Cyprus: The Next Blunder

By Charles Wyplosz, Professor of International Economics, Graduate Institute, Geneva (Via VOX)

The decision to tax all Cypriot bank deposits has attracted massive attention (Spiegel 2013) – and rightly so. It is a huge blunder:

  • In the unlikely event that all goes well, the government will receive a bit of cash – but not enough to cover the loan generously offered by its European partners – and the Cypriot banking system will be history.
  • The alternative is a massive bank crisis in many Eurozone countries – a huge blow to the euro, maybe even a fatal one.

Not an emergency measure

Policymakers have been debating the Cyprus’s bailout for nearly a year; this cannot be classified an “emergency action”. They engaged in a lively debate whether Cyprus is “systemic” or not, the answer to which can only be “it depends”. It depends not on the size of Cypriot banks but on the way the Eurozone acts. They also debated the Russian deposits that apparently represent a sizeable proportion of bank liabilities. The debate turned around the issues of how dirty this money is and how to do the laundry. They also debated on the size of a possible loan to the Cypriot government. The government itself requested something to the tune of 100% of its GDP, why not? After all this amounts to 0.2% of Eurozone GDP.

Eurozone’s help: Suffocating solidarity

From what is known:

  • Cyprus will receive a loan of about half the requested size under the usual austerity conditions.
  • The gross public debt of Cyprus will rise from its current level of some 90% of GDP to about 140%, a level that is unsustainable and will eventually require some deep restructuring.

This debt trajectory is a forecast, of course, but well in line with experience.

The effects of this Eurozone austerity programme are now well known. Cyprus joins a distinguished list of countries that benefit from suffocating Eurozone solidarity (Wyplosz, 2011).

  • The programme will impose tough austerity;
  • Its public-debt-to-GDP ratio will grow because deficits will not go away and because GDP will decline.
  • There will the need for more loans as economic predictions will be found to be “disappointing” over and over again.
  • Unemployment will skyrocket, spreading intense economic and social suffering.

Who knows, populist parties could well be on the rise, adding political drama to economic pain. This technology is now well oiled.

The bank deposit ‘confiscation’

What is new is that bank deposits will be “taxed”. The proper term is “confiscated”. Like everywhere in the EU, bank deposits in Cyprus are guaranteed up to €100,000. Depositors have arranged their wealth accordingly, only to be told that the guarantee has been changed ex post.

Taxing stocks is optimally time-inconsistent (Kydland and Prescott, 1977). It is a great way of raising money but it has deep incentive effects as it destroys property rights. What is at stake is the credibility of the bank deposit guarantee system throughout Europe.

The system was shaken in 2008 but in the opposite direction. Followed by all other countries, Ireland offered a full guarantee in a successful effort to stem an impending bank run. The cost to the government was such that it triggered a run on the public debt that led to the second bailout after the Greek “unique and exceptional” one.

That move has now been recognised as a mistake, which may explain how Cyprus is now being treated.

The Eurozone’s ‘corralito’

Because it is time-inconsistent, the decision to tax deposits has been preceded by a freezing of bank deposits. This is remindful of the Argentinean corralito of 2001, which led to economic dislocation, immense suffering and such anger that two governments fell (Cavallo 2011). Hopefully, the Cypriot corralito will not last too long.

The question is: “how bank depositors will react in Cyprus and elsewhere?” The short answer is that we don’t know but we can build scenarios:

  • The benign scenario is that depositors in Cypriot banks will accept the tax and keep their remaining money where it is. Depositors in other troubled countries will accept that Cyprus is special and remain unmoved.
  • A less benign scenario is that depositors in Cypriot banks come to fear another round of optimal, time-inconsistent levies. This is what theory predicts. After all, if policy makers found it optimal once, why not twice, or more?

Under the less benign scenario:

  • We will have a full-fledged bank run as soon as the corralito is lifted. Since bank assets amount to some 900% of GDP, there is no hope of any bailout by the Cypriot government.
  • Any new European loan would immediately translate into a run on the public debt.

