Cyprus’ economy is going to suffer terribly in the next few years. Some of that is inevitable given how bloated the banking system had become. But the disastrous handling of the crisis, especially in the past week, will make things much worse.
That said, the bailout deal that Cyprus reached with its euro zone partners in the early hours of Monday morning makes the best of an extremely bad job – both for the small Mediterranean island and its rescuers.
It establishes three important principles. First, there will be no losses for insured deposits. Last week’s aborted deal foolishly involved taxing them at 6.75 percent. Second, uninsured creditors rather than taxpayers will pay the entire cost of bailing out Cyprus’ two troubled banks – Cyprus Popular Bank (CPB) and Bank of Cyprus (BOC). Third, Cyprus’ oversized banking sector, which depended heavily on somewhat dubious Russian cash, will be slimmed down.
There are two lingering doubts. Will capital controls be imposed? And is Cyprus’ debt sustainable given the economy will be clobbered?
The key to the deal was to impose the entire pain of bank restructuring on the lenders’ uninsured creditors. CPB will be “resolved” – a euphemism for being put into controlled bankruptcy. Its good assets and insured deposits will be merged with BOC. But its 4.2 billion of uninsured deposits will be kept in the remaining bad bank and converted into equity. They could lose most of their money.