Euro Lessons Unlearned as Blunders Mar Cyprus RescueJames G. Neuger
As Greece lurched toward its first bailout in early 2010, the largest bank in Cyprus was stocking up on Greek bonds.
That lethal misjudgment helped drive the government in Nicosia toward a rescue of its own, a 10 billion-euro ($13 billion) project involving measures so novel -- beyond an unprecedented raid on bank deposits that sparked a global uproar -- that policy makers initially kept them under wraps.
Neither a plan for Cyprus to sell gold reserves nor one to repay a loan from the Cypriot central bank with real estate was disclosed in a statement by euro-area finance chiefs in the early morning hours March 16. The measures were cited by Jeroen Dijsselbloem of the Netherlands, the group’s chief, in a confidential recap, which was obtained by Bloomberg News.
“It’s clear they’re making stuff up as they go along: every bailout is different in an unexpectedly horrible new way,” Alexander Apostolides, an economics lecturer at European University Cyprus in Nicosia and a member of the Cypriot government’s economic-advisory council, said in an interview. “They’re not really thinking ahead.”
With another small country, Slovenia, fighting to avoid the euro region’s sixth bailout, the Cypriot misadventure raises the question of how much policy makers have learned in more than three years of straining against the debt crisis.
Hemmed in by an election campaign in Germany, along with demands of the European Central Bank and the International Monetary Fund, policy makers are fighting record unemployment, a second year of recession and austerity and bailout fatigue to keep the 17-nation currency bloc whole.
European Union leaders say the shock to the euro has sparked a drive to build new institutions mirroring the effort that followed World War II. Since the Greek panic broke out, the EU has established two rescue funds, passed eight economic-governance laws, enacted a deficit-limitation treaty, held 24 summits, and ginned up at least one “roadmap” and a “blueprint” for a better-run monetary union.
And yet, once Cypriot banks were reeling from the German-instigated decision in October 2011 to slash Greek bond values in the biggest sovereign debt restructuring ever, the crisis-management apparatus sputtered. Until two late-night bargaining sessions in March 2013, little was done for Cyprus, though it makes up barely 0.2 percent of the euro economy.
With her voters’ anti-bailout sentiment a risk to her winning a third term, German Chancellor Angela Merkel, Europe’s dominant politician, kept Cyprus at arm’s length. Her website shows no evidence of her publicly addressing the aid talks until January, and then only because she was asked in a briefing with the prime minister of Malta.
“While Angela Merkel needs to be strongly committed to the euro and strongly committed to the monetary union, domestically she cannot convey the message that she’s willing to help anybody,” Arturo Bris, a professor of finance at the IMD business school in Lausanne, Switzerland, said in an interview. “At the same time, there’s nobody else left.”
The powers in Europe -- centered on the German government in Berlin, the European Commission in Brussels and the central bank in Frankfurt -- blamed the lost time on the Cypriot political class for refusing to bow to the pain and retrenchment that come along with a rescue program.
More than ever before, the political logjams put the spotlight on the central bank as the ultimate guarantor of the euro’s survival. For now, it has held the currency together with a confidence trick, promising in July 2012 to unleash its bond-buying firepower on behalf of troubled countries that submit to economic discipline.
Still opposed by Germany’s central bank, ECB President Mario Draghi’s virtual intervention has defused tensions in European markets, sending bond yields in Italy, Portugal and Spain to their lowest since before the crisis.
It was little help to Cyprus.
Before pleading for financial mercy, Cyprus had a reputation as an EU troublemaker. It joined the union in May 2004, as part of the bloc’s post-Soviet eastward enlargement. Only the internationally recognized, Greek-speaking southern half of the island entered, after rejecting reunification with the north, occupied by Turkey’s army since 1974.
At a stroke, the EU -- which in 2012 would win the Nobel Peace Prize for tearing down national boundaries -- imported a border dispute. Cyprus, once prized by the British for its strategic position in the eastern Mediterranean, frustrated Turkey’s efforts to join. As the EU-Turkish question faded from the headlines, so did Cyprus.
