Beware of German gifts near elections: how Cyprus got here and why it is currently more out than in the Eurozone

The situation in Cyprus arose due to banking overreach, insufficient regulation, excessive government deficits, poor debt management and collateral damage from previous Eurogroup bailouts. The amount needed is small in absolute values, but large relative to the size of the economy. The Troika was unwilling to fund more than €10 billion. Extreme delay from the departing Cypriot government and persistence from the Troika led to the bailing-in of banking depositors to cover the gap. An attempt to spread the pain by suggesting a ‘shares-for-deposits swap’ for all Cypriot depositors was defeated in the Cypriot parliament. In subsequent negotiations, insured depositors were unharmed: uninsured depositors in the largest two Systemically Important Financial Institutions (SIFI), Laiki Bank and Bank of Cyprus, were bailed-in. Local debt rollover is part of the bailout, but as it currently stands, holders of external debt are to be paid in full. The exception is the Russian Federal Republic’s direct loan to Cyprus: the agreement is conditional to the loan being restructured. As a result of the above actions, Cyprus is left facing an unprecedented economic recession. Meanwhile the link between weak financial institutions and weak state finances remains, making a second bailout very likely. Cyprus has capital controls, and a deteriorating financial situation. At the same time it is facing local and domestic lawsuits that might overturn decisions. As a result, Cyprus is still dangling precariously from the euro exit cliff. Cyprus has dominated the news across the world since the early morning of 16 March, when the Eurogroup and the recently inaugurated President of Cyprus, Nicos Anastasiades, agreed to a rescue deal that would include the bail-in of uninsured and insured depositors in all Cypriot financial institutions.1 The bailout Cyprus needed (for government debt expiration, projected government deficits and for financial system support) was calculated then as €17 billion. The Troika of the European Commission (EC), the International Monetary Fund (IMF) and the European Central Bank (ECB) were willing to fund €10 billion, which is a big amount relative to the size of the economy of Cyprus (56 per cent of GDP in 2012). There are two reasons for the large gap between the island’s needs and the Troika’s amount. First, Cyprus needed €7 billion for the recapitalization of the financial sector, which Germany and other Eurogroup countries were unwilling to pay. They argued that providing funds to save the banking sector would lead to wealthy non-EU depositors in Cypriot banks being saved from the imminent collapse of their banks, a clear moral hazard issue.2 Secondly, the IMF would not participate in a programme that would push the debt of Cyprus into what it considers as unsustainable (i.e. Greek) levels. For reasons analysed below, the Cypriot banking system was far larger than the country’s GDP, and it was mostly funded by depositors (€66.7 billion) who made up 71 per cent of the liabilities. Out of those, just 40 per cent were Cypriot residents, 34 per cent were non-residents domiciled in Cyprus, 19 per cent came from Greece and 7 per cent from the rest of the world.3 Thus, a bail-in of depositors was considered ideal by the IMF due to the nature of the Cypriot banking system.4 The Eurogroup demanded that Cyprus must find the €7 billion needed for the banking sector using its own resources. The Cyprus government suggested proposals that would avoid a bail-in of depositors, but on 15 March it was made clear to the Cypriot delegation that only proposals where depositors would be affected would be considered. Junior bank bondholders would lose the €1.2 billion they had invested, but there was a disagreement over how to raise the remaining €5.8 billion from the depositors. Eventually, a deal was reached where an across the board ‘shares-for-deposits swap’ on all depositors was agreed upon, in order not to a bail-in above per cent of in As a result, all depositors in all Cypriot financial institutions were to be who had over the insured would per cent of their into of the financial institutions that would their in order to insured depositors were per cent of their The to bail-in insured depositors was by the and the of the bailout from the Cypriot saved the from the Cyprus government to find the Eurogroup made clear to the Cypriot government that they would to a bail-in of depositors, to funds to the were other than bailing-in depositors not be by the of and the but by the very nature of the Cyprus as a financial and a debt recapitalization of the banking system to would to the Cyprus government to to was not as it has of capital by its In it has for to to a direct as by the to The must be considered. Cyprus had a in the by the and by the the Eurogroup argued that to Cyprus would only the wealthy Russian depositors were In the Eurogroup negotiations, the Cyprus that there was a there would be a