Primer on the crisis in Cyprus

Genevieve Signoret & Patrick Signoret

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Cyprus, one of the euro area’s smallest members, is fully embroiled in the monetary union’s debt crisis. Despite the country’s small size, its problems are complicated and can affect the rest of the euro area (and the world). This primer contains some facts and a brief description of the situation. (Most of this primer is based on articles from the following sources: Reuters 1, Reuters 2, NYT, Bloomberg, WSJ).

Cyprus has an 18 billion euro economy, 0.2% of the euro area’s GDP. But its banking sector is much bigger: for example, it holds 70 billion euros in deposits (of which almost half is held by non-residents; most believed to be Russian.) The sovereign debt-to-GDP ratio is about 80 percent.

Cyprus’ main problem is that its relatively enormous banking sector is failing: Cypriot banks held a lot of Greek bonds in early 2012, and got very badly hit when that debt was restructured.

The country will need a bailout; in fact, Cyprus asked the troika for one last June. But a rescue has been postponed for several reasons: lenders’ attention has been focused elsewhere; bailout fatigue; wariness of Cyprus’ close ties to Russia and suspicion that it’s a haven for tax evaders and money launderers; and little sense urgency because Cyprus has so far managed with a large loan from Russia. Now, however, the government is close to running out of money (it’s unclear to us exactly when).

The size of the bailout package being discussed is about 17 billion euros (the ranges we’ve seen are between 16.5 and 17.5 billion), of which 10 billion would be used to recapitalize banks.

Even if banks were rescued directly (thus not counting as Cypriot government debt), the other 7 billion would still push the debt-to-GDP ratio to at least 120%. The IMF won’t lend money if it doesn’t deem a rescue to be sustainable, and in the past (with Greece) has shown that it considers 120% to be barely sustainable.

But remember that the euro area has resisted using its rescue funds to bail out banks directly, at least until the single banking supervisor is set up (not before early 2014). The Cypriot government could privatize state assets and take other measures, but the net cost of the bailout, including the tranche for the banking sector, would still push up debt-to-GDP to around 140-150%.

It is therefore widely recognized that any bailout will entail debt reduction: someone will suffer losses. Will it be government lenders? Cypriot and EU officials have ruled that out. Besides, a lot of the sovereign debt is held by the country’s banks. And a big portion has been issued under English law, which makes restructuring much more difficult.

On the banking sector? Probably; current proposals would potentially impose losses not only on bank shareholders, but also on some bond holders. Maybe even on depositors, but that would spark a bank run and would be resisted by Russia. But a bailout package that protects Russian depositors and depositors seen as tax evaders and money launderers won’t go down well with other euro area voters.

Negotiations between Cyprus and the troika will continue, but we know that a final deal won’t be reached until after the Cypriot presidential election, on February 17 (with a possible second round one week later). The clear leader in the polls, center-right Nicos Anastasiades, backs a bailout.

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