The Cyprus debt crisis: Capital Flows and Debt Restructuring
A key question for policy makers in Cyprus is whether there should be controls in the flow of capital out of the country, when the banking system re-opens for business. The laissez-faire approach says that banks open without any capital controls on outflows. If deposits flow out, then the European Central Bank (ECB) provides unlimited liquidity through the emergency liquidity assistance (ELA) scheme, confidence returns to the system and life goes back to business as usual.
How risky is the laissez-faire approach in this instance? We think it is risky enough that it should be avoided. We expect large deposit outflows when banks open. Russian depositors alone (individuals and businesses) are around 20 billion euros (before any conversions to bank equity). We know that the ECB will provide this liquidity through ELA to “solvent institutions”. We do expect a strong recession in the coming year, with non-performing loans (NPLs) rising quite rapidly. The biggest bank in the country (Bank of Cyprus) has been saddled with around 9 billion ELA resulting from the sale of the Greek branches of the three main Cypriot banks and the latest Eurogroup decision. As a result, it has limited ability to increase its ELA. If deposits flow out at a massive scale, one can build a scenario where the Bank of Cyprus suffers a liquidity crisis. It will then depend on the ECB to interpret whether the bank is solvent or not, when deciding whether to provide ELA. Given the worsening macroeconomic environment, it is possible that the ECB decides that the bank is not solvent any more and therefore switch off ELA. We therefore think that this is a risk that policy makers should not take. Losing one systemically important financial institution (SIFI) like Laiki in 2013 will worsen the recession. Losing the biggest SIFI, Bank of Cyprus, at this point will just make economic recovery in the next few years close to impossible. We think that, from a risk management perspective, free capital outflows is a risk not worth taking at this specific point in time.
We realize this is problematic in the Eurozone and there are other risks associated with a business environment that imposes controls in capital outflows but we think this is the prudential policy right now. Capital inflows can be unrestricted (both in and out after they are in) and the exit strategy will have to relate to the gradual decrease of ELA. We do not know what the optimal amount of ELA has to be but we think this should not be at levels that exceed macro-prudential requirements. ELA is supposed to be an instrument used during emergencies and emergencies cannot last for many months, let alone years. We therefore think that dependence on ELA needs to be gradually reduced as deposits flow back into the system. That should determine the exit strategy for capital controls.
The second important policy challenge in the coming months is the repayment of Cyprus sovereign debt. Under the agreement to be signed with the Troika, Cyprus will receive a loan of 10 billion euros. Seven tenths of that are earmarked to repay fully outstanding sovereign debt expiring in the next three years and three tenths covers projected budget deficits in the next three years. The local (English) law sovereign bonds give the right to 75% of the bondholders to call a meeting to change the payment structure of the bonds. If 75% of the debt is held by local banks, for example, and they decide to voluntarily restructure the debt maturity and payment structure, then the liquidity needs of the sovereign can be stretched out over a period of years without affecting the present value of the bonds (and their value in the banks’ balance sheet). In this way the government will not need all seven billion euros, and the debt to GDP ratio will suddenly become a lot more sustainable.
Recognizing that we have omitted a lot of details in the above recommendations, but at the same time wanting to contribute urgently to these debates, we hope our suggestions will generate a useful discussion to better inform policy makers in Cyprus.
Apostolides Alexandros4, Alexandros Michaelides1, Andreas Milidonis1, Bernard Musyck3, George Nishiotis1, Marios Zachariadis2, Stavros Zenios1
1 Department of Accounting and Finance, University of Cyprus
2 Department of Economics, University of Cyprus
3 Department of Accounting and Finance, Frederick University
4 Department of Accounting and Finance, European University Cyprus