New data shows haircuts no longer necessary

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 * A retroactive deposit tax would be smarter *

By Fiona Mullen

The election of Nicos Anastasiades to the presidency has probably improved the chances of a bailout. But it has yet to bring consensus on how to ensure that the debt burden will be sustainable.
According to earlier (probably outdated) estimates, the debt ratio after a bailout could hit 140% of GDP.
A restructuring of the sovereign Eurobonds issued under English law is legally tricky, and the banks have little debt on their books to target.
Therefore a number of voices have started to suggest that a bail-in of uninsured bank depositors (“a deposit haircut”) is the “only” solution for debt sustainability in Cyprus.
Those making these claims need to look closer at the Cyprus economy. New developments suggest that a deposit haircut is not even necessary, let alone desirable.
First, despite a real GDP decline of around 2.4% in 2012, the government managed to reduce the budget deficit to 5% of GDP in 2012 from 6.3% in 2011.
Far more importantly for debt sustainability in the longer term, it cut the primary deficit in half to €222m. So Cyprus is just a couple of hundred million euro away from servicing its debt without external help.
And this is before the average 10% salary and pension cuts that were passed in late 2012. A 20% increase in Inland Revenue income for January and a budget surplus twice as big as last year are also positive signs.
Second, the Cyprus News Agency reported on 22 February that the investment firm Pimco had cut its estimate for bank recapitalisation to €8.9 bln from an earlier estimate of €10.1 bln.
When GDP is only €18 bln, this kind of adjustment matters.
On the basis of the smaller than expected budget deficit and the lower bank recapitalisation number, I cannot get my debt/GDP ratio forecast above 130%, even with an expected decline in GDP and revenues.
If the debt/ratio peaks at 130%, it means that Cyprus needs to find just €1.8 bln to bring the debt/GDP ratio below 120% of GDP – the threshold that the IMF may find tolerable.
The obvious target for raising this amount of money is not haircuts but privatisation. The Electricity Authority of Cyprus alone has insured assets of €2 bln. Now that Mr Anastasiades has the election behind him, he can be more open about this option.

Banking and business services are the only job-creators
Another reason why the deposit haircut is such a bad idea is that it will seriously damage Cyprus’ chances of paying the debt back.
As noted in a recent research report I co-authored for PwC with Marina Theodotou, exports of financial and business services accounted for 14.4% of GDP in 2011 compared with 10.2% for tourism. Financial and business services added jobs at a clip of 3.9% per year in 2007-11, whereas tourism shed them at a pace of 1.7%.
Kill the banking sector by making deposits untrustworthy (Cyprus lost €1.7 bln deposits in January on the basis of the haircut rumour), and you have wiped out the only sectors that have been adding (young, Cypriot, graduate) jobs in the past few years.

“Shrinking the banking sector” is a simplistic answer
The other proposal, to “shrink the banking sector”, is also simplistic and based on scant knowledge of the local economy.
The €70 bln deposit base (nearly four times GDP) is big because Cypriot deposits were attracted home by the lifting of foreign exchange controls in 2002-04, the tax amnesty in 2004, the greater feeling of security against possible moves by Turkey brought on by EU membership in the same year and euro adoption in 2008.
Domestic deposits grew by €18.4 bln between 2005 and 2012 while non-resident, non-EU deposits rose by €9.7 bln. Sure, some of those domestic deposits will be the Russian-born residents of Cyprus who number 10,520 according to the 2011 census. But the vast majority of the €43 bln domestic deposits are held by locals.
That is not to say that the domestic deposit base is not too large. It grew because there are few other places to put your money apart from land.
Since there has been no privatisation, there is a now moribund, bank-dominated stock exchange, since Cyprus has only just passed legislation on UCITS funds, there are no big investment banks (only one or two corporate divisions of household names), since the government only really started borrowing abroad from 2005, there is no liquid local secondary bond market.
And since the competition commission is toothless, just two banks dictate how finance is raised, namely at high lending rates (and equally high deposit rates, which also reduces the relative attractiveness of other investments). For all the above reasons there is also no venture capital.
Lack of competition from other sources of funds meant that, until they took their fateful decision to invest in Greek government bonds, Cypriot banks had no pressure to do anything other than conduct business the old-fashioned way: lending around 90% of their deposits on the basis of land collateral and making healthy profits on their wide interest margins.
So if the deposit base has to shrink, let’s not do it by scaring away investors and depositors. It needs to be done the smart way, by taking on the recommendations of bright young locals to create the foundations for innovation and new funding sources.

Retroactive tax a smarter way to “punish” Cypriots and Russians
However, we should also acknowledge that another reason the deposit haircut debate continues to rage is because of perceptions that Cyprus has a lax regime against money-laundering.
This is behind the prevailing view that, not only must someone other than the EU taxpayer pay (Russia), Cypriots must also be punished for their bad ways.
And this has now become a political imperative for Germany’s Chancellor Angela Merkel, who faces elections in September.
But there are plenty of other ways to satisfy EU concerns about money-laundering without destroying the banking system.
A retroactive tax on deposits above €100,000, as has been suggested, is one.
It satisfies the political need for a Russian-Cypriot scapegoat. But it also ensures that EU taxpayers get their money back.

Fiona Mullen is Director, Sapienta Economics Ltd. The latest Cyprus report is now available at www.sapientaeconomics.com .