September 24, 2020

Political Economy: Cyprus Refuses to Learn From Its Mistakes

Cyprus will pay dearly for its sins. The Mediterranean island has committed many follies over the years — and is still making mistakes.

The Cypriots always seem to overestimate their negotiating position. In recent years, their first big mistake was to reject in 2004 the U.N. plan for uniting their island. That irritated their E.U. partners, put Cyprus in a weak strategic position vis-à-vis Turkey and left a jagged scar across the island.

The last Communist government was also virtually criminal in its failure to act as the crisis in Greece threatened to swamp Cyprus. If it had been willing to restructure the banks, the Cypriot economy would now be a lot healthier. It also would have been easier to make a deal with Germany then than now, when Angela Merkel is only months away from an election.

The new center-right president, Nicos Anastasiades, has been in office for a month. But he has managed to turn a crisis into a disaster by initially backing a plan to impose a 6.75 percent tax on insured depositors.

Of course, the other euro zone governments, the European Central Bank and the International Monetary Fund should not have approved this terrible idea either. And Mr. Anastasiades certainly had a gun to his head: He had to rustle up money somehow, as the euro zone was rightly unwilling to lend Cyprus more than €10 billion, or about $13 billion, leaving the country with a €5.8 billion funding gap.

But the Cypriot president is ultimately responsible for his actions. There was an acceptable alternative: Tax the uninsured depositors at 15.5 percent and leave the insured ones untouched.

Mr. Anastasiades did not want to do this, as it would have angered Russia and undermined Cyprus as an offshore financial center. But both of these have happened anyway.

When Mr. Anastasiades found he could not sell the deposit grab to his people, he backtracked. There was jubilation in the streets.

The Cypriot government then asked Russia for help. But again Nicosia overestimated its negotiating position. Moscow was not interested in buying bankrupt banks or lending more money. Michael Sarris, Cyprus’s finance minister, was sent home empty-handed.

Meanwhile, the E.C.B. has threatened to pull the plug on insolvent Cypriot banks unless there is a deal with the euro zone by Monday night. As of Sunday morning, the government was frantically trying to put together a deal focused on restructuring its banking system and imposing capital controls.

The banking system certainly needs a severe revamp. The second-largest lender, Laiki Bank, is essentially bust. The largest one, Bank of Cyprus, is not in much better shape. Controlled bankruptcy of one or both institutions would cut the amount of capital Nicosia has to pump into them while cauterizing the problem.

But imposing capital controls would be a historic mistake for Cyprus and the euro zone — even worse than the crass idea of taxing uninsured deposits. Noncash transactions would be limited, while withdrawals from cash machines would be rationed.

This would be equivalent to Argentina’s “corralito,” which lasted a year in 2001-02. If capital controls are imposed, it will be almost impossible to lift them because people will stampede for the exits once they are removed. But such heavy-handed rationing of limited cash would clobber an economy that is already heading for a slump.

It would also be a terrible precedent, probably contravening European treaties. Savers in Italy, Spain, Greece and other vulnerable euro zone countries might worry that they would be next and rush to remove cash from their banking systems. Capital controls really might spell the beginning of the end of the single currency.

Some of the technocrats trying to save Cyprus were belatedly waking up to such dangers over the weekend. But they were struggling to find a viable alternative. After all, if Cypriot banks open Tuesday morning without capital controls, there will inevitably be a run on deposits.

The least-bad solution is for the European Central Bank to offer to supply unlimited liquidity and finance a run. For it to do this within its rules, the banks must be properly recapitalized and have sufficient collateral.

The key is to separate the rotten parts of the banking system from the good ones. The uninsured depositors can then go with the bad banks and effectively be tied up until they are wound down. This will cut substantially the liquidity that needs to be provided to the system. Nicosia has effectively accepted such a solution for its second-largest bank, but was resisting doing so for the biggest one.

Provided a good bank/bad bank split can be agreed upon, the good banks will be in a healthier position to get liquidity from the E.C.B. or Cyprus’s own central bank. If they still do not have enough suitable collateral, the E.C.B. should change the rules to allow other types of assets to be accepted. If there is still a shortfall, the good banks should be allowed to manufacture collateral by issuing government-guaranteed bonds.

The Cypriot members of Parliament will not like any of this. But what is the alternative? Endless capital controls? Printing a parallel currency so people get Cypriot pounds instead of euros from the cash machines? Or quitting the euro entirely?

There are no good options. But the longer it takes for Cyprus to get real, the greater the damage.

Hugo Dixon is editor at large of Reuters News.

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