoked often to support this proposition, I doubt there is such a divergence between individual states in any function federal or near-federal structure anywhere... not even in Italy or Spain...

19/4/2013: Mountains to climb, canyons to wade across

Nice visual from Pictet gang, sizing up two banking systems:

That was pre-'rescue' of Cypriot economy from itself by the 'benevolent' Troika Partners...

Recall, the package deal includes scaling back Cypriot banks to ca x3 GDP, or cutting the sector back to just about where it was in mid-2012 for Iceland, given the magnitude of GDP contraction from 2012 levels that this would require. It will be the case of roughly 'Look to your left, look to your right - either both of the bank clerks next to you are gone, or you are gone with one of them in tow'.

Updated:

And another visual from Pictet folks:

16/4/2013: One question, Mr Market, please...

A uncomfortable question:

Faith seems to have no bounds once sentiment shifts. The Market seemed to have maintained confidence in EU's crisis-fighting 'measures' despite the fact that Cyprus case revealed an obvious lack of any real crisis-fighting 'measures' to-date.

The entire periphery-fixing policy tool kit in Europe - now into the sixth year running - still boils down to

1. Rolling out unfulfilled promises (ESM banks-sovereigns break, OMT, a banking union, fiscal policies coordination, fiscal supports for growth - do recall that EU keeps talking about the need to 'support' growth and yet does nothing about providing such supports), 
2. Dogmatic ECB stuck in a rates and money supply policies that neither ease currency and interest rates pressures, nor provide a break from the failed transmission mechanism, and 
3. Internal devaluations of the worst kind (ad hoc loading of debt on economies already carrying too much debt & lack of reforms in the real economy - keep in mind, setting deficit targets ≠ reform). 

So would The Market please run this by me: What HAS changed between Ireland 2008 (the beginning of the euro crisis) and Cyprus 2013 (it's latest iteration) other than the channels by which more debt is being piled onto over-indebted economies hit by crisis?

Well, not much. Yesterday, IMF has issued a statement on Greece (that's right - the second country that was 'repaired' by the EU approach to crisis, ...and then repaired again... and again) claiming that with the fourth round of 'reforms' promised, Greece is now (still?) on a sustainable debt path. Never mind that the 'sustainable debt paths' so far for Greece have meant debt/GDP ratios bounds for sustainability rising from 'under 120%' within Programme 1 to 'under 200%' within Programme 4.

15/4/2013: About that orchestra on Titanic's deck...

In a telling sign of total disconnect with reality, last week we heard two bizarre comments from the European 'leaders' all made in the context of Dublin Ministerial dealing with Cyprus.

First, "Klaus Regling, managing director of the ESM, told reporters that the fund had had its "most successful week". The statement can on foot of ESM selling EUR10bn worth of new debt in heavily oversubscribed markets. Alas, the said claim was made in the week when ESM became the sole vehicle for handling EU side of the Cyprus 'bailout'. In other words, Regling, like rest of EU 'leaders' measures success by how high he can pile on debt (EUR8bn worth of bonds here, EUR2bn worth of notes there), not by real economic outcomes (which can see Cypriot economy shrinking 15% in one year - some 'success').

However, the weekly prize for detachement from reality goes, as it often does, to Olli 'The Delusional' Rehn - the EU Commissioner for Something-to-do with Economy - who was forced to concede that Cypriot bailout can lead to the island economy shrinking up to 15% in 2013. Never, mind, says Rehn, as "I don't deny that there is uncertainty about the precise figure whether it will 10 percent, 12.5 percent or 15 percent."

Indeed, 'never mind'. You'd think he would make it his job knowing. But, of course, why bother, since 10-12.5-15 percent range clearly might reach into 20-22.5-25 percent range as easily and Mr Rehn wouldn't bat an eyelid. Especially since the host nation's Government - aka Ireland's 'best pupils in the EUssroom' - were there to cheer Mr Rehn in exchange for getting a handful of platitudes from important foreigners. Behold Jeroen Dijsselbloem's claim that Ireland is "a living example that adjustment programmes do work". Cyprus, presumably, will be the EU's roadkill of history... joining Greece and Spain, with Italy and Portugal in the waiting wings.

