The Cyprus banks and the budget: how close are we to the cliff?

ANALYSIS: By Fiona Mullen

If I had been given a euro (or preferably a Swiss franc) in the past six months every time I was asked by friends, colleagues or journalists whether Cyprus was going the way of Greece, I would be a rich woman.
The number of queries peaked last week, when there were doubts that EU leaders would hammer out a deal on Greece and the Central Bank Governor, Athanasios Orphanides, had warned that without “further and more drastic measures” Cyprus (like Greece) could find itself entering a support mechanism.
So how close are we to the cliff? To answer this question, we have to look at both the private sector banks and the government budget, so let’s start with the good news by looking at the banks.

Greek “default” is less than feared
The good news is that the agreement of the EU leaders last week, while not solving Greece’s debt problems forever, provides a breather for all those who have lent either to the Greek government or to the Greek private sector, including the Cypriot banks.
According to data released for the EU-wide stress tests, Bank of Cyprus (BOC) and Marfin Popular Bank (MPB) together hold EUR 5.8 bln in Greek sovereign debt. Separately Hellenic has reported that it holds only around EUR 110 mln.
So, the first relief is that the hit that will be taken by the private sector at this stage is around 21%–much less than the 50% some expected.
The Financial Times said that the weighted average Greek debt to 2020 was trading at 60 cents to the euro, implying that the market feared a haircut of around 40%.
The precise loss has yet to be worked out by accountants but for the purposes of this scenario, the working assumption is that the cut is around 20%.

Banks have both capital and cash
As the table shows, a 20% haircut on Greek sovereign debt, if all of it has to be taken off Core Tier 1, allows the two main banks to maintain healthy capital ratios: 6.3% for BOC and 6.9% for MPB.
These are comfortably above the Basel II minimum of 4%, and above the Basel III minimum which will be 4.5% from January 2012, rising incrementally thereafter. However, they would fall below the new minimum of 8% set by the Central Bank of Cyprus from July 8.

The banks also passed the EU-wide stress tests published on July 15. This is because, under pressure from both a cautious Central Bank of Cyprus and financial markets, who worry about the banks’ exposure to Greece, the three main banks have been raising their Core Tier 1 capital ratios.
As of the end of March 2011, Bank of Cyprus had a Core Tier 1 ratio of 8.2%, up slightly from 8.1% at the end of December 2010. MPB had a Core Tier 1 ratio of 9.4%, up from 7.3% at the end of March 2011, according to Annita Philippidou, Group Chief Finance Officer.
She added that this was “because of the successful rights issue in February”, when MPB made a rights issue of EUR 488.2 mln.

The nightmare scenario
The banks would of course run into difficulty if a bigger haircut of, say, 50%, were combined with a sudden 10% default on Greek private-sector debt.
This could wipe out their Core Tier 1 completely, leading the banks to find around EUR 1 bln to shore up their capital.
If they had to find this from a government that finds it difficult to borrow abroad right now, they we would be in trouble.
But this seems unlikely. Only last Wednesday, when financial market panic was at its height, BOC raised EUR 700 mln in covered bonds and on Friday MPB raised EUR 300 mln. Together, therefore, they raised around half of their capital requirement in the event of the nightmare scenario.
Another potentially mitigating factor is that the Central Bank forces the banks to hold 70% of their non-resident deposits in liquid form. For the banking sector as a whole, that means there is EUR 14 bln of the EUR 20 bln in non-resident deposits just sitting around. One can imagine that if the worst came to the worst, the Central Bank might allow the banks to be able to use some of that to plug the gap.

The (government-induced) Armageddon scenario
So why does everyone think we have a problem?
The answer lies with the government. The Armageddon scenario would occur if the banks suddenly found themselves having to plug a gap caused by a large Greek sovereign and private-sector default at the same time as the government was calling on them for ever larger funds.
At present, with yields on ten-year bonds rising above 8%, the government is finding it expensive to borrow abroad, so was forced to borrow EUR 714.6 mln from local banks instead at the end of June.
This level of borrowing is not unknown but it was the first time that it borrowed so much at such long-term maturity from the local banks.
The government has to find another EUR 1.4 bln between now and the end of February just to cover maturing debt, plus perhaps another EUR 500 mln to cover the budget deficit in the second half of the year.
And then one has to add the costs of providing emergency electricity supply after the explosion at Mari on July 11 took out the main power station at Vassiliko.
My working assumption is that the whole cost of buying in short-term electricity and rebuilding Vassiliko will cost EUR 1.5 bln over three years, with EUR 300 mln in 2011, EUR 600 mln in 2012 and EUR 600 mln in 2013.
I am also assuming that the government will have to pay back most of the EUR 600 mln that it might get from insurers, who might pay upfront but could then sue immediately for culpability.
As the table shows, this would bring the public debt/GDP ratio to 78.8% of GDP in 2013, from 60.9% of GDP in 2010.

A narrow window to “differentiate ourselves” from Greece
Such a fast pace of debt increase would no doubt attract the unwelcome attention of international markets and rating agencies, therefore it is critical that the extra costs of Mari are offset by expenditure cuts elsewhere.
Jens Larsen, Chief European Economist at RBC Capital Markets, said on FT.com that the EU deal last week gives peripheral EU countries “time to differentiate themselves” from Greece.
The budget negotiations currently under way with social partners will tell us if that opportunity has been taken, or whether vested interests have pushed us over the cliff of Greece.