22 May 2012 Cyprus should seek “standby” EU funding now

It will avoid further panic and prevent capital flight

The announcement last week that the government had guaranteed that it would buy up to EUR 1.8 bln shares in Cyprus Popular Bank (Laiki) if the bank cannot find other investors was welcome at a time when the news from Greece just kept getting worse.

As regular readers will know, I have my worries how the bank will be managed under state ownership. But it is still a better option than letting the bank fail and take the economy down with it.

However, the bailout of Laiki did little to calm the nerves of a jittery business community that is trying to calculate the bigger cost to the Cypriot economy of a possible exit of Greece from the euro. We have already witnessed a capital crisis at one bank because of the 70-75% write-off of the EUR 5.1 bln lent by the two main banks to the Greek government.

Imagine the impact of a 70-75% devaluation (I am taking Argentina as my guide) of the EUR 22.7 bln which the largest three banks have lent to the Greek private sector. Even allowing for the fact that these banks have EUR 15 bln on deposit in Greece, the loss in the value of net assets caused by a 75% devaluation could leave the banks some EUR 5 bln short of capital.

It looks like the government has only managed to bail out Laiki this time by instituting a debt for share swap that will see the government debt/GDP ratio rise to around 80% of GDP, from less than 50% of GDP in 2008. But it is highly unlikely that it can pull that stunt twice, especially when the sums involved will be more than twice as much.

In the event of a Greek exit, therefore, the banks will have no place to go but the government. Since I understand that China has balked at bailing out Cyprus with such a large sum (not that borrowing large amounts from non-EU countries does any good to our international image), the government will have no place to go but to the EU.

At the moment, EUR 5 bln is a small price to pay for the stability of a eurozone country. But if the government puts off going to the EU until the crisis hits the whole of the eurozone, it would be competing with those who will have much larger claims on EU funds—Ireland, Portugal, Spain, and possibly even Italy.

That is why the most sensible option is to ask the EU for an IMF-style “standby facility” now. With an IMF standby facility, money is put aside which a country can draw on in case of need. It is not always needed so is not always used. But the very fact that it is there helps to revive market confidence and restore stability.

We have already reached the point at which the market has lost confidence. If the number of phone calls I receive from friends panicking about the security of their deposits despite the government EUR 100,000 deposit guarantee is any guide, there is already a trickle of money flowing out of Cyprus. The government needs to act before this becomes a flood.

A provisional EU bailout, negotiated under relative calm, should come with less stringent terms than one negotiated in panic. It will also look considerably better to the international markets and rating agencies than a bilateral loan from a non-EU country granted with unknown strings attached.

But much more importantly, it will restore international confidence in the government’s ability to acknowledge its problems and be pro-active about dealing with them. This will keep our deposits secure and might even help us to start to draw a line under this chronic crisis.

 This article first appeared in the Financial Mirror