In short, we are now going verifiably gaga this side of the Atlantic, begging for a comparison with the orchestra that played through Titanic's sinking. Alas, the orchestra, as historian tell, was rather competent one - unlike Messrs Rehn, Regling, et al.

31/3/2013: Are European Brahmins Cypriot crisis-free?

In an Orwelian Universe that is the EU, the rules are different for different castes... the Brahmins are, obviously, the top of the pile. Not surprisingly, amidst deposits outflows from Cyprus immediately prior to the EU sanctioned expropriations, there are strands of Cypriot Brahmins rushing out of their banks. Here's the report by Rossija 24 - Russian news agency on the topic:

 via a tweet:

Let's translate verbatim the above:

"Greek press has found compromising material on Cypriot President. According to the Greek media sources, few days before the Eurogroup decision to bail-in deposits, relatives of President Nicos Anastasiades took emergency steps to save their funds. The issue concerns the amount of EUR21 million in funds. A company, which belongs to the relatives of the President, transfered these funds from Laiki bank to London, as reported by the Rossija 24 TV channel. The Laiki Bank is currently undergoing restructuring, and haircuts on clients' funds can reach up to 80 percent."

We should note, of course, that this is just one report, albeit here is a Cypriot press report from just 30 minutes ago covering the same: http://www.incyprus.com.cy/en-gb/Top-Stories-News/4342/33996/money-movements-questioned and Greek reports: http://www.imerisia.gr/article.asp?catid=26517&subid=2&pubid=113018547 and http://www.nooz.gr/economy/suggeneis-anastasiadi-evgalan-kata8eseis-apo-ti-laiki31313 and http://www.zougla.gr/kosmos/article/ligo-prin-to-eurogroup-melos-tis-ikogenias-tou-anstasiadi-figadefse-xrimata .

28/3/2013: Cyprus: too-small-to-fail, too-small-to-bail

This is an unedited version of my article for Sunday Times, March 24.


This week, euro area leaders have added yet another term to the already rich vocabulary engendered by the financial crisis. If only a few days ago the world was divided into too-big-to-fail (e.g. Irish pillar banks and Spain) and too-big-to-bail (e.g. Italy) institutions and economies, today we also have too-small-to-fail and too-small-to-bail economy, Cyprus.

Worth just 0.2% of the euro area GDP, with the insolvent banking sector and the liquidity strained sovereign, Cyprus is a tiny minnow in terms of both the required external assistance and its direct impact on the euro area economy. The country overall GDP amounts to about ½ of the cost of bailing out Anglo Irish Bank, and its banking and fiscal troubles need just EUR15.8 billion of funding to plug the gap left by the EU mishandling of the Greek bailout back in 2011-2012. With the reputational costs to the euro area of letting this nation go into an unassisted default, Cyprus is simply too-small-to-fail.

Despite this, the end game now being played in Nicosia, Moscow, Frankfurt and Berlin shows that Cyprus, perhaps, is also too-small-to-bail. The problem is that granting sufficient funding to Cyprus via Troika loans risks pushing the Cypriot Government debt/GDP ratio to 170% even with the haircut on depositors. Were the EU adhere to the conditions of the bailout that also envision Cypriot banking and financial services sectors shrinking to euro area average in size, the government debt to GDP ratio can reach above 210 percent. Yet, altering the terms of the bailout to provide funds that are not debt-based, such as directly funding the banks writedowns of Greek Government bonds, risks triggering calls for similar actions across the rest of the euro area periphery. Pretty quickly, Cypriot EUR10 billion bill can swell to EUR200-250 billion call on the ECB.

These dilemmas, yet to be fully articulated by the policymakers publicly, are nonetheless informing the mess behind the recent events. In the view of euro area leadership, dealing with Cyprus either requires bankrupting its economy and its people, or risking destroying the monetary system infrastructure that rests on the ECB’s pursuit of singular, deeply flawed, yet legally unalterable mandate. A familiar conundrum that has been played out in Ireland, Greece, Portugal and Spain by the incompetent crisis management from Brussels, Frankfurt and Berlin.

