new wave of consecutive downgradings rendered the sovereign debt non-investment gradeand made government securities ineligible as collateral for borrowing from the euro system.In parallel, the banking sector was increasingly cut off from international market funding andmajor financial institutions recorded substantial capital shortfalls. The situation in the banking sector worsened dramatically in early-2013. The delays in concluding an assistance package, unfavorable statements and rumors in the press regarding deposit haircuts and theconsequent fall in confidence led to accelerated and substantial deposit outflows.
Against the background of these severe economic and financial disturbances, on March 16and 25, 2013, an agreement was forged on the key elements of a programme, which includedthe restructuring and substantial downsizing of the banking sector, the reinforcement of efforts on fiscal consolidation, and initiation of structural reforms. Arguably, the mostimportant and extraordinary element of the programme was that the recapitalisation of bankswould be almost exclusively generated from the banks’ retail deposits. Deposits up to €100,000 were to remain unaffected. Amidst financial turmoil and public outcry, a bank holiday of 10 days was imposed, followed by an introduction of capital controls andrestrictions on deposit withdrawals – a course of action considered necessary to prevent whatwas probably an imminent collapse of the banking system. At the same time, the separationof the Greek operations of Cypriot banks was a required feature that immediately downsizedthe banking sector by a significant amount. It was also pursued in an effort to eliminate any potential spillovers operating in either direction. In that context, Greek deposits in Cypriot banks were unaffected.
On April 2, 2013, an agreement at the technical level was reached in respect of acomprehensive policy package to be implemented in a 3-year macroeconomic adjustment programme whose key objectives, measures and outcomes are specified in the MEFP between the IMF and the Republic of Cyprus.
The authorities’ concern, even dissatisfaction, regarding the chosen type of theunconventional financing method of “bailing-in” depositors and particularly the extent towhich this took place, is no secret. However, a variety of reasons, some of which areexplained in the staff paper, necessitated the use of this alternative. Furthermore, the delays inconcluding an agreement between all parties involved, worsened the situation and magnifiedthe size of the financing need that is now seeked out from the uninsured depositors, which theauthorities accept some responsibility for. Even so, they would have hoped that thenegotiations were dealt with a more sensitive and fair manner for the benefit of Cyprus, theeuro area, the EU and for the programme in general.
Nevertheless, despite so harsh realities, the lingering problems and the demoralizinguncertainty overshadowing the island for the past year have finally been addressed. Amacroeconomic adjustment programme has now been agreed that aims at restoring financialmarket confidence, re-establishing sound macroeconomic balances and enabling the economyto return to sustainable growth. To achieve these goals, the programme builds on three pillars:(i)A financial sector policy that aims to restore financial stability and resume credit to