Was the Cyprus haircut better than we think?

14 February, 2014 | Posted By: Financial Mirror

Was the Cyprus haircut better than we think?
GUEST OPINION: By Euronomist

The most startling development of 2013 was probably the Cyprus deposit haircut, an unprecedented event which caused numerous reactions around the world. In March, the Eurogroup came up with Plan A, i.e. to writedown or “haircut” all existing depositors, regardless of institution or the amount of money in their accounts, at a flat rate of 6.75%; a decision which the Cypriot parliament rejected. After two long weeks of bank "holidays" and intense negotiations, the plan changed to the dissolution of Laiki Bank and the haircut of all deposits above 100,000 euros in the Bank of Cyprus (the final amount of the unsecured deposit haircut was 47.5% as agreed in late July).
My reaction to the first plan was that it was unfair: a person with EUR 10,000 in his bank account would suffer more than a person with EUR 10 mln in his after a 6.75% cut. The second plan still seemed unfair but had the advantage that depositors in other banks would not be hurt and that the "little guy" would remain unscathed. Obviously, the "big boys" still get hurt, which means less investment and less growth, equaling more unemployment. Yet, there is actually much more good in this than was first considered.
First of all, the ones which got hurt more in the crisis were not CEOs or other businessmen; it was paid employees. Have a look at the table compiled by the Economic Policy Institute for the US:

As the reader may observe, in 2011-2012 the average worker compensation shrunk by 1.6% while average CEO compensation increased by more than 14%. What this indicates is that high-income earners do not get hurt by much during a recession. The average paid employee does, as similar data from Spain have shown. The simple reason is that the worker goes out first and the businessman continues to operate; most importantly it is the latter that makes the decision not the former. Even when a recession begins to fade, the businessman can exploit the situation and earn much more than before since wages are much stickier than profits (as also seen in the 2013 results of US firms).
The trouble with the Cyprus Plan A, i.e. the haircut on both secured and unsecured deposits, is that the former (i.e. secured depositors) would have been more prone to the use of their wealth than the latter. As Simon Kuznets has shown back in the early 1950s, the higher the income, the less percentage of your income you spend. This means that most of the money a low- or middle-income worker earns will end up back in the economy in the form of consumption. On the contrary, the money a high-income person earns are employed differently: if you take away from him, his consumption will not be reduced by as much for the simple reason that he will just save less. Since the economy is mainly driven by consumption (it comprises of the largest part of GDP) if it decreases, GDP will also be decreased.
An additional benefit of the haircut is that since the bank recapitalisation needs are covered through the bail-in of unsecured deposits, the state does not have to assume more debt. This means less decrease in state expenses (i.e. wages, pensions, development) which again force the drop in consumption to be less than what it would have been if severe austerity measures had been assumed. If anyone doubts what the effect of austerity measures on consumption and GDP is, have a look at what has been going on in Greece over the past four years.
Obviously, the haircut has many caveats: unemployment has reached 17% (the third highest in the Eurozone) and the already declining confidence in the banking sector was exacerbated, meaning that individuals prefer to keep their money under the proverbial (in this case even literal) mattress than deposit it. This can be easily seen in the data, with total deposits following a downwards trend since March, forcing the banks to request liquidity from the ECB. Yet, this is a short-term effect since keeping money under the mattress does not really work for too long. As the IMF points out, this exit of deposits appears to have reached its peak, with the overall amount in the system stabilising in October. NPLs are still a major cause of headache, yet an increase in consumption, in addition to the banks' increased ability of issuing of new loans due to higher equity ratios means that better days are ahead.
Summing up, the haircut on unsecured deposits is much fairer than first considered. It hurts those with larger wealth, who spend much less of their income (as a percentage) than those who are on the other side of the spectrum. This means that consumption is less affected by the haircut than by austerity measures. In addition, the state assumes much less debt, as bank recapitalisation is completed via the bail-in.
I am not suggesting that these outcomes were deliberate and that the EU authorities had actually considered them before conducting this experiment on Cyprus. Yet, the experiment turned out to be much better than the previous ones in Greece, Spain and Ireland.
We should not forget that the deposits haircut eliminated uncertainty, a state much more horrid than the actual outcome, as it discouraged investment and development. Add this to the less-than-expected decrease in consumption and you have that Cyprus has a better chance of experiencing growth faster than other countries is recession; since demand does not fall, employers have less incentives to fire people and businesses have greater incentives to invest.