from Macro and Markets

Cyprus: Endgame?

March 21, 2013

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Budget, Debt, and Deficits

One of the striking features of the Cyprus crisis is the extent to which the ECB is driving the process.  It was their threat to stop the flow of easy money to Cyprus that forced agreement on the earlier failed tax plan.  Now, their threat to cut Cyprus’ access to Emergency Liquidity Assistance (ELA) if the government does not have an EU-IMF approved program in place by Monday accelerates events. With the banks closed and cross-border payments suspended, the immediate impact of a decision to terminate ELA would be muted.  But without such funding, it will be virtually impossible for the major banks to restore normal operations, and reopening the banks would result in cascading failures through the entire financial system and the real economy.  The intent clearly seems to be to force the government to the table. Will it do the trick?  By next week, we may well know if there is a path for Cyprus to remain in the Eurozone.

The ECB is right in emphasizing that the ELA is only for solvent banks, but that hasn’t stopped them in the past from fudging the criteria to support countries during often protracted negotiations with the Troika.  ELA funding to the banks in turn financed the purchase of government paper.  So, while such a facility is and should be in the ECB’s monetary toolbox, in circumstances like the present its primary effect is to provide fiscal financing (and often the only financing available to governments).  It is a dangerous game in that, along with the other facilities provided during the crisis, it exposes the ECB to a great deal of credit risk.  With the ECB having already extended €9 billion in ELA credit to Cyprus, I understand why they want to change the rules, but it’s worth asking why now.

More bad ideas

Now that the Cypriot government’s effort to raise emergency financing from Russia and pressure Europe to soften terms has run out of steam, reports are that it has developed a new financing plan. Insured deposits would be exempted from tax, the large, non-insured deposits in solvent banks would be taxed 5 percent (down from 9.9 percent in the original proposal), and any insolvent bank would be split into a good bank and a bad bank (uninsured deposits presumably would go with the bad bank, rendering them worthless).  The government also would issue a bond backed by natural gas. The remainder of the needed financing would come from the transfer of the reserves of the state pension fund (€2.5 billion) and other state assets.

Wait a minute.  State pension funds now hold reserves and invest in government debt.  By seizing these funds, the government swaps debt claims for a contingent, future liability to retirees.  It may produce lower debt on paper, and it does provide cash for the government now that the ELA ATM has been turned off, but in economic terms its does nothing to produce a more sustainable debt profile.  Similarly, an oil linked bond may be worth considering (though a case like this with such high uncertainty, markets may not pay much for the link to natural gas) but it also boosts debt above levels the troika has firmly stated is more than the country can handle.  On these grounds, I would hope that the Troika promptly rejects the plan.