Thursday, 21 March 2013

To Cyprus: Resistance is Futile. "The EU Borg"

In a rather convincing vote (36 No, 19 abstentions, 0 Yes) the Cypriot parliament decided to reject the decision of the European finance ministers. The Cypriots decision has made a first, albeit small, dent to the EU's modus operandi. The assimilation to the collective, encountered some technical difficulties called parliamentary democracy. Obviously the situation is very fluid and there are many moving parts that confuse and blur the picture but here are some observations.

Political fallout

So far the market has taken on its stride the Cyprus question. This may be due to the rather insignificant size of Cyprus's problems. There are few bonds and not a great deal of obvious financial fallout. This coupled with the rather good news from the USA i.e. the printing of money, makes the markets in my view rather complacent about the situation.

*      It is not just that the deposit guarantee scheme that has been put into doubt. But also the fact that Europe seems to be ignoring all best practices and its own laws and directives in a very authoritarian way. That would set off many alarm bells in other small countries that may one day be in need of European solidarity.

*     Of course the counter argument to the above, is that historically all budding empires like the EU stumped on dissent and exercised unlimited violent coercion in order to form a united long lasting empire. Maybe some states or people do not subscribe to the idea, but lets be honest, EU aspires to be a major world force. Mild disagreement can be tolerated but as the Borg say "Resistance is futile".  In this version the weapons are bonds and deposits. I guess it boils down to what kind of empire we want. For example, do we want to be assimilated to the "hive mind" or collective consciousness or do we want to accept and cherish diversification and plurality and multiplicity that sometimes lead to extravagant or even delinquent behaviour?

*     Once again Europe is doing a "one off solution". So far we have had a string of "one offs". Each time is slightly different. In Ireland they raided the pensioners, in Greece the sovereign bondholders, and in Cyprus the depositors. All along of course the bill has been passed to taxpayers indiscriminately. Question is, what is the next "one off"? Could it be that they did not touch the senior bondholders of the banks because they want to implement this in Spain and Italy? Remember every time it has to be a unique "one off" solution.

*     The fact that Cyprus voted NO would give a lot of courage to the anti-European forces. This is the first sign of non-compliance. Politicians in south Europe should feel a lot more anxious about the future. So far, it was the threat of financial collapse that held their coalitions together. The pressure now for a different approach would increase. Perhaps we may see a change of heart from the French president too. This the market has not discounted properly.

*     A possible exit of Cyprus from the Euro may have some secondary but important benefits to some. Currently there is no mechanism for exiting the EZ. By trying it on Cyprus, a rather small country one can achieve a double master strike. First, it teaches other rebellious states the "resistance is futile" Borg statement. Second and perhaps most important, it would allow the Borg to set the rules of exiting the EZ, since now there are none. Setting the framework now for Cyprus is better than doing it with a bigger country.  In other words, the Borg can implement an exit mechanism for Cyprus and replicate it to the rest.

Recap of the story so far:

1)      Cypriot banks are bust, mainly because of exposure to Greece (remember contagion). The main culprits are Laiki banks (former Greek Marfin) and Bank of Cyprus. Many would argue that this is the second time the "mother" Greeks have deceived or given away their brothers in Cyprus. The first time was in 1974 when in the middle of the Turkish invasion the Greek chief of staff ordered his troops to go to bed and get some sleep. This time it is a Greek bank and the exposure to Greek assets that have ruined Cyprus.

2)      The problem was diagnosed early on. Troika and the Cypriots (previous Government) had months to come up with a solution of how to recapitalize the banks. Hundreds of spreadsheets and millions of notes were exchanged for them to come up with the naïve solution of raiding the retail deposits.

3)      Troika came up with a bailout package of 17bln. The GDP of Cyprus is around 20bln. So the bailout represents 85% of the GDP. Cyprus has a debt to GDP of about 85% up from 48% of four years ago, thanks to the former president Mr Christofias.

4)      It was natural for Europe to ask for Cyprus to bail-in. In other words for Cyprus to commit part of the money. The figure was set and agreed at 7bln, almost 30% of GDP. Admittedly, if this bail-in were to be spread to taxpayers over say 4-5 years it would have been harsh but perhaps more edible.

