16 January 2013 Cyprus debt: maturity is the only answer

Update with corrections

Fiona Mullen, Director Sapienta Economics Ltd

Those who talked up the needs of the banks in recent months in order to detract attention from the fiscal situation have seen their estimates come back to haunt them, as questions are now being raised about the sustainability of Cyprus debt – in other words, whether it can ever be paid back.

According to Sapienta Economics calculations, if the bank recapitalisation needs do indeed amount to EUR 10.3 bln, then the debt/GDP ratio could reach just under 140% of GDP by 2016. Since it is commonly accepted that a ratio of over 120% of GDP is unsustainable, a debate has started on how to bring the debt back to sustainable levels.


Haircut would not bring debt down far enough

One idea is for a haircut (write-down) of Cyprus government bonds, even before Cyprus receives any bailout money. The problem with this ideas is that of the outstanding estimated current debt of EUR 15.7 bln, or 86.2% of GDP, the only real ‘haircut-able’ debt is the EUR 3.8 bln in European Medium Term Notes (EMTN).

The rest comprises mainly EUR 7.7 bln in domestic debt, Treasury bills and other instruments held mainly by the very banks that need recapitalising, EUR 1.1 bln in loans from the European Investment Bank (EIB) and Council of Europe Development Bank (COEDB), and the EUR 2.5 bln loan from Russia due in 2016, which may be rolled over in any case.

As explained in an earlier Financial Mirror article (Cyprus haircut: Is it worth it?), of the EUR 3.8 bln in outstanding EMTN, perhaps EUR 2.1 bln is held by Cypriot banks. Any haircut on Cypriot banks’ bond holdings of course would only end up back as public debt in the form of additional capital requirements. So the net haircut would be only on the EUR 1.7 bln held by foreign bondholders.

A 75% haircut on EUR 1.7 bln would reduce the debt/GDP ratio from 86.2% of GDP at end-2012 to 79.2% of GDP. Would this make the debt sustainable? Apparently not.

According to my projections based on a EUR 10.3 bln bank recapitalisation requirement and negative or low growth for the next few years, the debt/GDP ratio would reach 134.0% of GDP by 2016 compared with 140.4% of GDP without a haircut.

So the debt would still remain well above the threshold of 120% and the Cyprus economy could also be saddled with default status, which would damage prospects for recovery.


Land and pensions an issue for privatisation                                                                                                                                                                                                                                   

Another idea is for privatisation of state-owned companies. Perhaps uniquely in Europe, the main electricity, telecommunications, ports and airports operators are all in state hands. According to my estimates, you’d have to cut the debt to EUR 11.5 bln (that is, raise more than EUR 4 bln in privatisation proceeds) in order to keep the debt/GDP ratio below 120% of GDP by 2016.

In this week’s Sunday Mail, Costas Apostolides believes that as much EUR 10 bln could be raised this way. However, most of his EUR 10 bln appears to depend on the sale of assets—presumably land—which in a falling market will be worth far less than their book value. In addition, one has to ask how much of a discount buyers will demand for those generous staff pension funds.


Hair-brained haircut on deposits

As ideas get dismissed, they also get more desperate. So the third idea, floated last week in the New York Times, is somehow to grab some of the EUR 70 bln held on deposit in the Cypriot banking system, of which EUR 20 bln is held by non-residents. This might be done by letting a bank fail and saving only deposits of up to EUR 100,000, which are covered by the deposit insurance scheme.

Inferring from the government’s 2011 contingent liability estimates for the deposit insurance, one might net as much as EUR 35 bln this way. However, there was a lot of movement of deposits within Cyprus during 2012, therefore there are probably considerably fewer accounts holding more than EUR 100,000 today than there were at the end of 2011.

Grabbing deposits from a banking system that survived an invasion would be a really radical move. It might satisfy those who have a knee-jerk dislike of Russians, who according to my estimates might hold between EUR 8 bln and 15 bln of the total EUR 70 bln deposits. But it would also destroy in one fell swoop the only sector that has created jobs in the past few years, namely the business and financial sectors.



Longer maturities until the gas comes

This brings me to the only option that is both viable and fair and also ensures that everyone gets their money back. That is to stretch out the maturities until the gas money rolls in.  According to my estimates published in the August issue of Gold Magazine, LNG revenue from Block 12 after major investment and running costs could be as much as EUR 40 bln based on today’s LNG prices in Europe.

Let’s say I got it wildly wrong and the potential revenue to the state is only half of that. That’s still EUR 1 bln per year for 20 years—the usual length of time for a gas supply contract. And that’s only on the basis of the estimated 7 trillion cubic feet in Block 12, not the additional blocks that are in the process of being licensed.

Put aside 20% in case the Cyprus problem is solved and this proportion is deemed to be the equitable share for Turkish Cypriots. That gives us EUR 800 mln. Put aside 50% of that for future generations to get EUR 400 mln. That still leaves an awful lot left over each year to pay back the debt.

The only problem is that the nature of LNG financing means that it will be a good 15 to 20 years before the plant is built and the revenue comes on stream.

That is why it is so important to give Cyprus a long time to pay the bailout back, perhaps with the privatisation of the most obvious targets and a proviso that if Cyprus Popular Bank reaches a certain market capitalisation threshold, then it must be sold and the proceeds given to the troika.

Longer maturities is a far more sensible option than trying to find “corrupt Russians” or “lazy Mediterraneans” to punish for the state in which Cyprus has found itself, which in any case is partly a result of the eurozone leaders’ decision to help Greece with a haircut.