Fiddling while Home burns
Cyprus has a liquidity problem. It has been barely two months since depositors of the two largest lenders of this small island state, Bank of Cyprus and Laiki, learned they were to face losses of 60 to 100 percent on the part of their deposits exceeding 100,000 euros ($129,278). Yet Nicosia’s streets haven’t been savaged by furious rioting, nor have the banks fallen victim to visible panic. The harm is more pernicious: capital controls are slowly smothering a domestic economy already hit by a heavy dose of austerity.
It doesn’t look obvious at first. Controls have been relaxed in stages since March. Businesses can now make cashless payments of up to 300,000 euros without supplying documentation, while permitted cashless transactions from one bank to another have been increased to 15,000 euros and 75,000 euros for households and businesses, respectively.
Yet a major problem lies beneath the surface. Imagine a fictional Cypriot business manufacturing car parts, Aphrodite Autos. And imagine that in mid-March, just before the bail-in, it had 1.1 million euros on deposit at the Bank of Cyprus, to provide a decent buffer against uncertainties such as a price hike of raw materials, which, in Cyprus, are mostly imported.
After the bail-in, Aphrodite Autos is in a tight spot. It still has the 100,000 euros of deposits that were insured. But the million euros that were uninsured are now down to 100,000 euros. 375,000 euros are definitely being turned into Bank of Cyprus shares of as yet uncertain value. Another 225,000 euros are also at risk of being bailed in. Finally, the remaining 300,000 euros have been summarily frozen too.
That’s bad enough. But Aphrodite Autos can’t even get its hands on all of the 200,000 euros of deposits it can theoretically access. Imagine that half of this is in the form of a one-year, fixed-term deposit maturing in June. When it does, the current capital controls mean that the firm is only allowed to turn 20,000 euros into ready cash. The other 80,000 has to be rolled over.
This is a big problem, because many of the importers Aphrodite Autos deals with now don’t trust the banking system and insist on being paid in newly-scarce cash. Payments by cheque take five days to settle if they involve two different banks. Meanwhile, companies and individuals alike are forbidden to manage this by opening new accounts in other banks.
Quantifying the effect of all this is tough without hard data, but it’s clear that many healthy firms could end up going bust. The longer capital controls endure, the more liquidity crises will hit businesses, according to OEB, a Cypriot employers and industrialists’ federation. Jittery consumers prefer to wait and demand has fallen off a cliff, according to a senior Cypriot businessman.
The Cypriot central bank could try to take one step out of the morass by taking Bank of Cyprus out of resolution. There are signs of progress: the Cypriot ministry of finance is planning to appoint a new management team and reconnect BoC to cheaper conventional eurosystem funding within days, according to a person familiar with the situation. And central bank data imply that the new BoC could end up with a core Tier 1 ratio of well over 15 percent if 60 percent of its uninsured deposits are bailed in. If that is deemed sufficient to withstand future losses, BoC can unfreeze the other 30 percent of uninsured BoC deposits.
That probably won’t happen. The central bank is reluctant to take BoC out of resolution until an independent third party values its assets – which could take months. And if capital controls are relaxed, resentful BoC depositors will withdraw their funds, and BoC could collapse.
Economists like Marios Zachariadis suggest that Cyprus could discourage mass withdrawals by slapping a punitive tax on BoC money leaving the country. The idea is that a one-off charge of, say, 25 percent could discourage a Cypriot stampede. Rates could be reduced for those who keep their money in Cyprus longer, or who bring it back within a predetermined timeframe.
But that looks like replacing one set of capital controls with another. And deposits might just drain out of BoC into fellow Cypriot banks. The ECB might agree to supply emergency liquidity assistance, and the Cypriot central bank could lean on other domestic banks to lend the money back to BoC on the interbank market. But both carry big legal or practical risks.
The most likely scenario is that BoC’s uninsured deposits remain frozen while capital controls are slowly relaxed. Then Cypriot GDP, which fell over 4 percent year-on-year in the first quarter, will plummet further. Unless the Troika helps solve Cyprus’s credit crunch, the 8.7 percent drop in GDP it had forecast for 2013 will prove far too rosy.