IS THE CYPRIOT FORMULA THE RIGHT ONE FOR BANKS IN DIFFFICULTY?

I have just spent three days in Cyprus talking to political and economic figures in the island. I encountered a very strong sense of determination to overcome their present severe economic difficulties. 

These difficulties arise from mistakes made in the banking sector, whereby very large overseas deposits (mainly from Russia) were invested by the banks in lending to the Greek private sector and in Greek Government bonds. Banks exposure to Greece totalled 28 billion euro, or 170% of the entire Cypriot GDP. This concentration of risks in one place was bad banking practice, in the same way that excessive concentration of risks in the construction sector, was bad banking practice in Ireland and Spain.

Meanwhile the Cypriot economy also lost competitiveness.

At the end of 2011, the EU/IMF/ECB found that the situation of the public finances of Greece was so severe that senior bondholders(whose position had been famously protected from haircuts by the ECB in the Irish case) would have suffer a 75% haircut. This created an immediately critical situation for the Cypriot banks. They lost 33% of their capital. 

This crisis for the Cypriot banking system was known to the EU/IMF and to the Cypriot Government of the time of the Greek haircut.  Apart from a temporary loan from Russia, nothing was done. The EU/IMF/ECB, who should have confronted the problem immediately, did not do so, and it got worse.

THE MYTH ABOUT RUSSIAN HOT MONEY

Meanwhile a press campaign was mounted to suggest that the Russian depositors in the Cypriot banks were tax evaders, money launderers, oligarchs or worse.

This campaign seemed to be designed to  persuade public opinion that depositors in Cypriot banks were less deserving of protection than depositors in banks in  Athens, London, or Frankfurt. In fact, little evidence has subsequently emerged to justify any of these stories.

And, indeed, there is a perfectly good, and legitimate reason for these Russian deposits in Cypriot banks. 

Many Russian businesses did not trust their OWN legal system, and felt that their assets would be better protected in a country like Cyprus, with a common law legal system, and which was in the euro. But in March of  this year, they were to be brutally disabused of the notion that euro zone banks were a safe haven. 

Eventually the problem was tackled, in March 2013, in an agreement by IMF, the EU, and the ECB with a newly elected Government in Cyprus, who had had little or no time to assess the options for themselves.

TROUBLING ASPECTS OF EU DEAL

The March 2013 agreement contained a number of elements that are troubling.

For the first time this century, depositors have had to take a haircut. The fact that this procedure was followed creates a new and permanent uncertainty for depositors who hold more than 100000 euros on deposit in any bank in the euro zone. They now must, to protect their assets, scrutinise the situation of their bank on an ongoing basis, and move money out of banks that seem to be pursuing risky strategies.  But getting the relevant information will be difficult and time consuming. There will be a tendency to move money towards bigger banks, which will aggravate the “too big to fail” problem.

No haircut was, however, imposed on the depositors in the Greek branches of the Cypriot banks, and those branches were transferred to Greek banks. This inflicted additional losses on Cyprus, and  is hard to justify, within a monetary union that comprises both Greece and Cyprus as equal partners. 

CREDIT FROZEN FOR CYPRIOT BUSINESS

The Cypriot banking model of attracting overseas deposits has been destroyed, although Russians continue to invest and holiday in the island, which disproves the suggestion that they were all fly by night tax evaders and hot money merchants. . It would be interesting to know which country’s banks are now benefitting from these Russian deposits that were formerly in the Cypriot banks.

Meanwhile, viable Cypriot businesses, that were well capitalised and equipped with working capital before March, are  struggling to access funds to keep going. 

Deposits they could have used have been reduced by haircuts, and capital controls mean that what remains in their  accounts cannot be used freely. Bank credit is frozen.

A Cypriot export model, to replace the old bank deposit led model, cannot be put in place without access to day to day funding.

I left Cyprus feeling that, if Cyprus did not constitute a mere 0.2% of the euro zone GDP, and was physically closer to the centre of Europe, it would not have been the subject of these radical experiments in European banking policy.

It would, instead, have been the subject of much timelier, and less harsh, actions by its partners.

Of course, Cyprus must abide by the terms of the March agreement, and, like Ireland, establish a good track record.

But if it does so, it should, like Ireland, see progressive easements in the terms of its bailout, so that its economy can be allowed to breathe again.