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Get real

22 March 2013 By Hugo Dixon

Cyprus will pay dearly for its sins. The Mediterranean island has committed many follies over the years – and is still making mistakes.

The Cypriots seem congenitally inclined to overestimate their negotiating position. In recent years, their first big folly was to reject in 2004 the United Nations plan for uniting their island. That irritated their European Union partners, meant that Cyprus still has a weak strategic position vis-à-vis Turkey and leaves a jagged scar across the island.

The last Communist government was also criminal in its failure to act as the crisis in Greece threatened to swamp Cyprus. If it had been willing to restructure the banks, the Cypriot economy would now be in a lot better shape. It was also much easier to do a deal with Germany then than now, when Angela Merkel is only months away from an election.

The new centre-right president, Nicos Anastasiades, has been in office for less than a month. But he has managed to turn a crisis into a disaster by initially backing a plan to impose a 6.75 percent tax on insured depositors.

Of course, the other euro zone governments, the European Central Bank and the International Monetary Fund shouldn’t have said OK to this terrible idea either. And Anastasiades certainly had a gun to his head: he had to rustle up money somehow given that the euro zone was rightly unwilling to lend Cyprus more than 10 billion euros, leaving the country with a 5.8 billion euro funding gap.

But the Cypriot president is ultimately responsible for his actions. There was an alternative: tax the uninsured depositors at 15.5 percent and leave the insured ones untouched. Anastasiades didn’t want to do this as it would have angered Russia and undermined Cyprus as an offshore financial centre. But both of these have happened anyway.

When Anastasiades found he couldn’t sell the deposit grab to his people, he backtracked. There was jubilation in the streets. How quickly the mood has changed now that queues have started forming outside cash machines.

The Cypriot government then asked Russia for help. But again Nicosia overestimated its negotiating position. Moscow wasn’t interested in buying a bankrupt bank or lending more money. Michael Sarris, Cyprus’ finance minister, was sent home empty handed.

Meanwhile, the ECB has threatened to pull the plug on insolvent Cypriot banks unless there is a deal with the euro zone by Monday night. The government has therefore scrabbled together a “plan” with three elements: “resolving” Cyprus Popular Bank, the country’s second-largest and most troubled lender; imposing capital controls; and creating a national “solidarity fund”.

The best of these ideas, apparently originally proposed by the IMF, is to resolve CPB. It would be divided into a good bank and a bad one. The insured depositors would go with the good assets; the uninsured with the rotten ones. They might suffer 40 percent losses. That’s a lot more than the original deposit tax but the losses would be focused on one bank. The government’s bill for shoring up banks would be cut by 2.3 billion euros.

Imposing capital controls may be necessary. But it is hardly a cause for joy. Even if the banks re-open on Tuesday, there could be so many restrictions on taking out money that it will look like they are still partially shut.

The solidarity fund is a half-good idea. The plan is to pop pension fund assets, offshore gas reserves, the Cyprus church’s wealth and some state property into a fund. The hope seems to be to raise enough cash to fill the rest of the 5.8 billion euro hole. Even if it worked, it would amount to a fire sale of the county’s assets.

But this scheme has already run into a roadblock. Merkel says she will not be party to a scheme to grab pension assets.

Cyprus’ problems are far worse than finding a billion or two to make up the gap from pension assets. Last week, it had a chance of salvaging most of its financial centre. Now that will be largely destroyed. Last week it was staring at a middling recession. Now, with confidence crushed, its economy faces a slump.

All the number-crunching behind last week’s deal with the troika is therefore out of date. The country will need more than 17 billion euros because the fiscal deficit will rise and an avalanche of bad debts will push up the cost of shoring up the banks. Meanwhile, Nicosia won’t be able to sustain even 10 billion euros of extra debt because its economy will be smaller than envisaged.

Euro zone finance ministers indicated last night that they were willing to go along with a deal based on the old numbers. But even then Cyprus would be stuck with a zombie economy and zombie banks. It’s also unclear whether the IMF, which has argued strenuously for debt sustainability, could sign off on such a deal without destroying its own credibility.

It may be best to recognise this and go for an even more severe restructuring of the banking sector. At the minimum, Bank of Cyprus, the country’s largest lender, would need to be resolved along with CPB.

The Cypriot MPs won’t like any of this. But what is the alternative? Endless capital controls? Printing a parallel currency so people get Cypriot Pounds instead of euros from the cash machines? Or quitting the euro entirely?

There are no good options. But the longer it takes for Cyprus to get real, the greater the damage.

 

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