Alas, what is still missing in the Cypriot Dilemma debates is the consideration of the longer-term impact of this latest iteration in the euro area crisis on broader European economy.

In this context, Cyprus is neither too-small-to-bail, nor too-small-to-fail. Instead, it is a systemically important focal point of the euro area financial crisis.

The Cypriot crisis orderly resolution requires funding from some non-debt sources to plug the gap between EUR17 billion in funds needed and EUR10 billion that can be committed in the form of loans. The EU has opted to bridge this gap with a levy on the deposits, thus triggering a wholesale expropriation of private property without any legal basis for doing so.  This expropriation, termed in the language resembling Orwell’s “1984” “an upfront one-off stability levy”, also cuts through the allegedly inviolable State Guarantee on all deposits under EUR100,000.

As the result, since last weekend all European and foreign depositors in the EU banks are no longer treated either pari passu or senior to risk investors, such as bondholders, but subordinated to them. Safety of deposits is no longer assured by the banking system or by the Sovereign guarantees. One of the cornerstones of the yet-to-be-established European Banking Union - the joint system of deposits insurance protection – is no more a credible mechanism of protection of ordinary savers.

In the short run, as highlighted in the media during the week, this means potential for bank runs in Greece (where depositors are already facing substantial potential losses through their savings in Cypriot banks and the state finances are in a much worse state than they are in Cyprus), Spain (with the Government desperate to fund its fiscal adjustments amidst rising tide of discontent with austerity measures) or even Italy (where savings in form of bank deposits are the main pillar of pensions provision for the aging population). In Cyprus itself, the debacle of the European leadership crisis management approach is now leading to the growing risk of the country being forced to exit the euro area.

In my view, these are low probability, but high impact risks that must be considered simply for the devastating effect they would have on the rest of the euro system.

Even if the above short-term nightmare scenarios do not play out, the Cypriot Dilemma is not going away.

Throughout the crisis, the EU has adopted a ‘muddle-through’ approach to dealing with the problems. This has meant that instead of using aggressive monetary policy, as the US and the UK, in addressing the crisis, the EU used debt tools to plug the financing gaps in the banking and fiscal sectors. The result of this was a dramatic uplift in overall debt burdens.  While euro area General Government deficit is expected to reach a relatively benign 2.56% in 2013 with a primary balance (excluding debt financing costs) forecast to post a surplus of 0.25%, close to the pre-crisis 2008 levels, euro area government debt is expected to rise from 70% of GDP in 2008 to 95% this year. Deficits are down, debt is up, public and private investment and deleveraging running at negative or zero rates. These dynamics clearly show the true cost of the EU leadership crisis.

In the long run, Cyprus blunder is going to yield dramatic economic and social costs.

Firstly, any resolution of the Cypriot crisis will involve unsustainable debt for the Government and the wholesale destruction of the Cypriot economy. With EU-demanded scaling back of the banking sector on the island to the ‘euro area average’, Nicosia is facing an outright contraction in the nation GDP of some 15-17% on pre-crisis levels. Second-order effects of this measure and the increase in the island corporation tax rate also demanded by Brussels will take economic losses closer to a quarter of the national income. There are no potential sources for plugging this economic hole. Even the promises of the off-shore gas reserves will not deliver economic recovery to the society with effectively no oil and gas expertise, skills or firms present in the economy.

The EU is de facto sealing the fate of one of its members as the second-class state within the Union just as it did with the rest of the ‘periphery’.

Long-term impact of debt accumulation as the sole mechanism for dealing with the crisis will also hit the entire euro area.  Per IMF relatively benign projections, euro area combined debt to GDP ratio will now exceed or equal 90% bound for at least six years in a row. This means that the euro area is facing a debt overhang crisis of the size where Government debt levels impose a long-term drag on overall economic growth. Any adverse headwinds to economic growth and fiscal performance in years to come will have to be faced without a cushion allowing for fiscal policy accommodation.

Undermining of the sovereign guarantees and depositors’ protection principles in the Cypriot case, even if reversed in the final agreement, will also have a long-term effect on euro area growth potential. With savings no longer secured from expropriation, euro area is facing long-term realignment of the household investment portfolios. This realignment will reduce bank deposits, especially the more stable termed deposits, and lower euro area assets held by the households. The end result will be higher cost of bank credit and equity in Europe, smaller supply of loanable and investable funds and, thus, lower long-term investment activity.