deal was being the banks in Cyprus The economy into as was to more than a from the the had its March, a deal was the banks a world banking Bank not when the banks the banking system is still capital controls, the to be the The of March deal the bailout amount to of the damage by the bank and capital The Cyprus bailout amount from €17 billion to billion, an to per cent of Cypriot the that Cyprus needs to that Cyprus the of the bailout as the of March Cyprus into a The European a of GDP of just 15 per cent over the IMF a by more than per cent just is likely. The of the of Cyprus that a of GDP of over per cent in is The that the debt by the IMF are not and a second bailout is The between the of March deal and the previous deal was the depositors in Cyprus would be as as the Eurogroup that all the of Cypriot banks be to a The deal Cyprus to bail-in the uninsured depositors of the two largest banks in the Laiki Bank and Bank of Cyprus as banks needed was not to bank but to insured depositors would be to Bank of Cyprus, all the The uninsured depositors of Laiki were and they would the of which would a amount of In the Laiki and bondholders were The would bail-in uninsured depositors, a and the insured depositors and of The board and the bank was over by the Central Bank of Cyprus who the The all only to the the local a to the the of The to the by of the in the bondholders and in of lawsuits are in the and the Cyprus government due to the the was The in the Cypriot At of to the that the bail-in is the has argued that not be by the as are government and not the of the the is in In of in The on the to bail-in the depositors of the two banks, but on the the banks and the and of their by the As an the local system the the of of the banks The has in as an is from to be in of the deal was the of Cypriot bank in The bank of all Cypriot banks, of they were in were to be to bank in Greece by the order of the The deal was but the Troika that Cyprus be to of to the rest of the that depositors in Greece the bail-in of Laiki and as of Cypriot in Greece were billion, the of the affected Cypriot depositors, who be in more of the was the to for The billion from by the Financial Fund up by the For that Cyprus billion of are Cyprus was the of the to the just for Laiki in Greece that was billion. In the that was to fund of depositors from Cypriot banks of the Cypriot being on Thus, Cyprus was to cover the gap of the that were to needed to be to the which was to as a result the Laiki has very depositors of Laiki very The deal was poor that Laiki to the on their The that was by the to Laiki is The is not part of the it is the of the the the its local the up to billion of in as the bank was facing Laiki as for the a of for Laiki and an for the The is that the providing to it clear that the bank was Laiki had billion of by The bank to to the bank for President has to that the of by the previous government was conditional on Laiki remaining the for The that Laiki but was still an Cyprus in the President to in due to the bail-in that Cyprus would to and its banks as the to Laiki would The of Laiki and the would that the of the would the that were as and the amount in order to the was the its as the to the to the of of the by the not to of the that the but by the to the Bank of Cyprus, it has the of the depositors of There for the of the in providing to Laiki and to being to the to the by the The to the the led to the to capital for the Cypriot economy. is the would be by far the bank in Cyprus and bank would be but not very was that as of the would be to as the in the banking system for insured capital were The of capital is to the is clear that the deal on March might a deal for the it European insured depositors, but the deal was a for the Cypriot financial The needs to over and two banks that are far larger than and is to bail-in the depositors of a small it is to it to the two largest banks of a that per cent of all Cypriot must be that in Cyprus, not avoid Laiki they were by far the largest banks on the by and were the in of The of Russian due to for a more of who the damage of the There was of Russian depositors to 15 March as European made of the that a bail-in of uninsured depositors would be part of the Cyprus the for in Cyprus were than in was that of the was In the bail-in was on all uninsured on As a result, the bail-in affected of Cypriot the of capital of large Cypriot which financial a their over into was for it was for the of which had only its recapitalization needs in by just large and funds in Cyprus were the led to the local The has reached a all In the Cyprus bail-in is very and to is not to who is for is the bank of a of to as insured for for In the and the Cyprus government demanded to the and to The has demanded that all and be the that the bail-in a has for for the affected The of has to include institutions and local but there is still be as the size of the the amount the depositors be The delay in the of the and the of capital is of of the banking There are to what their in Cyprus, which financial