Monday, 25 March 2013

Cyprus – A Solution That Makes The Problem Worse

What kind of a solution is it that makes the initial problem worse??? According to the details so far available, Cyprus is to effectively close one of its banks – Laiki Bank – and transfer the deposits of its savers with less than €100,000 to its other bank – The Bank Of Cyprus. In other words, they will create a bad bank, using Laiki Bank. The deposits under €100,000, therefore, now in The Bank of Cyprus, will be secured under the European Bank Deposit Guarantee. Deposits in The Bank of Cyprus over €100,000 will face a levy, possibly at a rate of 4%, some time in the future. In the short term, the deposits in Laiki Bank will face a levy of around 40%!!!!

The consequences of this are fairly predictable. Anyone who has lost 40% of their money deposited in Laiki Bank, is going to remove the rest as soon as capital controls are relaxed. That other 60% represents a considerable sum of money still. It means the original problem facing Cypriot Banks, of lack of liquidity will be made worse. Laiki Bank will then go bust. That means any other banks with exposure to it will be hit. British Banks are reported to have exposure of about €1 billion.

But, that also means that Cyprus will then need to go back to the EU and IMF for even more money to deal with the crisis that will ensue from that. Anyone, with money in The Bank of Cyprus or any other Cypriot Bank, seeing the inevitability of that will also be getting their money out in full as soon as possible, because if the 40% haircut on deposits in Laiki Bank is not enough, resolution of the further crisis will inevitably mean coming back for more of depositors money, and it will be unavoidable to take deposits under €100,000.

Given that one of the problems identified was the fact that Cypriot Banks had deposits equal to 8 times GDP, the consequence of such an inevitable large scale capital flight are obvious. Cyprus GDP is $22.5 billion. That means current deposits are around $170 billion. If we assume these deposits are split fairly equally between Laiki and Bank of Cyprus, then we would likely see $50 billion withdrawn from Laiki Bank, and pretty much all of the $85 billion in Bank of Cyprus. Preventing that means that capital controls would have to be in place for some considerable time. The longer they are in place, the more a lingering death will occur, as depositors take out what they can, whilst no one in their right mind will put money in.

The continuation of capital controls for any length of time will also cripple the Cypriot economy, because it means business cannot function. What business would risk having its payments paid into a bank account under these conditions? In fact, if you were considering buying a house in Cyprus why would you. If the house cost more than €100,000 you would risk losing nearly half that payment simply during the conveyancing process, as the payment went through the banks!!!! But, it also means that uncertainty and fear is increased across Europe, because the question must then be, who will be next, where next will such capital controls be imposed?

The answer to those last questions seems to be Luxembourg and other tax havens like the Channel Islands, as I pointed out – After Cyprus, Who's Next?.

But, if Cyprus then needs around €130 billion to cover the capital flight, how is that a solution for a problem that originally only required €17 billion? In the meantime its likely to turn Cyprus into a pre-banking economy, causing effectively a credit crunch of mammoth proportions, within Cyprus. That may be capable of being contained within Cyprus, but the contagion of fear, and the effect of large numbers of people removing their money from banks across Europe, and particularly from those tax havens cannot. Given the extent of exposure of Luxembourg, nobody in their right mind is going to leave their money in its banks, above or below the €100,000 limit.

There is no shortage of tax havens around the globe, where the problems associated with tax havens in the Eurozone do not exist. In fact, had Cyprus wanted to really build its economy around being such a tax haven, it would have been well advised to have stayed out of the Euro, and to have stuck with the Cyprus Pound. A tiny economy like Cyprus, could easily on that basis have dealt with its problems by simply printing the currency it needed to meet immediate liquidity needs, in a way that an economy like Greece could not.

It may be too late for Cyprus to follow that route now, but that does not stop money moving to those places that have. Apart from Switzerland, that is bad news for many of the smaller EU economies.


Yusef Asabiyah said...

Given that one of the problems identified was the fact that Cypriot Banks had deposits equal to 8 times GDP, the consequence of such an inevitable large scale capital flight are obvious. Cyprus GDP is $22.5 billion.