Violation of the property rights and trampling upon the principles of the common market in structuring of the original Cyprus ‘rescue’ plan means that overall risk-return valuations by investors will be re-adjusted to reflect the state of policymaking in Europe that puts bondholders over all other financial system participants, including, now, the depositors.

Currently, euro area economic activity and investment are funded primarily via bank credit, reliant on deposits and bank capital. Shares and equity account for around 14.3% of the total household portoflios in Europe as contrasted by 32.9% in the US. In order to rebalance the euro area investment markets away from reliance on more expensive and risk-prone bank lending, the EU must incentivize equity holdings over debt and shift more of the banks funding activity toward more stable deposits, reducing the amount of leverage allowed within the system.  Cypriot precedent makes structural change away from debt financing much harder to achieve.

Lastly, the Cypriot crisis has contributed to the continued process of deligitimisation of the EU authorities in the eyes of European people who witnessed an entirely new and ever more egregious level of the first-tier Europe (the so-called ‘core’) diktat over the social and economic policies in the peripheral state.

Prior to last week, Cyprus might have been too-small-to-fail or too-small-to-bail from Frankfurt’s or Berlin’s perspective, however the way the EU has dealt with this crisis exposes systemic flaws in the political economy of the euro area that cannot be easily repaired and will end up costing dearly to the entire EU economy.

Box-out: 
The revenue commissioners annual statistics data for 2011 throws some interesting comparisons. Back in 2010, prior to the more recent increases in income-related levies and charges, gross taxable personal income in Ireland amounted to EUR77.7 billion against the taxable corporate income of EUR70.8 billion. The amounts of income and corporate taxes paid on these were, respectively EUR9.82 billion and EUR4.25 billion, yielding effective economy-wide rates of tax of 12.6% for personal income and 6.0% for corporate tax. Thus, excluding USC, PRSI, most of Vat, and a host of other taxes and charges applicable uniquely to households, Irish Government policy is explicitly to tax personal income at an effective rate of more than twice the rate of corporate income. Of course, this disparity in taxation is inversely correlated with the disparity in representation: when was the last time you heard our leaders talk about not increasing tax burden on people as a sacrosanct principle of the state in the same way they talk about protecting our corporation tax regime?

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: The False Vacuum of the EU: a must-read essay

On rare occasions does one come across an essay so brilliantly argued and provocative in its depth. A must-read: Nucleating the False Vacuum of the European Union

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?

8/3/2013: The Cyprus' Russian Bail-in Dilemma

With the new Government in place and with more urgency than ever before, Cyprus is heading for the last ditch effort to secure the bailout from the Troika.  However, all indications are there will be no agreement in March, pushing any potential deal closer to the June 3 when EUR1.415 billion of Government bonds come to maturity. The bonds amount to a massive 9.65% of the country GDP and are unlikely to be rolled over unless at a punitive yields.

Cyprus original request for the bailout dates back to June 2011, looking for up to EUR17bn (ca 100% of GDP) and the current foot-dragging from the EU is a clear signal of Frankfurt's and Brussels' conviction that the acute peripheral crisis is now over and there is little risk of contagion from Nicosia. If the full EUR17bn were granted, the bailout would push Cypriot Government debt to ca 145% of GDP, well ahead of the IMF-set sustainability threshold of 120%.

Furthermore, the EU policymakers clearly perceive Cypriot crisis to be distinct from other peripheral states while Cypriot banking system (the cause of the crisis) to be decoupled from the rest of the euro area. The former smacks of the usual euro area denialism, while the latter is probably closer to truth. Nonetheless, someone has to be concerned with sustainability of any debt in excess of 90-100% of GDP in an economy that is about to take a massive hit at the heart of its growth engine: banking and associated exportable services.

Cypriot banks hold assets valued at 8 times the country GDP (roughly EUR 120 billion worth of assets), with deposits of roughly EUR70 billion recorded prior to the recently started 'quiet' bank runs. Within last week alone Cyprus banks lost just over 2% of their deposits. Around 42-43% of these deposits belong to foreign (primarily British and Russian) residents.