has led to a to and In the Cypriot capital controls, an by the and the still be in of into by Cyprus, to the and the The capital are in the more depositors and the of the Cypriot economy the of as more to be per cent of the uninsured has to the per cent has to and the remaining per cent is by the when the bail-in be capital in the situation of the financial to for the uninsured depositors. to very in the remaining of Cyprus, that of In they to needed and the demanded by the The of a of a of to the is Cyprus from being a of the The to bailout capital for the banking sector is in all other a rescue fund was to banks to by the was that the banking sector was there was a that a government debt a financial sector that would debt the that made the Cypriot bailout was that the was facing a banking a government debt the Eurogroup not the between two The state is not to from the sector to the the lead to the financial sector more At the same time the and a in the state to but the local financial institutions not be to that link between the weak financial sector and weak government finances is depositors are to that a second bail-in might as the economic a bail-in only to the Cyprus there is a it not it is a for the depositors to their of the The size of the Cyprus bailout is still The European Commission a of what the government of Cyprus needs to for as from in from the of of the billion from of billion on local debt rollover and from debt of the direct loan by the Russian the be The as they The Troika Cyprus €10 billion, of which to the sector, billion is for the needs of the state over the and billion to in of the of The of the debt of Cyprus is The is billion by the government of which billion be the government An billion be saved by the rollover of domestic debt a in The be for between and Cypriot was for reasons in Local debt was a The previous government a suggested by the Troika that the government to the of local the government but it is not in the local to There be a but not a of the banking sector be only affected by the The direct loan the Russian made and is due in be a loan in and providing a the Greece was to be an and in the Cyprus it is just not the bondholders European more depositors in two banks were and local bondholders be into their and might be to a bondholders are to be paid on time and in full. is argued that is in order for Cyprus to its to as a in the Cyprus was due to the financial of its banking sector, which was far larger than the domestic as the of the banking sector is and capital the to as a is The government of Cyprus not be to to the to of the banking sector and the of capital controls, and the banking and capital be the of the and the by a of are is that bondholders are to be from to their in a to domestic bondholders and the Russian it is that the of to bondholders the of the Cypriot bailout At a time when Cyprus be to its billion of the of billion of Troika to the holders of on only for Cypriot government and needs for the of of there are for bondholders to be into the same that is being to the local institutions and the Russian of of in who the of Cypriot bailing-in Cypriot are being the amount of the Cypriot bail-in and capital the of on debt that the of Cyprus be to local and are in The above the situation that arose the how Cyprus up in and what are the in The of Cyprus the in all the exception of the and it to the the were the European was considered a for a that has in the but is since and since The in the the but in more than per cent of the is Cyprus was the in of of the in the in the relative other Cyprus was a to the and the into the in Cyprus the for had an of per a GDP of per cent and its was per The of on the in that were of the and only left the Cypriot only 40 per cent of the would a for Cyprus, and just per cent of the of the was a for other was due to the relative of the Cyprus in being a a into the was considered for Cyprus for two The had to due to the by the of on the and the of the of the government a for the economy was The of capital to to the for led to a of a for the government and for the government and that to their debt to levels. the on government and its in the Cypriot 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the same time they would the to their making Cyprus more of a for capital and in order to their and of in part how Cyprus is considered of the largest in Cyprus is the of Russian and and were to Russian and Cypriot banks, but other and non-EU and financial institutions that were in the the time of to the domestic from that were for The for of of and on Thus, banks a to as they a to the large banking sector being a more than of on not than they would in other their Cyprus is due to the and by the that by the banking sector to far larger than the local by March Cypriot banks had over billion of when the GDP of Cyprus was billion. 