Cyprus’s now-certain default

By Felix Salmon
January 25, 2013

Many congratulations to Stephen Fidler, who has managed to get some actual news in Davos: EU economics commissioner Olli Rehn went on the record telling him that Cyprus is going to have to restructure its debt — just two weeks after ruling such a thing out.

That might come as little surprise, given that Cypriot banks were loaded up to the gills with Greek debt, and Greek debt suffered a 70% haircut. Cyprus is tiny, and could never afford the €17 billion needed to bail out the banks and the government — especially since that would bring the country’s debt load up to more than 140% of GDP.

Still, after the EU forced Greece to default, it drew a line in the sand: no more sovereign defaults, it said, since Greece was “unique and exceptional”. So this does go to show that you can’t really trust Europe’s promises. What’s more, Cyprus’s now-certain restructuring is going to be significantly messier than Greece’s was.

Greece’s debt restructuring was essentially unstoppable for one main reason: most of its debt was issued under domestic law, rather than foreign law. A tweak to domestic law, and suddenly the vast majority of Greece’s creditors were bailed in to any deal, whether they voted for it or not. Cyprus, in contrast, doesn’t have that luxury: its bonds are mostly issued under foreign law. And that means any restructuring is going to be much more difficult.

Lee Buchheit and Mitu Gulati have a potential solution to that problem, which involves amending the treaty governing the European Stability Mechanism. But the other big problem in Cyprus will still loom: the question of the country’s bank deposits.

In a country like Cyprus (or Iceland, or Switzerland), where the banking sector is many multiples of national GDP, there’s very little distinction between rescuing the banks and rescuing the country. And if the asset side of the banks’ balance sheet is full of Greek sovereign debt, the liability side is equally dodgy: Cyprus is a notorious center of dodgy offshore banking, especially for Russians. If Cyprus is going to restructure its liabilities, it’s going to have to face one huge question: will those restructured liabilities include Russian and other foreign deposits?

If there’s any hint that Cyprus might force foreign depositors to take some kind of haircut, of course, there will be a massive run for the exits, and Cyprus’s current solvency problem will become a much more serious and immediate liquidity problem. The last thing that Cyprus or any other country needs is a bank run, which will leave the national balance sheet in the classic pinch where “on the left, nothing’s right, and on the right, nothing’s left”. What’s more, in many ways the precedent of forcing depositors to take a haircut would be even more damaging than the precedent of imposing a haircut on Greek bondholders: at that point there would be really no reason at all to have deposits in any Mediterranean country.

That said, foreign deposits in Cyprus amount to some €30 billion: the opportunity cost of protecting them in full, while imposing a substantial haircut on Cyprus’s bonded creditors, would be huge.

So even if Europe has made its first big decision — to force Cyprus to default — it still faces many more. Should it amend the ESM treaty to make any restructuring easier? Should it impose a haircut on Cyprus’s uninsured depositors? And how can it structure the process to minimize the chances of a messy bank run, default, and possibly even exit from the euro? It’s easy to dismiss Cyprus as too small to worry about. But it’s still an important sovereign state. And if the EU missteps on Cyprus, that would bode very ill for any similar problems in bigger eurozone countries in the future.

4 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

“Should it impose a haircut on Cyprus’s uninsured depositors?”

Sure, why not? What part of “uninsured deposit” didn’t they understand when they put the money there in the first place? That’s kind of what “uninsured” means–if the bank goes bust, you lose. Maybe we’d have fewer bad banks if we let some people actually experience that.

Posted by Moopheus | Report as abusive

Moopheus- because this is a 100% EU created situation. In 2009 Merkel said no country in the EU would be allowed to default. Cypriot banks, regrettably, took her at her word and loaded up on Greek debt, which was then haircut 70%. Now Cyprus either gets a bailout or defaults. And the “logic” offered for not bailing out Cyprus is that – get this – tax discipline in Russia is poor!

Cyprus joined the Euro in 2008 and will have defaulted in the beginning of 2013. Five years from prosperous independence to poverty, thanks to the Euro.

Posted by johnhhaskell | Report as abusive

Thank you for the very good atricle Felix. On the same topic, you might want to check the always dependable Prodigal Greek, “Cyprus, with friends like these” ( http://theprodigalgreek.wordpress.com/20 13/01/24/cyprus-with-friends-like-this ).

My favourite line : “[...] And it is at this point that Europe, in its usual fashion, started messing this one up.”

Posted by dandraka | Report as abusive

Hi Felix! Is it possible to have a copy of “When Countries Go Bust”, which is based of the presentation you are giving at Columbia University this October 2013. Thank you in advance.

Posted by eddyfi88 | Report as abusive