The latter are now at the crosshair in the EU vs Cyprus war for bailing-in the depositors in insolvent Cypriot banks.

In 2012, there were some 60,000 Russian expatriates living in Cyprus, a country with the total population back in 2011 at 1.116 million. Russia was the second largest source of tourists inflows into Cyprus in 2011-2012 and Russia received FDI of USD12.3bn via Cyprus (although probably 99%+ of this was recycling of funds that originally left Russia for Cyprus). In 2011 Russia extended a EUR2.5 billion bilateral loan to Nicosia. Despite common theme in the press about Cypriot banking system being used for Russian tax evasion, Russia and Cyprus have signed and ratified the Protocol to the Double Taxation Treaty.

At the end of 2011, many, but not all and not even majority, of the non-Euro deposits in Cypriot banks originated from Russia - amounting to ca EUR18 billion (more than 100% of the Cypriot GDP), but just 20% of the total deposits in the country. Russians are also major holders of equities in BOC and CPB banks. These Russian deposits have declined since then. More ominously, the accounting of these deposits is somewhat dodgy. There are many conflicting figures out there.

Below is the table - courtesy of the Piraeus Bank - detailing the deposits structure in Cypriot banking system through early 2012:

In contrast, Fitch (via International Herald Tribune) reported slightly different figures that are at odds with both above figures and the Min Fin claims (see below):

According to the Min Fin, as of end of 2012, Cyprus banks deposits remain around EUR70 billion and less than EUR30 billion of these are accounted for by foreign depositors, with Russian deposits standing around EUR15 billion. The problem is that all of the above figures include deposits in Cyprus-regulated pure Russian banks, such as division of VTB, for example, which are not going to be covered by the bailout or the haircuts.

A recent estimate by the Euromoney puts non-domiciled Russian deposits in Cyprus closer to 7-10% of total deposits or EUR5-7 billion.


Confusion aside, it is relatively clear that so-called Russian 'oligarchs' funds, while prominent in the overall deposits volumes, are neither the source of the Cypriot problems, nor a source for the sustainable solution to that problem. Even a 50% bail-in of these would not deliver (given the existent EUR100,000 guarantee on deposits, and the fact that large volumes of the Russian money is most likely held in the names of EU-registered entities) Cypriot system to health or even to contribute more than EUR2-2.5 billion to the EUR17-17.5 billion bailout.

Matters are worse, when it comes to bail-in of Russian depositors, when one considers the existent and growing links between the real economies of the two countries. In 2008, Cypriot economy gained EUR1.9 billion (11% of GDP) from tourism trade surplus. Inflows of Russian visitors to the island were up 55% in 2011 in y/y terms and they now represent the second largest source of tourism revenues after the UK (although Russian tourists account for only around 8-10% of all visitors to the island, as opposed to the UK tourists who accounted for closer to 50%). A loss of Russian tourism in the wake of any bail-in would be pretty hard to offset for Cyprus' economy left without the core pillar of International Financial Services. Country income from accounting and legal services amounted to ca EUR700 million or 4.0-4.1% of GDP in 2008, and much of that came from Russian residents, businesses, investors and depositors.

Russian investments in real estate in Cyprus (excluding Russians resident in Cyprus) amounted to ca 7% of total real estate investment back in 2006, a rate that is 1/10th of the UK residents investments there, but nonetheless - significant support for the economy. And this excludes investments by Russian nationals resident in Cyprus.

Overall, prior to the crisis, Russian business and individual activities in Cyprus contributed closer to EUR600-800 million in annual revenues to the economy, excluding taxes and wages. Applying some multipliers to that suggests overall GDP contribution from Russian-linked activities to Cypriot GDP of some EUR2 billion annually or up to 11.7% of the country GDP.

In other words, bail-in of Russian depositors can gain Cyprus some EUR2-3 billion under very adverse conditions imposed on non-resident depositors and cost Cyprus some EUR0.75-1 billion in annual economic losses. How fast does this math start spelling net loss? And how fast does this math start spelling inability to service 120% or so debt/GDP ratio post bail-in?