I'm not sure Boffy, but you may be in error here. Cypriot banks have assets of 8 times GDP. Bank assets are not the same as bank deposits. Bear in mind banks class loans as assets, not liabilities, as all other businesses do. In other words, the Cypriot banks have extended a huge amount of loans -- 8 times the GDP of the nation! Or maybe you can point out to me where I have this wrong. Great blog, as always.

Boffy said...


Actually,I think you are right. I think I did make a pretty basic error there. In fact, I was wondering myself the other day when I saw reports that suggested deposits were around €80 billion.

Its a problem with trying to respond to things quickly, and so making such basic errors, but no excuse.

Even so, the basic thesis of the argument remains , because it still means the deposits are around 3-4 times GDP, and you'd expect them to be moving out, and in fact there seems to be signs of that. In fact, I'm wondering to what extent the crisis itself was started with a bank run, as some of these depositors were tipped off about problems and started to withdraw back in February and early March.

The figures available certainly suggest that there were unusual outflows as early as February. That would tally with the proposed haircut now rising from the initial 40% proposed to up to 80%, as they find they have fewer available deposits than thought.

The point then is that if the actual assets are bad, and you'd expect Cyprus property prices, for example, will tumble, it will be even more impossible to cover redemptions. So, my point that what was a €10 bn problem has been turned into a much bigger problem remains.

But, thanks for pointing out the basic error anyway.

Boffy said...

I just wanted to make clear that the basic error was not that I was classing deposits as assets, but that in haste I'd failed to read the reports correctly, and thought they were saying that it WAS deposits that were 8 times GDP.

Of course, when banks assets rise, because of making loans, their deposits also tend to rise, because the way they make the loan is by also creating a deposit. The problem for Cyprus seems to have been in part that the deposits were not created in Cypriot banks. They were lending to Greece, by buying Greek Bonds, so the deposits were created in Greek banks.

A large part of Cyprus problem is the fact that Greece was allowed to default without it being classed as a default so Credit Default Swaps were not triggered. So Cyprus banks lost a large part of their loans to Greece without being able to recover it via insurance through CDS's.

The details of that need uncovering, and exposing, because it means that much of this crisis lies at the doors of the EU and IMF that imposed that deal.

Slovenia seems to be the next country being lined up for similar treatment, but from what I can see Luxembourg is the most exposed. According to Jim Rogers the other day, he has already started getting his company to shift funds out of Spain and Italy, and reduced his personal bank deposits to below the guarantee limit - not that that will hold when the shit hits the fan in a couple of months.

I saw a quick report on Bloomberg yesterday that I haven't had time to chase down, saying that Spain had seen a big fall in bank deposits in March.

With Basel III putting further pressure on banks, another credit crunch looks likely. Stock market valuations are highly extended, and at this stage of the Long Wave, I expect the Rate of Profit to start falling - though the volume of profit is likely to continue to rise - which means things are set for another large stock market correction, which is likely to see a further scramble for cash.

The global economy is growing again as part of the 3 year cycle. I ahd anticipated the EU would benefit from that too, but the austerity measures seem to have more than counteracted it, as they have in Britain. That means the relief that might have been gained from increased economic activity may not now appear, or will at least be delayed until the end of the year.

Yusef Asabiyah said...

Given enough rope, the capitalists will now hang themselves.

Boffy said...

Data yesterday showed that EU banks overnight deposits at the ECB had fallen below €100 bn for the first time since November 2011. My guess that is because depositors are taking money out of EU banks.

In other words, there could be a rapidly developing credit crunch again. Latest talk seems to be that Cyprus might be eased out of the Euro, given as predicted they now need to find a lot more money, and capital controls as again predicted keep being extended etc.

I doubt Capitalism is going to collapse as a consequence of this crisis. My guess is that in the end they will have to do what is necessary - probably after German elections - which is to mutualise debt and issue EU Bonds. Before then the ECB will probably have to ease the way by engaging in some kind of money printing on the scale of the Bank of Japan.

The Euro may fall close to parity with the dollar, especially as US QE may be reduced in a few months time.