As a result, the fate of the 862,000 Cypriots was on few radar screens after the October 2011 summit. Europe’s crisis managers were preoccupied with Greek Prime Minister George Papandreou’s planned referendum on the aid conditions, leading to a precedent-setting threat by Germany and France to boot Greece out of the euro; then came the death throes of Silvio Berlusconi’s government in Italy and the Spanish bank rescue.
The Greek writedown was a “terrible mistake,” Athanasios Orphanides, then head of the Cypriot central bank, said at the time. Europe’s leaders tacitly agreed, labeling Greece a “unique” case.
They weren’t the only ones at fault. Bank of Cyprus Plc built up an inventory of Greek government bonds after Greece’s fiscal woes became known. Its holdings rose from 100 million euros on Dec. 10, 2009, to almost 2.4 billion euros by June 2010, according to a March 2013 report commissioned by the Cypriot central bank by consulting firm Alvarez & Marsal that was obtained by Bloomberg News.
In November 2011, the IMF estimated Cypriot banks’ losses on Greek bonds at 2.7 billion euros. The banks’ total capital needs were put at 3.6 billion euros by the European Banking Authority, equivalent to about a fifth of the wealth produced annually in the island’s economy. There was no hiding the need to pump more money into the banks.
At this point, Cyprus’s Communist President Demetris Christofias -- a Russian speaker and holder of a doctorate in history from the Institute of Social Sciences in Moscow -- made a diplomatic misdirection play. He turned to the Kremlin for a loan, hoping to parlay Cyprus’s economic relationship with Russia into more favorable terms than could be gotten from European creditors and the IMF.
With dual-taxation treaties turning Cyprus into a tax shelter for Russian individuals and businesses to reinvest back home, the financial links between Nicosia and Moscow were tight.
Cyprus is the top destination for Russian investment, pulling in $22.4 billion in 2011, according to the Russian central bank’s latest full-year data. The island with less than one-tenth the population of Moscow was simultaneously the prime investor in Russia, sending $13.6 billion there.
The revolving-door relationship made it a matter of course for Russia to grant Cyprus a 2.5 billion-euro loan in December 2011. It proved to be a time-buying arrangement that kept Cyprus off the European agenda, until the reckoning couldn’t be postponed any further and the costs, for the Cypriots and Europe as a whole, were higher.
The Cypriot strategy was to play Russia off against the EU. Vassos Shiarly, Christofias’s finance minister, made that clear in June, days before Cyprus asked for European cash: “Your negotiating position in talks with the European Union is much better when you have a bilateral loan already approved.”
It didn’t work out that way. By mid-2012, Brussels officials calculated that Cyprus would need a full-scale bailout including a loan for the government. As European officials pressed that case, Christofias squirmed to escape the economic vassalage of a full program. Selling off state assets and downsizing the banks were, for him, non-starters.
In 1995, banking and insurance generated 4.9 percent of Cypriot gross domestic product, according to European data; that figure rose to 6.5 percent in 2004, when Cyprus joined the EU, and 7.8 percent in 2008, when it adopted the euro. By 2011, Cyprus was deriving 8.9 percent of its output from finance, compared with the euro-area average of 5.1 percent.
For a long time, European authorities weren’t bothered by the shift toward financial services, which helped bring Cyprus’s per-capita wealth up to the European average in 2009. The Brussels-based commission, the guardian of the euro’s laws and regulations, authorized Cyprus in 2007 to make the currency switch partly because the island’s banks were “substantially interlinked” with the rest of Europe.
Nor did the ECB raise the alarm. While its pre-euro assessment made a passing reference to the emergence of a current-account deficit and the inflow of “non-resident” deposits in Cyprus, the central bank confined its non-binding policy prescriptions to a call for debt reduction, wage moderation and product and labor-market reform. Similar off-the-shelf recommendations went to other countries.
Not until late 2011, as part of the crisis-driven tightening of economic oversight, did the commission gain the power to monitor “imbalances” such as asset bubbles and punish countries that fail to correct them. And by the time it warned in February 2012 of “wide-ranging challenges” in Cyprus, including the banks’ susceptibility to Greek losses and a debt-swamped private sector, it was behind the curve.