Enter ECB, stage right

At this point in the scenario script, the ECB enters the play. Being the only lender of last resort, the ECB will have to decide what to do.

  • In principle, it could stabilise the situation at little cost as total Cypriot bank assets represent less than 0.2% of Eurozone GDP or 0.5% of the central bank’s own balance sheet.
  • But this would involve the risk that it could suffer losses – especially if the banks are badly resolved, i.e. the bankruptcies are badly handled.

This is not unlikely since the ECB does not control Cypriot bank resolution.

Remember that the current version of the banking union explicitly leaves resolution authority in national hands. In Cyprus, as almost everywhere else, national authorities are deeply conflicted when it comes to their banking systems. Powerful special interest groups become engaged when banks go bust and governments decide who pays the price. Thus, it is a good bet that Cyprus’s bank resolution will be deeply flawed. The risk to the ECB is real.

Proper resolution under European control could have been part of the conditions for the loan just agreed. But this does not seem be the case. The omission most likely reflects a belief by policymakers that the Cyprus crisis has been solved successfully. The problem is that this belief is false: Cyprus’s predicament remains even under the benign scenario.

All the conditions for a total disaster are in place

The really worrisome scenario is that the Cypriot bailout becomes euro-systemic – in which case the collapse of the Cypriot economy will be a sideshow. This will happen when and if depositors in troubled countries, say Italy or Spain, take notice of how fellow depositors were treated in Cyprus.

All the ingredients of a self-fulfilling crisis are now in place:

  • It will be individually rational to withdraw deposits from local banks to avoid the remote probability of a confiscatory tax.
  • As depositors learn what others do and proceed to withdraw funds, a bank run will occur.
  • The banking system will collapse, requiring a Cyprus-style programme that will tax whatever is left in deposits, thus justifying the withdrawals.

This would probably be the end of the euro.

Conclusions

The likelihoods of these three scenarios – benign, less benign, and total disaster – are difficult to assess.

What is clear is that the Cyprus bailout has created a new situation, more perilous than ever before.
Once more a deeply dangerous policy action is decided apparently without any awareness of its unintended consequences.
It is also another violation of sound existing arrangements. We have a no-bail-out clause in the Maastricht Treaty – a clause that was essential to the Eurozone’s stability. Putting it aside in the case of Greece was the heart of the today’s problem – the reason the crisis spread (Wyplosz 2010). This no-bail-out clause has once again been put aside summarily.

We are now witnessing another radical change as a perfectly reasonable deposit guarantee is being undermined. Historians will one day explore the dark political motives behind this move. Meanwhile, we can only hope that the bad equilibrium that has just been created will not be chosen by anguished depositors.

References

Cavallo, Domingo (2011). “Looking at Greece in the Argentinean mirror”, VoxEU, 15 July 2011.

Kydland, F.E. and E.C. Prescott, “Rules Rather than Discretion: The Inconsistency of Optimal Plans”, Journal of Political Economy, 1977, 85(3): 473-491.

Spiegel, Peter (2013). “Cyprus depositors’ fate sealed in Berlin”, FT.com, March 17, 2013 6:23 pm.

Wyplosz, Charles (2010). “And now? A dark scenario”, VoxEU.org, 3 May 2010,

Wyplosz, Charles (2011). “The R word”, VoxEU.org, 29 April 2011.

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Comments

  1. The Troika are certainly brazen; I think we can all agree on that. Living in Spain, this development gives me a very uneasy feeling. We have seen numerous tax increases and reductions in our public safety nets here in the name of austerity and bank bailouts over the past few years. Now, we have the prospect of having a percentage of our deposits seized by the Troika.

    I have a question to all of the readers. If you lived in Spain, what would you do this morning with your checking and savings deposits?

    • Personally I’d get it out straight away and invest in safer, dollar/sterling assets/property/gold etc.

      That’s why I was asking you the question on the previous page. I struggle to believe that depositors in peripheral countries will be unmoved.

