On why the ECB is cutting off Cyprus on Monday

Today’s daily commentary is on Cyprus again. The latest information on Cyprus is that the ECB has told the Cypriots it could no longer extend the ELA facility being used by the now bankrupt Cypriot financial institutions. Cyprus has until Monday to find the funds to support their recapitalization or they will be cut off after the jump I will explain what led to this decision and what alternatives Cyprus now has.

The Cyprus banking system recapitalization problem has been known since June ever since Greek sovereign creditors received haircuts of up to 75% on their Greek sovereign bond assets last summer. Cypriot banks were heavily damaged by this and needed to be recapitalized. The Cypriot government stalled, hoping that events would be favourable as they decided on a course of action.

However, by January, the ECB had had enough. The Cypriot banks were insolvent and being kept alive by the Cypriot central bank via liquidity under the European Central Banking System’s ELA program. The ECB threatened to cut the Cypriot banks off from the ELA emergency funding facility because they were insolvent. However, the ECB demurred because, after months of stonewalling by the Cypriot government, the ECB believed general elections in February would produce a government that was more likely to settle the issue than the outgoing left-of-centre communist-backed Cypriot government led by Stavros Malas.

The February elections did produce a government that was considered more in line with the ideological leanings of the European core on issues like privatization, structural reform and so forth. And so the stage was set at this past week’s EU summit in Brussels for negotiations. We all know what happened at that summit, so I won’t rehash it here. But, the new Cypriot President felt pretty hard done by. And like his predecessors from Ireland, Spain, Portugal and Greece, the new Cypriot President Nicos Anastasiades was all but given an ultimatum. As Greek Prime Minister Papandreou told European leaders to do, they “put the loaded gun on the table”.

So Anastasiades was forced to go back home with this deal for taxing insured deposits, something considered the least bad option on the table given the insistence by Germany and its allies in Slovakia and Finland that the Troika commit no more than 10bn euros to the bailout. After this deal was rejected by the Cypriot people, the banks in Cyprus had to continue to remain closed because if they opened there would have been a bank run and the banking system would have collapsed.

Meanwhile, the Eurogroup continued to insist their stance had not changed. The ECB’s two-month extension actually ends today. But the Cypriot financial institutions remain closed. So, the ECB, having already allowed the bankrupt Cypriot financial institutions to have two more months’ breathing room, lowered the boom. You could see this coming as ECB board member Jörg Asmussen said just yesterday that the ECB can “only provide emergency liquidity to solvent banks”.

The Cypriot government is therefore trying to come up with an acceptable way to raise their part of the funds necessary to get the EU money to recapitalize the Cypriot banks. A lot is being made about the Russian angle in Cyprus and the Finance Minister is in Moscow trying to secure a commitment from the Russians. But the latest word is that none s forthcoming. At this point, I should mention that a poll of Cypriots showed that Cypriots preferred eurozone exit and stronger ties to Russia over the original bank levy scheme. That tells you the potential for this to end disastrously is not contained.

What are the options then?

• The bank levy option is limited now. I think touching insured deposits at all is going to be difficult politically. So Cyprus could just levy the deposits over 100,000 euros. But this would be rejected by the Russians and they might pull aid. As I mentioned yesterday, the concept that Cyprus is all about mob money is false; there is much legitimate Russian business in Cyprus. So this avenue is risky.
• Cyprus could find other ways to raise the money. One avenue that has been floated is raiding the social security kitty or nationalizing the private pension funds and raiding them. The Cypriot church has said it would make funds available as well, mortgaging its land for example. All of these measures sound draconian and are not liable to produce revenue in the time period allotted. The loans need to be in place to recap the banks so they can open for business. The best – and most likely alternative – is a solidarity tax. I expect the Cypriot government to announce something on this tonight (see BBC link).
• Cyprus is also talking to Russia [Update: 5bn euro loan – link here]. And there has been a lot of speculation that they could offer the Russians natural gas drilling rights and military bases in exchange for aid. The US and the UK would not like this as it would give the Russians a base in the Mediterranean and threaten Nato’s stronghold in that region. Right now, this avenue seems fruitless as the Russian news agency RIA says Russia will not provide loans. And I should mention here that Russia held similar talks with Iceland when Iceland had the same problems. So, there is no guarantee this option would work in the few days before the ELA deadline. But, the Cypriots are said to have potentially hundreds of billions of euros worth of natural gas reserves. The Russian angle would be a good option if the price is right.
• Cyprus could simply default on its sovereign debt and recap the banks while defaulting on sovereign debt. I haven’t thought through what that might mean in terms of capital controls, banking system stability or reaction from Brussels. Nonetheless, it is an option.
• The last option is the nuclear one – and that’s default, both on sovereign and bank debt, followed by capital controls and a potential euro zone exit. Cyprus could play this card to extract more money and do the deposit levy at a lower rate on uninsured deposits only, with or without Russia’s cooperation. 

So that’s my quick summation of what kind of options we have in Cyprus. None of them are good and there exists a real possibility that the stand-off in Cyprus could lead to eurozone exit. The reason Cyprus is important is that, despite the small size, it is an euro zone member. Everything that happens there is replicable anywhere in the euro zone. If Cyprus were to leave the euro zone, it would provide a template others could use, avoiding the pitfalls.

UPDATE 935 EDT: The option I flagged as the likely one seems to be a go. The Cyprus Mail reports that the government has agreed to a solidarity fund. I think this plan will work. More details will follow.

UPDATE 955 EDT: Note that none of this solves Cyprus’ longer term structural problems. Paul Krugman has a good quick and dirty analysis here – busted economy, banking model dead, huge sovereign debt. The potential for sovereign default down the line is still high given what Krugman outlines. It really is not looking good – and that’s one reason I believe an eventual euro zone exit is not entirely off the table.

UPDATE 1630 EDT: Yves Smith takes issue with the tenor of some of Krugman’s commentary. I addressed those same concerns yesterday. But the macro view is right: busted economy, banking model dead, huge sovereign debt. Sovereign default is likely in my view.