When it comes to financial negotiation, lenders nearly always have more power than borrowers - and the smaller the borrower, the more that’s true. Which is why Cyprus’s rejection of the EU bailout proposal was always dangerous. If they couldn’t come up with a Plan B, then there was always a risk of the worst-case scenario as spelled out by Cypriot president Nicos Anastasiades: the ECB would stop propping up Cyprus’s banks, which would immediately fail, causing 8,000 families to lose their income, 60% losses for bank depositors, bankruptcy for thousands of small Cypriot businesses, and probably (although Anastasiades didn’t spell this out explicitly) exit from the euro.
Well, now the ECB has brought Cyprus one step closer to Anastasiades’s “catastrophic scenario”: it has said that absent an EU/IMF deal which can recapitalize Cyprus’s banks, it’s going to stop lending to Cyprus on Monday.
Politically speaking, this places everybody concerned in a really tough position. The Cypriots aren’t getting anywhere with the Russians, who in any case can’t deliver an EU/IMF deal on their own. And the Eurocrats seem to be losing patience too:
The European Commission said Wednesday it was now up to Cyprus to put forward an alternative rescue plan after its lawmakers voted down a proposed bail-out package agreed by the Mediterranean island and its eurozone partners last Saturday.
“It is now for the Cypriot authorities to offer an alternative scenario respective of the debt sustainability criteria and of the financing parameters,” Olivier Bailly, a commission spokesman said ... "The ball is now in Cyprus’ court,” Mr Bailly told reporters in Brussels.
The problem with this is that the EU has two big conditions before it will sign on to any Cypriot plan. The first is clear and pretty much accepted by all: the EU and IMF will lend no more than €10 billion. But the second is actually more problematic: the stated reason why Europe won’t lend more than €10 billion is that Europe refuses to allow Cyprus’s debt level rise above a certain level.
As a result, even if Cyprus gets its €5 billion loan from Moscow, that wouldn’t actually help: in the eyes of Brussels, you don’t solve a debt problem by managing to find more debt. Similarly, borrowing billions of dollars from Cypriot pension funds wouldn’t help much either. The EU position is clear: we’ll give you the maximum amount of debt that you can handle. The extra billions need to be in the form of cash, which never needs to be repaid; the money can’t come in the form of loans.
So long as the EU sticks hard to that principle, Cyprus would seem to have precious few options; certainly the Buchheit-Gulati option wouldn’t help, since, as Joseph Cotterill notes, it keeps Cypriot liabilities at an unacceptably-elevated level. (Unacceptable to the EU, that is, and they’re the people who matter here.)
Cypriot negotiators have lots of perfectly sensible things they can tell the European purse-string holders about why this obsession with debt sustainability is silly. They can point to future natural-gas revenues, for instance, which give Cyprus the potential ability to pay of debts which seem huge right now. They can also point to the denominator here: if failure to reach a deal results in GDP collapsing, then the debt-to-GDP ratio will soar even if the debt level doesn’t rise at all. But the Europeans aren’t acting like impartial judges: by all indications, they’ve made up their mind.
Which leaves Cyprus in a very, very tough position. It can accept the idea of taxing bank deposits - or it can find itself tossed unceremoniously into the Mediterranean, left to fend for itself. Essentially, the EU is telling Cyprus that it can come up with any plan it likes, so long as the plan involves nothing but fiddling around with the Breakingviews deposit-tax calculator. You want to preserve all insured deposits? Fine, raise the tax on uninsured deposits to something over 15%.
Such a plan would mark the end of Cyprus as an offshore banking sector - but then again, so would the alternative. Cyprus’s banks are insolvent, thanks to the haircut they were forced to take on their Greek government bonds. And so if the island wants any kind of banking system at all, it is going to need to be able to continue to draw on emergency assistance from the ECB. Which means taxing deposits and generally doing as it is told by the EU.
But there’s a niggling problem here: Cyprus is a sovereign nation, and nothing is going to happen unless and until a law is passed by the Cypriot parliament - which has already rejected a deposit tax once, and which doesn’t seem any closer to accepting such a thing now.
Paul Krugman has a great post today on what he calls “the Sum of All FUBAR”: all the different things which have gone wrong in the past, and which are certain to get worse in the future, with respect to Cyprus. But Peter Coy sums the whole thing up best:
In retrospect, most or all of this could have been avoided if Cypriot banks had been prevented from lending so heavily to Greece. Once it was clear that the Central Bank of Cyprus was underregulating, the European Central Bank should have made noise, even though at the time it lacked authority to dictate terms. When the halloumi hit the fan, the EU, ECB, and IMF should have stood by Cyprus unconditionally. The time for tough love is before the crisis, not during it.
In other words, the only real solution to this crisis is for the EU to go back in time and stop it from happening in the first place. And the next-best solution would be for the EU to stop being so self-defeatingly stubborn on debt ratios. But if that doesn’t happen, the Cypriot parliament is going to face an unbelievably tough vote at some point in the next few days. Will they essentially cede their sovereignty to unelected Eurocrats, and rubber-stamp a deal which looks very similar to the one they’ve already rejected once? Or, standing on principle, will they consign themselves to utter chaos and a very high probability of leaving the Eurozone altogether? Such decisions are not always made rationally. Which means that if I were Joe Weisenthal, I’d be pretty worried right now about losing my $1,000.