5)      However, Troika did not accept part of the 7bln to come from any future revenue that (the proven) energy reserves would provide to Cyprus. The excuse that was apparently given of being unreliable or disputed does not hold much water. European involvement could have made these not only reliable but also geo-strategically absolutely undisputed. Now the EU has thrown a huge spanner into the works. Without the "protection" of the EU these oil and gas finds could very possible become a source of dispute and conflict. Could the EU be so short sighted?

6)      What was amazing about the 7bln that Cyprus committed to chip in, was that Troika demanded all or at least 5.8billion of it to be payable immediately. This is an unprecedented figure that represents more than 25% of the GDP to be given effectively TN (tomorrow next). Given the situation the only source of cash readily available was the large deposit base of Cypriot banks (68billion or 340% of GDP).
The current solution
On the table right now is a solution that involves converting a portion of deposits to equity in order to recapitalize the banks. Despite the real injustices of this solution, in terms of finance this represents a rather clean option for the Cypriots. But when you add how it was sold to the Cypriots and the behind the curtain politics it was a disaster. It was an extremely clumsy and unprofessional, the way it was presented to the Cypriots. Let me clarify what I mean. Since the major banks are effectively bankrupt the solution that is standard and it respects order would have been the following.

*     First wipe out all the equity capital and any subordinated debt (Tier1, hybrids convertible, etc).

*     Then invite the senior debt holders and depositors to participate in a voluntary offer of debt for equity in order to keep the bank as a going concern and also save the state.

Although this would have taken slightly more time the advantages are that 1) you respect the capital order, 2) you invite people of the island to socialize the banks. Given the very patriotic nature and social mind-ness of most Cypriots these would have been a much better proposition than say raiding the pensions.

Instead Troika chose to surprise and presents an ultimatum that violated even the basic rights of depositors that thought their small savings are guaranteed by the ECB. Troika had ample time to come up with a clever solution. Instead, it used brute force. Financially, the problem was small change for Europe.

Cyprus's Options. Important date is 28th March

Having rejected the plan overwhelmingly, Cyprus needs to find some alternative or face a rather uncertain evolution of events.

Plan 0. EU and troika say sorry for the misunderstanding. The chocolate cookies offered on the negotiating table were bad causing most finance ministers to sign in haste, as they had to run to the toilet. It was fun to watch how few hours after they agreed, everybody tried to shift the blame to someone else. "No it wasn't me it was him, no it wasn't me it was the other guy....... ".

This is highly unlikely to happen. For example, they could water down the proposals and ask for the bail-in to be spread over time rather than upfront.

Plan 1. Cypriot government finds the 5.8billion by haircutting only deposits of above 100k and converting them to equity.

·         This is an awkward plan as many of the biggest depositors are foreign owned companies. The size of the haircut would be big enough to classify as expropriation and thus open to legal action with high degree of success. Cyprus as I mentioned in previous note has 23 bilateral investment treaties (apparently only 16 out of them ratified) and many double taxation treaties. Furthermore, it is would endanger if not kill completely the current business model of the island and thus plunge Cyprus into a very deep depression, perhaps deeper than the Greek one.

·         The argument that this is a one off levy (that one-off expression again) in this case is not strong enough.

·         This plan also suffers from all the pernicious effects of not having wiped out any other subordinate creditors, however small they are, and thus it is still defective.

·         A by-product should this happen is that the shareholders of the banks in Cyprus would be mostly non-EU companies and citizens. Cyprus also needs to give something in return, namely share certificates, if it has any chance of fighting the accusation of expropriation of foreign owned assets without adequate compensation.

Plan2. Cypriot government uses the pension fund reserves.  They account for about 5bln.

·         This would be a rather more severe measure for the people of Cyprus. It was done in Ireland before. If this money is deposited with the banks then it would be an easy target.

·         The downside of course is that the pension system would need to operate on a day-to-day cash basis as there would be no reserves. Many pension funds schemes work in other countries like this (the gap is huge in many countries and is not represent as a liability of the state, which it is).

Plan3. Some combination of the above plus perhaps a possible restructuring of the sovereign Cypriot debt under local law (around 4.4billion). The English law (around 3.8bln) is harder to touch unless a moratorium is declared. Lee Buchheit and Mitu Gulati have a variant whereby the depositors get certificates of deposit instead.

Plan 4. Cyprus finds the cash by selling assets or the Banks to some foreign Russian speaking investors.

·         The papers are full of stories of Russian money coming to the rescue of Cyprus. One of them wants Russia to place 4bln and sweep Laiki bank.