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an attempt to its far larger Laiki in to two was in not Cyprus was the Bank and Bank to Bank The of banks were as Bank a per cent by The was a for was of the banks, into very early in the financial by over per cent of its was to billion was in to to in a by of were as the and all paid in the of the loan The to into a of in the the of Cyprus a direct of the poor of in Greece as a of the Cypriot who would to as the of the in the that was in was not March that it must clear that was and that the of was on the as the suggested as far as is not clear the had the then to the of to an the and was in the was billion of for which the an of capital of billion. that there would be of the the the in government it had the Cyprus was of the sector as agreed by the and were made to to the of its of The of Laiki and Bank of Cyprus to the were billion, of the Cypriot being to a government The was not the only Cypriot bank that in as the was and that the then and of Bank of Cyprus, the that the bank 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the economy was by the previous but it was to the of collateral damage from the debt the to the were debt to GDP was per and there was a previous small government for two per cent of the economy into a per cent of The by the government was a of government that by per the government by per in and in the that previous had by in the government gap between and larger the weak of the the government than and by the debt to GDP to 71 per cent of the of the government to to the banks, to a of the to government was by the then of who to but were by the There was to by the then which led to The government in to the by in the board and by the management of debt from the a debt in the of the government direct over the management of the The in of Cypriot by Cyprus from in March to in led to the government more The nature of debt of the Cypriot debt in an unsustainable by over 71 per cent of the debt needed to be in the of Cypriot debt being the in the in domestic was but far more was the the of 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the by the then that Cyprus for due to the billion the on the Cyprus banking was a in the Cyprus as it that the banking the government the of the to to the banking The time on the Cyprus and it for a Troika bailout on on President a bailout, but then had a of by from funds and by providing billion of capital to Laiki and for the Cypriot banking to in by only the Cyprus bailout As a result of the previous the a of were are for was due to the to billion on and the to from a bail-in was as the of of for The of the previous government how Cyprus a banking and a government debt The Cyprus bailout programme was by a very by the Cyprus on not the of the of the Cypriot are in between euro in Cyprus the rest of the to an for capital The is to be the from all bailout Meanwhile it is that Cyprus its As a result Cyprus is in more of the than capital it is to when they be since the of Cypriot are and they not be willing to in the Cypriot banking Meanwhile the banking that the bail-in of depositors to has an is its is the of a of the of the the of capital and the of the to the of Laiki to the Bank of there is direct by the Troika to the banking sector as in other bailout the between a weak government that is to and a weak financial sector that needs capital not Cyprus to the be as a by the the of bailing-in insured depositors was to were and were the of the Cypriot in Cyprus in the and an economic it exit the but to the rest of the the of small for the The damage for Cyprus has The of capital from the bail-in is that had their capital into The of is since banks and in and as the loan The capital the of the sector, the to in order to in The economy is still a the of and a on As a result the economy has per cent to the bailout, are to to over per is There is to is clear that the previous government a large part in the in Cyprus is in excessive and the of of the of the made the Cypriot a banking and debt The Cypriot banking sector and its must be for the banking sector of and for in and the subsequent The government of President made its of the is it was only in for 15 to the Eurogroup a part of the must be to the Troika and the as The of of the Troika to their own European has led to being made on Cyprus which The Eurogroup is a in the of European above in a bail-in of depositors and a world bank As for the Eurogroup has economic in a time the of for The Cyprus be the banking sector is and the to are in and the bailout agreement of March was only by the Cyprus by for exit from the euro and The bailing-in of funds in Laiki and Bank of Cyprus might just the into a as Cyprus needs is and from the rest of the In order for Cyprus to find its must that direct of the banking sector be since Cyprus is the Cyprus needs to find its are relative to the as a European Commission and for economic and funds to economic in Cyprus, but the are far than the needs of Cyprus be to Cypriot debt in a to the local debt and the Russian government the government of Cyprus to and was by the Eurogroup on debt is of the Cyprus Cypriot be on a time the European the of Bank and the be on as of the Russian