Cyprus bailout: deeply flawed – but a best effort in desperate times

 

Larry Elliott, economics editor guardian.co.uk, Monday 25 March 2013 10.32 GMT

The deal at least removes immediate risks of a banking collapse, but chances of a further bailout and Russian fallout are high

The Cyprus bailout will be overshadowed by serious knock-on effects, but is probably the best possible deal after initial terms were rejected by parliament. Photograph: ZUMA/Rex Features

The bailout deal for Cyprus is deeply flawed. Some analysts say it is even worse than the original plan announced just over a week ago.

For sure, it will have serious knock-on effects, some of which will only become apparent over the coming weeks, months and years.

But it was probably the best that could be achieved in the desperate circumstances that followed the rejection of the original terms by the Cypriot parliament last week. And it has removed the immediate risk of a banking collapse and exit from the single currency.

The new proposal removes the most objectionable aspect of the first package – the levy on all depositors – making it less politically toxic. Money will instead be raised from rich depositors – those with savings of above €100,000 – and bondholders.

By raising money from the better off – many of them Russian – Cyprus will get €10bn from the troika (the European Union, the European Central Bank and the International Monetary Fund).

The threat that the ECB would stop providing day-to-day support for the Cypriot banking system has been lifted. That should ensure that the banks can reopen later this week, and means there is no immediate risk of Cyprus going bust and leaving the single currency in a disorderly manner.

Markets saw this as the doomsday option and rallied after the agreement was reached in Brussels in the early hours of Monday.

The shakiest of the Cypriot banks – Laiki – will be closed. Deposits of more than €100,000 – amounting to €4.2bn in all – will be placed in a "bad bank". That means savers will only get a fraction of their savings back and the deposits could, in theory, be lost entirely.

Smaller deposit holders at Laiki will be transferred to the Bank of Cyprus, which will need serious recapitalisation, not least because it inherits Laiki's €9bn debt to the ECB. Money for that will come from Bank of Cyprus's own wealthy deposit holders. These changes, it is hoped, will avoid a run on the banks when they reopen for business.

This, though, is certainly not the end of the story. For a start, Cyprus faces a bleak economic future in which the need for a second bailout looks a strong probability. It is not just that the country's economic model has been destroyed. Nor is it simply that a brutal austerity programme is the condition for the €10bn loan.

These will both hurt, but be compounded by a ferocious credit crunch as the banks seek to shore up their balance sheets by lending less and at higher rates of interest. The risk is of a full-scale economic collapse that will result in Cyprus having a debt problem worse than that in Greece.

Although eurozone politicians say otherwise, what has happened in Cyprus will have ramifications for the rest of the single currency.

For a start, any depositor with more than €100,000 in, say, an Italian or Spanish bank, will wake up this morning wondering whether to move it somewhere safer. And in the event that speculation did start to mount about the need for a bailout in another member of the eurozone, those with deposits of less than €100,000 would recall what happened in Cyprus. The risks of a future bank run have increased.

Finally, the Russians who have a total of €20bn stashed away in Cypriot banks are going to be caned by the bailout deal. The chances of retaliation against the eurozone by the Kremlin over the coming months are high.

Cyprus bailout: deeply flawed – but a best effort in desperate times | Business | guardian.co.uk