·         If this happens, then Russia would control the banking in the island. It would also control a rather large chunk of the Greek banking system through Laiki (Marfin) in Greece. Of course the deal may not involve the Greek branches, but I find this odd.

·         Lastly we have the oil and gas reserves. A lot has been said about them. I remember that the first visitor to Cyprus when it was announced that a huge gas deposit was detected (Oct 2010) was Medvedev followed by Sarkozy and Merkel (Jan 2011). To say that the Merkel and the Germans or the French does not care about the oil & gas is simply not true.

·         So any deal that involves Russians it would necessarily involve Gaszprom. Here is where things are getting slightly more complicated. If Gazprom gets its hands on the gas find it would seal a huge hold on Europe's energy supply. Having an almost monopoly on Europe's energy is a stated goal for Gazprom. Currently it is the biggest supplier and Merkozi were planning to break that monopoly using Cyprus's oils and gas.

·         In other words, Cyprus is possibly playing a high stake game. Getting help from Russia should in principle upset Europe greatly. An issue here is whether the guys doing the negotiations are versed into international relations and politics or just excel spreadsheets. They are different languages.
Plan 5. Cyprus decides to go alone. The banks are declared bankrupt.

·         Not having a banking system in a country that derives most of its income from banking services is not ideal, it is a disaster. Presumably then the deposit guarantee would kick in. Thus the government would be liable for some 30billion. However, everything would depend on the depositors. Would they ask for their money back or would they trust and help the government by not withdrawing it immediately. The same goes for the foreign depositors (20billion out of 68).

·         By far the most important player here is the ECB. The island's banks currently depend on the ELA mechanism (apparently around 17billion). The next ECB governors meeting is on the 28th March. It is then that they can lift their approval and stop the ELA causing chaos to the banks. Effectively, Cyprus has till the 28th to find a solution and a compromise.
If they fail to find an alternative source of funding and the ECB pulls the plug we have the next case.
Plan 6. Cyprus decides to exit the Eurozone

*      Exiting the Eurozone is the last option the Cypriots have. There are plenty of known unknowns for such a move and many more unknown unknowns. There are no standard procedure in the EU but we can describe some principles

            All euros that are in banks are converted to NCYP (New Cypriot Pound). Also all physical notes are stamped. All the contracts that were drafted under Cypriot law would also convert to NCYP.

            The ELA holdings would also convert to the NCYP since the ELA is the liability of the state of Cyprus.

            ECB repo. The assets that the ECB holds as collateral would almost certainly be passed on to the ECB. Any losses would have to be written down. Here of course is the important difference with Greece. The losses would not bankrupt the ECB, they are manageable. Those bonds that are German, for example, are already held by the German central bank. However, any Cypriot assets would probably be worth less (in CYP) so Cyprus would have to pay the difference (in the future).

Is this a good solution? Well, it all depends on the response of the people and the international investors. If Cyprus is manages to save their business model and protects its services then the immediate drop in the GDP that an exit would cause may be reversed in a short period of time. Also the future receipts from energy may help propel Cyprus to a leading position in the region.

The other side of the coin is not very shiny either. If there is a run on the banks and also of the international investors, then the business model would be dead. There are plenty of alternatives and Malta is already picking up customers from Cyprus. In this case, there would be no rebound and not much of a prospect for the next 3-5 years or till gas is pumped. Finally, this is a rather risky political scenario. Cyprus needs to have strong geopolitical alliances to survive in this very dangerous part of the Med. It is a small country and sovereignty is only as good as your friends and allies. Relying on Greece has historically proven a bad choice. Cyprus chose to align its future and interests with those of Europe. If it re-aligns outside Europe it would be a major shift in the international relations of the region at a period of intense change and turmoil.

In my view Cyprus's future is brighter within the EU and EZ.  One can only fight for a change from within. This is not an easy but a brave path.


Although the size of Cyprus's financial woes are not a cause of much market or financial concern, the political ramifications for the government already in a rescue program or soon to be rescued are significant. Furthermore, the EU has shown remarkable short slightness for the wider international consequences a re-aligned Cyprus outside the EU would have both for Europe but also for the Middle East. Europe seems to be oblivious to the wider role it has been asked to play. One has to remember that one of the reasons Germany did not win the WWII was not the lack of military power, but because it failed to comprehend that a world war needs a lot more than sheer force.