Europe gets real – not before time

The right plan for Cyprus after dreadful unforced errors

by FT editorial

Europe has arrived at the best available remedy for Cyprus’s woes – but not without first trying every other option and nearly letting a tiny peripheral economy shatter the monetary union. The deal agreed early on Monday, especially the tortuous route by which it was secured, sets profound precedents for eurozone banking and finance, in some ways for the worse, in others for the better.

Few in Cyprus may agree, but the island state has got the best deal it was entitled to expect. This was not the morality play rolling across media bulletins that paint the country as an innocent victim of European highhandedness. It chose a high-risk strategy of living off a banking system far bigger than the state could support. Two years after Nicosia lost market access, the banks still have books seven times Cyprus’s annual economic output. Even proportionately small losses are unaffordable for the state to make good.

A metastasised banking system sucked in more funds than it could usefully deploy at home. Beyond fuelling a housing bubble, Cypriot banks recycled funds to Russia and other origins, and made a big bet on Greek sovereign bonds. In the event, Athens’s restructuring killed the Cypriot banking sector. But the choice to hitch the economy to offshore banking was made with the complicity of leaders and the acquiescence of a population content to live beyond its means.

Other countries made clear that their taxpayers would not pay for a model Cyprus itself cannot afford with loans it could never pay back – from their public treasuries or the European Central Bank. They kept a €10bn rescue loan to meet the government’s financing gap – but not cover banks’ losses – on the table throughout. Even ignoring claims (not all frivolous) that the banks also serviced tax avoiders and money launderers, the idea cannot be sustained that European solidarity entitled Cyprus to more, flattering as this is to Nicosia. The perception of Cypriots and others that Europe “forced” the island to ruin depositors only testifies to abysmally bad communication by the rest of the currency union.

Cyprus will suffer. The banking meltdown will worsen a contraction some forecast at 25 per cent. But no other package of policies would be better than this – as orderly a restructuring as could be hoped for. Rather than a tax on small depositors that keeps zombie banks alive, both big banks will be sacrificed. Laiki will be closed; its insured deposits and central bank debt moved to Bank of Cyprus. It, too, will be restructured with noninsured deposit-for-equity swaps. The relative victors are small depositors, who faced an unconscionable haircut, and non-financial business which was spared much worse chaos in a euro exit.

Much work remains. Jobs and profits in offshore banking will not return; banking itself will not return without good policy. Cyprus must chart a new economic course, probably by accelerating natural gas exploitation. Restructuring holds the best prospect for quickly re-establishing a functioning banking system. But the crucifixion of Cypriots’ trust in banks – a casualty of the original tax on insured deposits – means any “good” bank rising from the ashes will struggle to win their confidence. Hence the introduction of capital controls. While necessary to guard against an immediate run when banks reopen, they are incompatible with monetary union in the long run.

Cyprus and the rest of Europe must work together to ensure capital controls are lifted as soon as possible. If they can be limited to the two problem banks, it will send a very positive signal. It will focus punitive actions on where the rot resides and teach uninsured investors – including depositors – to monitor the institutions to which they entrust their money.

A contemplated deposit raid and actual capital controls will weigh on the European economy. Against that, some healthy precedents are set by the deal. Broke banks can be resolved and not kept alive by the taxpayers of their own or other countries. The hierarchy of claims will be respected: the bail-in of senior bonds is a big improvement on earlier “rescues”. The quiescence of markets prove they can tell solvent debtors from insolvent ones.

The political fallout has no such redeeming features. Somehow, politicians did not foresee a backlash from Nicosia’s attempt to place the burden on small savers. Berlin did not understand it would (wrongly) be blamed. Russia never had much to offer, but defter European diplomacy would have left relations less damaged. Most worryingly, hopes of the euro navigating the debt crisis successfully were hit badly by its leaders’ breathtaking amateurishness in the Cyprus case.