Friday, March 29, 2013

Cyprus solution is band-aid, not cure

Another crisis, another half-solution, another sigh of relief. When will the Eurozone stop rattling financial markets? Not in the near future, I guess.

In Cyprus, those concerned- the EU, the ECB, the IMF and the government of Cyprus- had the sense to rework a badly flawed proposal and come up with something that seemed to pass muster. But this does not mean the Eurozone problems have gone away. Indeed, the approach in Cyprus raises serious questions about what would happen if problems in Spain, Italy or Portugal reared their head again.

The total cost of the bail-out is € 17 bn. The absolute amount is so small that the EU could easily have underwritten all of this. But voters in Germany won't stand for it- they want to see citizens in the distressed economies suffer for their past sins. So, Cyprus had to bear some of the pain. The issue was what form it should take.

Mercifully, the insane proposal to penalise insured depositors- which mean a straight flouting of the EU-wide guarantee- was given up. Instead, Cyprus agreed that their share of the burden-
€ 5.8 bn- would fall on large deposits (those over € 100,000). In return, the EU would hand Cyprus 
€ 10bn. 

What are the implications? First, Cyprus has imposed capital controls, which goes against the principle of an economic union.  These controls are supposed to be "temporary" but we all know what that means. Secondly, and more importantly, the principle of bailing in creditors has been carried farther than in the case of Greece. In Greece, bond-holders suffered a hair-cut; here, uninsured depositors have been included. 

You might say this is fair: creditors should suffer in any bankruptcy (after shareholders), not tax payers. Not accepting this principle gives rise to moral hazard, which has been the bane of banking. But there are costs to this approach. First, Cyprus' banking system will shrink. Make no mistake, this means that GDP will shrink. What happens to the debt to GDP ratio then? How does the Cyprus solution solve the basic problem of sovereign indebtedness?

Secondly, how would depositors in other troubled economies, such as Italy and Spain, respond? Can we expect a flight of deposits to safer economies? What does this mean for recovery in Italy and Spain? Lastly, in the case of Greece, bond-holders were told that the losses they had to take were an exceptional case. It now turns out that this is to be the norm. What does this mean for the cost of raising subordinated debt for banks in Europe? Debt is going to become more expensive and this will translate into higher costs for borrowers. Also, at the first hint of trouble, bondholders will flee. Again, growth will be a casualty.

Granted, all stakeholders in banks will have to suffer the burden of adjustment in what is fundamentally a banking crisis. But the burden has to be distributed not just among bank shareholders, creditors, taxpayers and the citizens of distressed economies. Taxpayers elsewhere in Europe - and indeed the rest of the world- have to chip in if stability and recovery in the Eurozone are to be facilitated. Banks in Europe have to be recapitalised and the costs of recapitalisation must be universally shared, albeit in differing degrees. 

FT has a good article on the balance to be struck between moral hazard and systemic risk and resolving banks.  

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