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The Side Effects of the Cyprus Cure ET dt. 20-03-13

The proposed package shows how EU measures become the problem rather than the solution

Satyajit Das

It will be ironic if Cyprus, one of the smallest countries in Europe with little over 1 millionpeople and 0!" of the EU economically, were to prove a key infle#ion point in the crisis

Cyprus needs around 1$%1& billion to recapitali'e its banks (around 10 billion) and for general

government operations including debt servicing ( $%& billion euro)*hile small in nominal termsand well within EUs resources, the amount is large relative to Cypruss +- of 1& billion The

package proposed by EU incorporates privati'ation of state assets, increase in corporate ta#es

(from 10" to 1.!") and withholding ta#es on capital income (to .&") and restructuring of

e#isting bank or sovereign debt /ost controversially, ordinary depositors will face a ta# onCypriot bank deposits, amounting to a permanent write down in the nominal value of their

deposits The deposit levy will be $!" on less than 100,000 (the ceiling for EU account

insurance) and " for deposits above that amount In return, depositors will receive shares in

the relevant banks The unprecedented write down of bank deposits, e#pected to raise !& billion,is motivated by many factors 2ne, the I/3 participation re4uires the debt level to be

sustainable The write%off of depositors reduces debt and also the si'e of the re4uired bailoutpackage to Cyprus to 10 billion Two, Cypriot banks have limited amounts of subordinated or

senior unsecured debt (that are cleared only after other lenders are repaid)This means a write

down of bondholders would only raise between 1 and . billion, below the re4uired amountThree, as in the case of the +reek debt restructuring, the European Central 5ank (EC5) and

others are unwilling to take losses on their e#posure

Capital Flight

3our, restructuring Cypruss sovereign debt is risky because many bonds are governed by Englishlaw where the right of the creditors are more protected 6ny attempt to restructure these whileinsulating official creditors from losses would invite litigation 3ive, +ermany, 3inland and

7olland are increasingly concerned about losses on bailout loans +erman Chancellor 6ngela

/erkel does not want concern about actual cash losses to +erman ta#payers to affect herprospects in the 8eptember .019 elections 8i#, +ermany wants to prevent any bailout fund

flowing to :ussian depositors, such as oligarchs or organi'ed criminals who have used Cypriot

banks to launder money The ta# on depositors is a significant e#pansion of the principal of -8I

(private sector involvement), which was applied in the case of +reece and presented by EU as aone%off measure *hereas in +reece losses were allocated to sovereign as well as ;unior and

subordinated bank bond holders, the Cyprus measures e#tend burden%sharing to ordinary small

depositors *hatever the case for the Cyprus package, it risks grave side effects 2ne, it maytrigger capital flight from banks in +reece, -ortugal, Ireland, Italy and 8pain, based on depositor

concerns about loss of capital in any future debt restructuring If capital flight accelerates, then

the EC5, national central banks and governments will have to intervene

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Crisis Will Worsen

Two, the Cyprus bail%in provision will make it difficult for European banks, especially in

vulnerable countries, to raise new deposits or issue bonds Three, the Cyprus arrangementsundermine the credibility of EC5 and EU and measures announced last year to combat the crisis,

which have underpinned the recent relative stability 6fter Cyprus, it will be difficult for

countries like Italy and 8pain to ask for EU and EC5 assistance, if re4uired, knowing that if afuture debt restructuring is necessary then domestic ta#payers face a loss on bank deposits The

EUs much vaunted banking union was rightly critici'ed for failing to provide funds to undertake

any re4uired recapitali'ation of banks and the lack of a consistent deposit protection scheme inthe region Cyprus highlights these shortcomings 3our, the Cyprus package highlights the

increasing reluctance of countries like +ermany and 3inland to support weaker EU members

The ability of the recently elected Cyprus government of -rime /inister