Several months of shadow boxing pitted the Cypriot government against experts from the “troika” of the commission, the ECB and the IMF. With polls showing his party doomed to defeat in February elections, Christofias worked to put off the national humiliation on his successor. The Finance Ministry relied on short-term borrowing to postpone bankruptcy.
Parallel negotiations over a retooled Greek program poisoned the atmosphere, reminding northern European creditors of unmet pledges in the south. Demands by the IMF also rankled. The fund, headed by Christine Lagarde, who started the crisis as French finance minister, pushed for a writedown of official loans to Greece -- a no-go for the German leadership.
IMF insistence on bringing Greece’s debt down to a “sustainable” level made a deal on Cyprus harder to achieve. Creditors were contemplating loans of 17 billion euros for Cyprus. While that would be the smallest package so far in raw numbers, it would be the biggest in relative terms -- roughly 100 percent of Cypriot GDP. It was hard to see how Cyprus would pay those loans back.
What was later described as “guinea pig” treatment by the new president, Nicos Anastasiades, was only getting started.
As European creditors and the IMF scuffled over Greece, bailout fatigue took on new forms in Germany. Spurred by a leaked German secret-service report that the opposition Social Democrats were elevating into an election issue, Finance Minister Wolfgang Schaeuble questioned how much of the Russian money sitting in Cypriot banks was on the level.
The stage was set for something the ECB’s Draghi would later call a “not smart” innovation: shaking down all Cypriot bank customers, rich and poor alike, to pay for the rescue.
Cypriots woke up on March 16 to the news of a “stability fee” of 6.75 percent on insured accounts under 100,000 euros and 9.9 percent on larger, uninsured sums -- the product of all-night Brussels talks that national, European, ECB, IMF and Cypriot officials all claimed wasn’t their idea.
“Accountability does exist, but it is often hard to read,” EU President Herman Van Rompuy said at an April 22 conference in Brussels. “I can understand people wonder: who exactly is politically responsible? Who is democratically accountable?”
The message went out that European-mandated minimum deposit insurance, boosted from 20,000 euros in 2010, wasn’t credible. An extended bank holiday was all that prevented the Cypriot financial system from collapsing.
As the recriminations flew, the Cypriot parliament vetoed the tax, compounding the disarray and starting the countdown toward the doomsday scenario of an unprecedented exit from the euro. A failure to reach a deal would have led the ECB to cut the lifeline of Cypriot banks, starving the country of European cash and forcing it to come up with its own medium of exchange.
While the ECB has backstopped European bond markets since 2010, lent unprecedented amounts to commercial banks and announced the still-unused “unlimited” bond-support program in 2012, the endgame on Cyprus took the politically independent central bank further away from its comfort zone than it had been before. The institution that owed its existence to the euro was one step from pushing a country out of it.
In the end it didn’t have to, thanks to an unwritten European rule that a problem has to become existential before it can be solved, often at an all-night head-banging session. In Cyprus’s case, the solution came at 2 a.m. on March 25, when finance ministers approved a revised package that scrapped the tax on uninsured accounts and instead liquidated state-owned Cyprus Popular Bank Pcl, the country’s second-largest bank.
What wasn’t disclosed added to the confusion. On March 18, two days after the original deal, Dijsselbloem, the chairman of the euro meeting, cited two unpublished elements of the deal -- the sale of Cypriot gold and the redemption of a loan from the Cypriot central bank.
The gold sale didn’t become public until April 10, when a commission analysis sent to German lawmakers showed Cyprus would unload “excess” reserves to raise around 400 million euros.
The central bank loan was itself an anomaly, dating to 2002, before Cyprus became subject to euro rules barring monetary financing of governments. Neither the gold sale nor the use of state-owned real estate to pay down 1 billion euros of the 1.4 billion-euro central bank loan feature in early drafts of the memorandum of understanding between Cyprus and its creditors.
Coen Gelinck, a spokesman of the Dutch Ministry of Finance said that while that no official announcements were made on those measures, “we did not withhold any information.”
“We have not done everything right,” Jose Barroso, the commission’s president, said April 22 in Brussels. “We have not been able collectively -- the European institutions, the member states -- to explain really what was at stake and to build the necessary support.”