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Cyprus: Shining the Spotlight Back on Europe

Michelle
Shwarzman

Invesco
Global Liquidity

For a while, it seemed as if investors could get away with forgetting about the eurozone sovereign debt and banking crises, especially since last year's commitment by European Central Bank (ECB) President Mario Draghi to do whatever it takes to keep the euro intact. That commitment and subsequent asset purchase program seemed to quell market fears and shore up investor confidence. But the banking crisis in Cyprus forced investors to snap out of their euro complacency. While the Cypriot crisis and resolution have not led to broader contagion1 in the periphery, it has introduced a new — and perhaps concerning — precedent in the management of the ongoing eurozone crisis. In this quarterly commentary, we discuss the evolution of the banking crisis in Cyprus, the proposed resolution and what this could mean going forward.

Years in the making: the crisis in Cyprus

Before delving into an analysis of the Cypriot banking crisis, let's take a step back and look at the evolution of crisis management in the eurozone. During the past few years, eurozone economies facing sovereign debt and banking crises required bailouts by the so-called troika — comprising the European Union (EU), the International Monetary Fund (IMF) and the ECB — to provide emergency funds. In return, nations were required to begin austerity measures to reduce budget deficits, formalize a deleveraging plan for government debt levels and recapitalize their banking systems. This led to formal financial support measures such as the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM) and the Outright Monetary Transactions (OMT) facility.

In 2012, the ESM provided loans to the Spanish and Greek governments to recapitalize their banking systems rather than lend the funds directly to the banks, which added to sovereign government debt levels. As part of its bailout package, Greece completed the largest sovereign debt restructuring in history, in which Greek government bondholders exchanged their bonds for approximately 54% less debt in a voluntary exchange known as Private Sector Involvement (PSI).2

This leads us to the origins of the crisis in Cyprus, which was years in the making. Cyprus had grown its financial sector and its reputation as a financial center for several decades. It has a robust framework for the rule of law and a well-educated workforce. Importantly, it established double-taxation treaties with several countries, including Russia, stipulating that if profits are taxed at Cyprus' lower corporate tax rate, they are not taxed again in the other country. This resulted in an oversized banking system. While bank assets were small in absolute terms, their size as a proportion of the economy — nearly seven times gross domestic product (GDP)3 — was particularly significant (Figure 1).

Source: The Wall Street Journal. "Luxembourg, Malta: We're No Cyprus" March 27, 2013.

So the country's banks attracted large nondomestic deposits (Figure 2), particularly from Russia, the proceeds of which were invested in Greek government bonds. According to the IMF, exposure of Cypriot banks to Greek government bonds and loans to Greek residents totaled 29 billion euro (160% of GDP).4 The write-down in Greek debt as a result of the PSI wiped out 4.5 billion to 5 billion euro in assets from Cypriot banks.5

Source: Central Bank of Cyprus, Feb 28, 2013.

Cyprus is more than a small, sun-soaked island tax haven strategically nestled in the eastern Mediterranean. To divorce it of political context is to lack critical understanding of the origins and drivers of the crisis. For centuries, Cyprus had been at the mercy of various conquering forces and became a pawn of regional superpowers. To some extent, Cyprus' political and economic policy choices could be understood within the prism of trying to secure its independence and sovereignty. In 1974, just 14 years after Cyprus established its independence, Turkey invaded the northern portion of the island and remained there even after a cease-fire, which resulted in a partition of the island and national pathos over the issue of reunification. This is significant because these events — not necessarily economic reasons — were among the driving forces behind the Cypriot decision to join the EU in 2004 and the eurozone shortly thereafter, along with strong political, social and business ties with Greece. The drive for reunification also led Cypriots to elect a communist president, Demetris Chrisofias, with the hope that he would mollify Turkey,5 which he did, but at the cost of devastating the government's public finances, a key driver in the subsequent banking crisis. In a bit of historical irony, Cyprus' attempt to secure political and economic independence and reunify has yet again placed the island at the mercy of its larger, stronger neighbors.

Protecting taxpayers: the Cypriot bail-in

On March 25, the troika agreed to a 10 billion euro bail-in deal of the most affected Cypriot banks. The bail-in is an unprecedented development in the ongoing eurozone crisis. As compared with a bailout, in which outside investors rescue a borrower by injecting money to help service a debt, a bail-in involves the restructuring of liabilities of a distressed financial institution by writing down its unsecured debt and/or converting it to equity. This approach aims to protect taxpayers from exposure to bank losses and reduce moral hazard. This seemed to make sense for Cyprus because from an economic perspective, given the size of its banking sector and the tattered condition of its public finances, the Cypriot economy wasn't large enough to bear the burden of bank recapitalization. Or, put more bluntly, it would have been politically impossible to push forward a plan which bailed out wealthy Russian depositors at the expense of German savers.