      • I agree on your points; thanks for the comment. The problem is that most people can not get their assets out of the country. They only have the option of trying to get their deposits out of the banks. Anybody who does not think some sort of bank run in the periphery countries is a very real possibility given what is happening is making a very dangerous assumption IMHO.

        Does anybody have an opinion on what are the international economic implications of a bank run or perceived bank run in one of the periphery countries. I am not talking about large capital outflows, I am talking about national savers attempting to exchange their inside money for hard cash aka outside money; this is the only option for most Spanish depositors.

        • “The problem is that most people can not get their assets out of the country.”

          Just out of curiosity, how does the Spanish government prevent this?
          (a) can’t you buy a USD/Euro bond ETF/mutual fund?
          (b) can’t you open a bank account in Ireland and transfer the money there?

          • jt26 I think it is more a question of the net worth of most Spanish. Most people have very limited savings and I would guess at least 75% of the country has less than 25,000 euros in total net worth (excluding their homes). Both of the options you list above are practical and/or attainable only for higher net worth individuals..

              • You got it.. Houses are very illiquid, and in Spain today even more so, and most of peoples net worth is locked in real-estate. If you have 75% of the population with 25,000 euros total savings or less (again I think this is a good rough estimate) in a country with 26+% unemployment and a lot of underwater mortgages I think the train of thought is more day to day survival as opposed to ETFs or opening a foreign bank account. This is why I think bank runs (the old fashion kind) are a very real threat here in Spain taking into consideration what has happened in Cypress.

                Finally, as I said in another post. Being a non Spanish citizen it is much easier for me to get money out of the country. I have accounts in the other country where I am a citizen and it is effortless to transfer money out; at least, for the time being.

  2. US stock futures are already coming back. I bet we end tomorrow down marginally. This is a non-event.

    • I guess it is a “non-event” as long as you don´t have a checking our savings deposit in any of the periphery countries. I am not as confident as you are that this will just blow over as non macro-economic event. Time will tell.

      • Do you have US or British bank branches such as Citi, HSBC, Chase? These are international banks.

        • No we don´t. For example, our business uses a Deutsche Bank account here in Spain. However, DB in Spain is just a franchise. They are under Spanish law and incorporated in Spain. They are not directly tied to DB in Germany. The same goes for Citi, Barclays, etc.

    • Capital may flow to the USA and Germany as deposits are withdrawn from weak EU states. This could drive the US stock market higher.

  3. At the end of the day, somebody has to pay, always. And from the POV of the creditor nations taxpayers, better the them again, the depositors in Cyprus. I mean, this banks- and nations-bailoutomania madness must end somewhere and somewhen, no?

  4. Certainly a very interesting quandry. German taxpayers bailing out a state that has been identified as a tax haven & centre for money launderng… this was always going to end well!

  5. I will spend some tears for the oligarchs, the greek and turkish tax evaders and the likes. My apologies for the few cents you loose.

  6. If money is dirty take them to court. Stealing from thieves does not make theft moral

  7. Wow, the range of opinions on the issues are very broad!

    We’re talking about government confiscation too, not taxes.

    • Yes indeed, no question about it; this is absolutely illegal government confiscation. Try to imagine if the Treasury, Fed and FDIC forced Delaware to come up with 5 billion dollars from privately held bank deposits to help bail out the state. I can´t help but think the entire country would be up in arms. (I understand the difference of a common monetary and fiscal union in the U.S. as opposed to Europe, but just to get a gut reaction try and imagine).

      This is the situation we find ourselves here in Europe. I guess it makes it a lot easier to accept when you can pigeon hole the problem as one of money laundering and dirty Russian Oligarchs. But I thought we had rule of law to deal with money laundering, not illegal confiscation of private property. Once again the Troika has moved the goal posts and now seizure of private property is fair game.

      • It’s very disturbing to see so many who see it as fair or “deserved” or believe the spin about it being a tax (per the actual dictionary definition, they’re incorrect).

        It’s not different this time.

        • But isn’t the alternative to ‘tax’ Germans because a Cyprus business failed?
          Who is being rescued here?
          Is it savers and widows?
          Or did the Cyprus banks create deposits by making ill-fated loans?

