15 November 2015 Don’t rush the bailout exit

The Republic of Cyprus is looking forward to ‘graduating’ from the bailout programme in the early months of 2016.

The Memorandum of Understanding with the Troika of international lenders—the European Commission, International Monetary Fund (IMF) and European Central Bank (ECB)—was launched in April 2013 after a slow, then dramatic deterioration of the banking sector.

Two years later, and things are a lot more stable: bank deposits are increasing and the government is running a budget surplus. With legislative elections coming in May, it is tempting to try to rush the exit and leave before the official end in March 2016.

This is probably why we keep hearing that the latest Troika review, technically the second to last, might actually be the final one. But there are a few reasons why the government would be wiser to go the full course.


Wait for more upgrades

The first relates to borrowing costs. When Cyprus issued its €1-billion bond a few weeks ago, it was done during a short window between one Troika review and another when the ECB was able to buy government bonds under its expanded asset-purchasing programme known as QE.

Once Cyprus is no longer in a programme, it will not be eligible for QE until it has reached investment grade. Even with the latest upgrades, Cyprus is still four notches below investment grade by Fitch Ratings and Standard & Poor’s and six notches below for Moody’s.

An exit from the programme will probably lead to more upgrades, but I’d be very surprised if the agencies upgrade by four notches all at once.
The reason why it will take time to reach investment grade relates to the second motive not to rush: namely the extremely high level of non-performing loans (NPLs).

As economist Symeon Matsis said in a recent presentation, “we are now the world champions in NPLs”.

Rating agencies are unlikely to pull Cyprus out of junk status until the two remaining pieces of legislation on loan sales and asset securitisation are passed and NPLs show strong and consistent signs of falling.


Capital may be an issue

High NPLs lead me to the third reason not to rush, namely the uncertain accounting treatment of bad loans by the ECB’s Single Supervisory Mechanism (SSM).

We have already seen a few suggestions that the SSM could force the cooperative sector to raise more capital because of the problem. There was the hint by the finance minister, Harris Georgiades, that the supervisors are moving the goalposts in his speech at The Economist conference, and an unnamed bank official wondering in the Cyprus Weekly if the SSM would accept that bad loans could be recovered in four years.

This is quite serious. The longer the SSM thinks it will take you to recover a loan, the more money you have to put aside for provisions and the more this raises the risk of capital shortfalls. There is still €1 billion in unused Troika funds earmarked for the cooperatives. But calculations in my latest monthly report suggest they might need a little more than that in the worst-case scenario.

If additional coop recapitalisation comes from the government, it would have to happen before the Bank Recovery and Resolution Directive (BRRD) comes fully into force in January. If not, we run into the directive’s rules about having to impose haircuts on ‘creditors’ (including depositors) before tapping into any taxpayers’ money.

Finally, if negotiations to solve the Cyprus problem continue to make good progress, the international markets are going to start asking questions about what kind of economy they are buying into, since the economy they currently know will suddenly incorporate the whole island.

In sum, the longer the banks have to cut NPLs and the more the markets are reassured that expert assistance is being brought in to support the economic stability of a united Cyprus, the faster the country will reach investment grade, and the lower the costs for the taxpayer.