In the case of Greece and Portugal, bank bailouts were primarily financed by taxpayers. In the case of Cyprus, the aid package required that the creditor bear some of the burden of writing off the debt, so that neither the Cypriot government nor European taxpayers would inject any additional funds into the above-mentioned banks. Specifically, under the terms of the agreement with Cyprus, Laiki Bank, the country's second-largest, would be closed, and its bad loans separated into a "bad bank" and wound down over time. Laiki's insured depositors (under 100,000 euros) would be transferred to Bank of Cyprus. In turn, Bank of Cyprus would be restructured and recapitalized, with losses borne by uninsured depositors with accounts larger than 100,000 euros. Those deposits, estimated at 10 billion euros, would be frozen pending a "haircut" — returning only a portion of their deposits to depositors — to be determined by the bank's capitalization needs. In addition, as a precautionary step, capital controls were imposed to prevent a bank run.

Implications for the eurozone: a new precedent?

Thus far, the Cypriot bail-in hasn't rattled European markets or led to massive bank runs in other periphery economies, as was initially feared. The yield on the Spanish 10-year bond increased from 4.95% on March 25 to a peak of 5.07% on March 27 and has fallen steadily since then. This movement was mirrored by the yield on the Italian 10-year bond, which increased from 4.61% on March 25 to 4.77% on March 27, but it too has been steadily declining since then.

So what insights, if any, can be gleaned from the crisis in Cyprus and its resolution? Given the muted market reaction, we could be led to believe that Cyprus is too small and its circumstances too unique to draw any broader conclusions. However, while the Cypriot bail-in may or may not have constituted a watershed event, it serves an important precedent in that European taxpayers are no longer on the hook for every failed bank in the eurozone. The apparent success of the Cyprus bail-in has also moved the dial in the public discourse on the crisis. Jeroen Dijsselbloem, the Dutch head of the Eurogroup of finance ministers, acknowledged that it might serve as a template for future rescues, although he later publicly reversed his position. And while ECB President Draghi stated that Cyprus is not a template, he also stated that "a bail-in in itself is not a problem."8

Was Cyprus a one-off? A special case involving a unique country? Yes, probably, until the next one appears.

About Invesco Global Liquidity

We believe Invesco Global Liquidity is positioned to help our clients meet their evolving liquidity needs with our judicious investment philosophy and rigorous investment process. Our credit team has developed and strictly adheres to a comprehensive set of criteria for evaluating credit risk and identifying high-quality securities. Our portfolio management team constructs and manages the money market portfolios, keeping in mind our commitment to the preservation of principal and liquidity, while seeking to deliver a competitive yield.

About risk

Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified funds.
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.

1 Financial contagion refers to the transmission of a financial shock in one entity to other interdependent entities.
2 Source: Bloomberg L.P., "Greece Readies Record Debt Swap," Maria Petrakis and Fabio Benedetti-Valentini. March 8, 2012
3 Source: Cyprus Economic Policy Review, "The Banking System in Cyprus: Time to Rethink the Business Model," Constantinos Stephanou, Vol. 5, No. 2. As of 2011.
4 Source: International Monetary Fund. Cyprus: 2011 Article IV Consultation. Nov. 29, 2011.
5 Source: The Economist, "What Happened in Cyprus. An Interview with Athanasios Orphanides," March 28, 2013
6 Haircut is a percentage that is subtracted from the market value of an asset that is being used as collateral.
7 Source: Financial Times. "The FT/Reuters Dijsselbloem interview transcript," March 25, 2013 Past performance is no guarantee of future results
8 Source: Introductory statement to the press conference (with Q&A). Mario Draghi, president of the ECB, Vítor Constâncio, vice president of the ECB, Frankfurt am Main, April 4, 2013

Any views and opinions expressed are those of the author and are based on current market conditions; they are subject to change without notice due to factors such as market and economic conditions. Any views and opinions expressed are not necessarily those of Invesco and are not guaranteed or warranted by Invesco. Any such views and opinions are not an offer to buy a particular security and should not be relied upon as investment advice.

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. This does not constitute a recommendation of the suitability of any investment strategy for a particular investor.

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An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in such a fund.

NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE

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