          • Two of the main issues for me are that it sets a disgusting precedent, and that the bond and stock holders haven’t taken a haircut.

            Another part of the potential precedent is that the 1st 100k was supposed to be insured.

  8. Illuvator, a lot of information there.. :-) I enjoyed the read and your passion. At its essence, I agree with you and your son that this is an attack on property rights.

    I think you will find this interesting as a PPPPS :-).. Spain passed a new law at the end of last year that requires all residents and citizens to report all assets outside of Spain over the value of 50,000 euros. This includes stocks, bonds, real estate, even metals from what I understand. Failure to comply and file your holdings entails incredibly high fines (10,000 euros for each violation of not reporting holdings/ assets of 50,000.)

    They have raised our taxes and cut our social services, in the name of a misguided bank bailout and necessary austerity. And now they want to know every nook and crany where we have whatever is left over. It is infuriating, unfair, and undemocratic. Take this together with what just happened in Cypress and you have an oh oh spaghetii -o moment somewhere on the horizon.

  9. The haircut for depositors is not confiscation of private property.

    The insured depositors have more grounds for complaint, but if the insurer (government of Cyprus) is bankrupt too, they also are just suffering the normal commercial loss.

    The underlying reality is that debts that can’t be repaid won’t be repaid and the Cypriot banks can’t repay in full.

    The banks lost money, (much of it from the haircuts on Greek bonds). Someone has to wear that loss. Normally it is the shareholders.
    The loss more than wipes out the shareholders so the bank is both illiquid and insolvent.

    In most countries the national government steps in and wears the loss, nationalising the bank and eventually recapitalising it.

    In Cyprus because of the scale of international operations (which many say is money laundering) the banks are much bigger than normal compared to the economy and the tax base and government asset base and the government does not have the capacity to fund the losses.

    But still someone has to wear the loss.

    In a non-bank the creditors wear the loss once the shareholders are wiped out. Unsecured creditors lose first, secured creditors position depends on the value of their security.
    Cypriot banks have relatively small amounts of bondholders and some of them are secured ie they hold covered bonds and so might lose nothing.
    So other than the interests of other EMU members the depositors large and small would share the losses pari passu.
    With ordinary depositors that are insured they would be made whole by the government. Governments could do this by taking a covered bond for the amounts lent to the bank to make insured depositors whole, reducing the amount available for the non-insured unsecured creditors. This is traditional where new money is introduced to a company that is insolvent or under administration – new money takes highest priority security if it is not already under the control of secured creditors.

    So the only things that reduce the loss to unsecured creditors is the interest of government or the other EMU members.

    Given there have not been runs in Spain, Portugal and Italy there seems to be little contagion in spite of the insured depositors being proposed to bear some losses by the one off tax mechanism. So why should the unsecured, uninsured creditors not bear the loss?

    Why should the loss be imposed on external parties, particularly when many of them are also under stress? Why should ordinary creditors / voters not learn that they need to elect financially responsible governments?

    Why should the insured depositors not learn that the guarantee of a bankrupt government is not worth anything, so keep your government with margins of safety in solvency?

    Why should large commercial investors not learn that they should ensure they only lend to creditworthy institutions with appropriate long term governance and supervision with a national government with a significant margin of safety in solvency and borrowing capacity?

    The unsecured creditors of the Cypriot banks ought be grateful that the government and the Euro institutions are prepared to absorb much of the loss that they would otherwise suffer.

    The original proposal is not confiscation of private property, it is an orderly work out being negotiated by the large interested parties with the ordinary unsecured creditors getting a benefit from government and Euro institutions based on the fears of the contributors and the fears of the creditors.

    It is very fair for the insured depositors to point out the risk of contagion if insured depositors are let suffer losses and for external contributors to point out the losses the unsecured creditors will suffer if the banks suffer a disorderly insolvency.

    Alternatively the ECB could just “print” to cover all the losses and recapitalise the banks, but who would learn anything from that?