Cyprus II: Considerable Improvement, but Serious Risks Remain

We can heave a sigh of relief about the revised Cyprus deal. Early this morning, Cyprus, the various European authorities, and the IMF found common ground on the outline of a deal that is much better than the very flawed agreement of the previous weekend. At the same time, the earlier botched proposal will carry some long-term costs and the actions taken now, while necessary, create real risks of their own.

The best news is simply that an agreement of any kind was reached, allowing European support to flow to Cyprus and preventing, for now anyway, the possibility of an exit from the eurozone. It is also very good news that insured bank depositors in Cyprus will be protected after all, eliminating a terrible precedent with repercussions across Europe. Further, there are real advantages to inflicting large losses on the uninsured depositors and the bondholders of the two largest Cypriot banks. This is by far the strongest message Europe has ever sent that people must pay attention to the strength of the banks with which they deal. It brings the hope that market discipline will finally be a significant aid to outright regulation in ensuring that European banks act prudently at all times.

The first risk is the flip side of passing losses on to those who put their money in banks. In practice, Europe has a long tradition of protecting all depositors, not just the insured ones, and, in most cases, the bondholders as well. For example, the much vaunted, and highly successful, Swedish bank rescues included guarantees for all liabilities. Over time, in reaction to this, there may be major flows of deposits from the weak banking systems in Europe to the stronger ones, further exacerbating credit crunches in the periphery. The ECB and national central banks can offset these flows, but only with further distortions that carry costs of their own. Weaker banks, and those in weaker countries, will find their borrowing costs rising on bonds as well, as investors take heed of the lessons of Cyprus. Even banks in strong countries are likely to see costs increase over time, as depositors and investors react to this major change in regulatory regime. These costs will generally be passed on to customers, potentially slowing economies down at least modestly further. (The ECB can partially counteract this effective tightening of credit conditions, but it is already close to “pushing on a string”, hitting conditions where it is difficult to ease further and have any effect.)

The second problem is that we cannot “unring the bell” of potential hits to insured depositors. The first Cyprus deal raised the real possibility that insured depositors across Europe could lose money if their banking systems and national governments became too weak. The strong reactions to this, and its complete elimination from the final deal, reduce this damage considerably, but it will remain in people’s minds. If there is another serious banking crisis in a weak eurozone nation, depositors may be more prone to move their funds to safer banks and safer countries, in a classic bank run.

The remaining risks are about Cyprus itself. The economy will be severely damaged by the deal and the turmoil around it. A severe recession will be exacerbated by the losses taken by businesses and others with large, and therefore uninsured, bank deposits, and by the restrictions on banking transactions that may remain for some time. Confidence, of course, has been badly shot. Further, nearly a fifth of the Cypriot economy consists of financial services, a sector that will shrink very sharply now. There will also be other conditions imposed on Cyprus as part of the larger agreement with the eurozone and the IMF that will likely hurt in the short run even if they may be for the best in the long term.

It is going to be extremely difficult for a fast-sinking Cypriot economy to produce the results necessary to hold the country’s debt down to a sustainable level. Thus, we are being set up for a future round of tense negotiations to either bring in more eurozone support or take drastic actions such as a bond default, similar to Greece’s. Such a default would carry at least some contagion risk for the rest of the eurozone, unless the larger crisis is essentially resolved by then.

In short, there is no cause for real celebration, but there is reason to feel relieved that disaster was avoided and some of the ill effects of last week’s debacle have been erased. The initial market reactions seem about right; they are up after the weekend’s news, but not soaring.