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Cyprus crisis: The four scenarios

Monday 1 April 2013

By Ben Hall in London and Peter Spiegel in Brussels

The Cyprus financial crisis has entered a new and dangerous phase following the parliament’s rejection of a €10bn bailout from the IMF and EU which included a €5.8bn levy on Cypriot bank accounts. Unless Nicosia can come up with an alternative way of raising revenue, or the EU and IMF ease the terms of their rescue offer, the island’s banking system could lose access to low-cost central bank loans that have been keeping them alive for months. Without that funding, Cyprus is facing the prospect of a banking meltdown and exit from the eurozone. So what are the options?

1. Russia rides to the rescue

Michael Sarris, Cypriot finance minister, is in Moscow to appeal for aid. The Russians were not keen to pony up additional aid during the more pro-Moscow administration of former president Demetris Christofias, as any loan from Russia would only add to Cyprus’s debt pile, pushing it over the level deemed sustainable by the IMF. So Cyprus will probably need to sell assets.

There are two options: First, Russia could strike a deal for access to Cyprus’s prospective gas reserves. But as Nick Butler pointed out on Monday, the island’s gas reserves are an uncertain proposition, and there are still international rights issues outstanding. Second, a Russian purchase and subsequent recapitalisation of one of the Cypriot banks. The most frequently-mentioned potential marriage is between Gazprombank, the financial arm of Russian gas giant Gazprom, which would swallow up Laiki, the island’s second-biggest bank and the one in most perilous financial need.

But would the eurozone really be happy with Russia taking such a financial foothold when the EU is determined to downsize Cyprus’s financial sector and sever the island’s umbilical cord to Moscow? And would the Russians be happy to purchase a bank when confidence in the Cypriot banking system is rock bottom and any bank remains at the mercy of the ECB, which could withdraw its lifeline of low-cost emergency loans at any stage?

2. Cyprus backtracks

President Nicos Anastasiades will now come under intense pressure in Europe to go back to the idea of imposing a heavier levy on bigger depositors while exempting all those with accounts under €100,000. It means hitting the island’s Russian clients hard, and international lenders have been taken aback by the extent to which Cyprus’s political classes have defended foreign depositors. As one noted, in most countries it is the locals that politicians worry about. Apparently not in Cyprus. As Erik Nielsen of UniCredit argues, depositors in Cyprus have benefited from higher rates of interest than elsewhere in the eurozone:

“A Cypriot (or foreigner) who placed €100,000 in deposit in Cyprus in 2008 would by now have earned just around €15,000 more than if he had placed that money in Italy or Spain (and some €23,000 more than if he had placed it in Germany). Why does the Cypriot parliament (and many commentators) seem to suggest that a 15 per cent tax on such deposits (which would cover the bill also for the sub-€100,000 deposits) would be unreasonable now the banks are in trouble, but that German, Italian and other eurozone taxpayers should rather foot the bill? To me, the Cypriot position is simply unsellable in the rest of the eurozone.”

But Mr Anastasiades is loath to penalise big depositors, fearing the consequences for the island’s status as an international financial centre on which the economy is built. In any case, he would now struggle to get this through parliament. Protecting the island’s offshore financial services sector appears to have been a matter of political consensus.

3. The eurozone relents

Mr Anastasiades may be hoping that when faced with the prospect of a Cypriot exit from the eurozone, the bloc will bend to keep the island in – bailing out its big creditors in the process. Nicosia has been newly enthusiastic about a plan to nationalise its pension funds to raise anywhere from €3bn to €5bn, something originally suggested by the European Commission but rejected by Berlin. Thus far, brinkmanship with the EU appears to be a miscalculation. Cyprus has few friends at the moment. Even those countries squeamish about penalising depositors, such as France, are determined that the island must downsize its financial industry and wean itself off dubious Russian money.

Probably the only way to increase help in extremis for Cyprus would be for the European Stability Mechanism, the eurozone’s €500bn rescue fund, to directly inject capital into the island’s banks, thereby easing the debt burden on the Cypriot government. But the prerequisites for such intervention are not yet in place. Germany says such a move would be illegal under German law (as now configured). In any case, direct recapitalisation would require external supervision and wholesale restructuring of Cyprus’s financial sector, which Nicosia would be desperate to avoid.

4. The disaster scenario Nicosia will keep its banks shut for several more days as it tries to find a way out of this mess. If it fails to convince the eurozone that it has a viable alternative to bailing in depositors, then the ECB could decide that Cypriot banks are no longer eligible for the eurosystem’s emergency loans, known as Emergency Liquidity Assistance (ELA), which is now the only thing keeping the island’s banks afloat.

The ECB’s next governing council meeting, when any decision to withdraw ELA could be taken, is on March 21. That is the gun pointing at Mr Anastasiades’ head, something made clear to him by ECB officials at the late-night negotiations in Brussels on Friday. Without eurozone liquidity, Cyprus has no central bank to prop up its banks like a non-eurozone country does. So either Cyprus becomes an economy with no money and reverts to the barter system, or Nicosia would have to start printing its own currency to keep its banking system running. When Cypriots next go into their bank branches they may be withdrawing Cypriot pounds.

Copyright The Financial Times Limited 2013.

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