The Cypriots and troika are calling the loss of depositors’ funds a tax, but this term is hiding what has happened in Cyprus. For the first time in the euro crisis, banks have failed and depositors and junior bondholders are taking the hit. Note that senior bondholders, mostly large European institutions, are exempt from these haircuts.
The tax has sparked a bank run in Cyprus, but it will not do the runners much good. The tax has already been frozen in Cypriot bank accounts. This was no accident.
The troika meeting where these issues were decided started one hour after American markets closed for the weekend. In the wee hours of the morning, the troika moved like thieves in the night creating and implementing the bank levy so that the news would be fully digested by the time markets began opening again in Asia on Sunday night.
Despite taking this unprecedented step, the bailout is standard troika issue. Privatizations, austerity and fantastic projections of future economic growth and herculean budgetary discipline form the core of the plan:
- Depositor Levy raises €5.8bn
- €10bn troika loan, equal to over 50% of Cypriot GDP.
- Russia will extend the repayment of the €2.5bn loan for five years to 2021 and lower interest rate from 4.5%.
- Cyprus corporate tax rate raised 25% to 12.5%, which may raise €200mm per year.
- Privatize telecoms, electricity and ports.
- Downsize Cypriot banking sector by more than half.
The IMF has passed on the sustainability of the current bailout. Under the old one being floated in the media for the last two months, depositors would have been made whole, but Cyprus would have taken on €17bn in new debt.
Determined not to allow Cyprus to become another Greece, the IMF insisted on a sustainable plan involving less debt. This meant either more direct aid to replace loans, or finding another €7bn or so for the bailout. With German elections approaching in the fall, direct aid was out of the question and the depositor tax became the answer.
This bailout raises two questions. Will Cyprus’ bank run spread to the periphery? It should, but I believe that it will not. Any depositor in the periphery must understand that if its country requires a bailout, not one euro in either country is safe. However, time has shown that the periphery has a great deal of faith in the current system. There may be some people withdrawing money Monday morning, but the run will quickly dissipate. It will be back to business as usual fairly quickly.
The other question this bailout begs is whether or not Cyprus will have a sustainable debt load of 100% by 2020. I delved into the numbers and can safely predict that it will not. Once again, the troika is making unrealistic projections of GDP growth and budget savings.
Cyprus is in the midst of a Greek and Spanish style austerity depression and showing no signs that it will return to growth. The island’s main industry is banking, and it is supposed to reduce its banking sector from 8 times GDP to 3.5 times GDP by 2018. Cyprus will take a double hit on growth because the banks will be reducing both their employment and the loans originated to the rest of the economy. During this massive deleveraging, the Cypriot economy will be lucky to remain stagnant let alone grow.
Despite this fact, I am using an average 2% annual growth rate for purposes of this analysis. Cypriot GDP is currently €18bn with current government debt at €12.8bn (71.1% of GDP). If the economy grows at an average rate of 2% per year starting today, the country will still have a debt to GDP ratio of 110% in 2020 assuming a balanced budget every year. This means that the Cypriot government will need to run approximate annual budget surpluses of 1.5% a year until 2020 in order to have a debt load of 100% of GDP.
If growth is only 1% per year, then the ratio will be 118% in 2020 assuming a perfectly balanced budget for seven years. Since the crisis began in 2009, show me one afflicted country that has been able to maintain both a balanced budget and a 1% growth rate.There isn’t one, and, more importantly, there will not be one because of the multiplier effect.
Since 100% is the number being bandied about, we know that wildly optimistic forecasts are being used to make it appear that this bailout will lead to sustainability. This number is obviously a placeholder with the Cypriot can being kicked down the road.
This tactic is typical of German crisis fighting. Do as little as possible to maintain the status quo while allowing the problem to continue to fester.