Cyprus Gets Crazy

Fisher Investments  |

Cyprus, in case you haven’t heard, is in a tight spot. It needs €17 billion ASAP to keep paying the bills, otherwise it faces bankruptcy, disorderly default and—potentially—a eurozone exit.

Understandably, Cypriot leaders don’t want this to happen, so they’re trying to secure a bailout from the EU/ECB/IMF “troika.” But most troika officials are less than keen to oblige since Cyprus’s problems stem from its status as a haven for foreign money and alleged laundromat for Russian oligarchs and criminals. Cypriot banks have about €68 billion in deposits—over three times GDP—and about 40% is foreign. But because Cyprus’s economy is so tiny and private businesses are few, loan demand isn’t great, so banks have to put the deposits to other use in order to provide savers a decent interest rate. And many Cypriot banks chose to invest in Greek debt—understandable considering Greece’s proximity and lengthy history with Cyprus, but not the wisest move.

Two Greek defaults later, the banks are practically insolvent and rely on the ECB’s Emergency Liquidity Assistance program to stay open, the economy’s in serious trouble, and Cyprus can’t secure financing on capital markets at affordable rates. A €2.5 billion loan from Russia last year helped bide time, but Cyprus now needs a heavy cash infusion to recapitalize the banks and allow the government to keep functioning while it finds ways to cut debt.

The troika’s willing to help, but only to a point: They’ll lend Cyprus €10 billion, leaving Cyprus to scrape €6 billion from whichever domestic sources it can. It’s tougher than terms given to Greece, Portugal and Ireland, but officials believe it’s necessary to mitigate the risk of taxpayer revolts throughout the eurozone core—most folks won’t want their tax dollars used to bail out Russian oligarchs.

Problem is, neither do Cypriot taxpayers, so the traditional VAT hike is out, and officials are getting creative. In a bad way.

First, they tried to make foreign depositors foot the bill courtesy of a tax on bank deposits. Under this plan, Cyprus would collect 6.75% of accounts up to €100,000 and 10% of accounts over that amount as a one-time levy, and savers would receive the equivalent amount in bank issued bonds as compensation—a direct violation of EU deposit guarantees and private property rights. Sure, savers would technically be compensated, but swapping cash for an illiquid bond backed by Cyprus’s unproven and undeveloped natural gas reserves is hardly like-for-like. Predictably, outrage ensued and savers began withdrawing as much as they could from ATMs (a prolonged bank holiday has prevented customers from closing accounts or transferring funds off the island). So Parliament rejected it. Uninamously.

So Cypriot officials scrambled for a new plan, and on Thursday, it seemed they’d hit on one: Nationalizing private pension assets into a “solidarity fund,” and allow foreign investors to contribute by buying new bonds backed by those natural gas reserves. Russia liked the idea—Russian officials would much rather invest in Cypriot assets than extend another loan—but troika officials didn’t. In their eyes, the new bonds would only add to Cyprus’s debt load, compounding the existing problem, and they continued to advocate for the depositor “bail in”—which, as I write, is suddenly back on the table.

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But everyone’s missing the larger picture: Any plan that involves the seizure of private assets, whether through the deposit “tax” or pension nationalizations, is bad news. Governments have no business expropriating private property. Capital markets agree—investors tend to avoid places where private property rights are weak and governments have a history of seizures, like Argentina and Venezuela. And Hungary, where Prime Minister Viktor Orban’s 2011 nationalization of private pension funds was universally denounced. Why Cyprus would even think of imitating such bad policy is beyond me.

Especially since, despite what officials claim, Cyprus isn’t exactly out of options. Like most of peripheral Europe, it has a decades-long history of socialism—heck, the last government was communist! That means it has a bloated public sector and huge roster of state-owned assets. Rather than trying to close the budget gap by raising revenues, Cyprus could just cut back—officials could make the painful public sector cuts the Greeks, Portuguese, Spanish and Italians have endured in recent years. Yes, near term, it hurts, but over time, a growing private sector can absorb these workers and, likely, produce and create more wealth than the public sector could.

Privatization is another solution. In fact, had the last government agreed to privatize state-owned firms in 2011, when Cyprus’s troubles first came to light, we might not even be talking about Cyprus today. But former President Demetris Christofias repeatedly refused, saying it violated his Communist Party’s principles and, thus, violated the electorate’s good faith (assuming a vote for Christofias was a vote for good old fashioned communism, damn what’s best for the country). And so Cyprus remains the proud owner of its telecommunications monopoly, port authority, electricity provider and other interests. Credible plans to sell these might just be enough to satisfy the troika and earn some bailout cash.

Whether this good sense prevails, however, remains to be seen. For the moment, Cyprus seems more focused on playing chicken with the troika—why make meaningful changes when you can cozy up to Russia, make EU officials worry about Vladimir Putin gaining a foothold in the Mediterranean, and give them a huge incentive to cough up the full €17 billion? Negotiating with Russia while proposing wacky plans to the EU might just be part of Cyprus’s strategy. Heck, it might even work—troika officials could decide lending Cyprus an uncollateralized €17 billion is the least of three evils. Remember, the troika’s not exactly known for sticking to its guns. Tellingly, Cyprus’s aptly named central bank chief, Panicos Demetriados, is rushing through plans to restructure the banking system, strengthen deposit protections and consolidate failing banks—seemingly preconditions for receiving aid. I wouldn’t be shocked if a troika compromise soon followed.

On the bright side, since Cyprus is so tiny and not terribly integrated into the global economy or financial system, this is mostly an academic debate. Provided the eventual Cypriot solution keeps private property rights intact and doesn’t establish a bad precedent for the rest of the eurozone, the global economic and capital markets impact of this saga should be small. Even a Cypriot bankruptcy and eurozone exit shouldn’t much shake markets over the long run—fear might spike at the outset, but the eurozone’s financial system backstops should help the currency union weather the exit.

This article constitutes the views, opinions, analyses and commentary of the author as of March 2013 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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