KBC ECONOMIC RESEARCH (GCE) MACROECONOMIC UPDATE SIEGFRIED TOP (02/429.59.91) AND DIETER GUFFENS (02/429.62.

87) 25 MARCH 2013

Update on the Cyprus bailout deal

EXECUTIVE SUMMARY
Cyprus, the Eurogroup, the ECB and the IMF reached a new agreement on a financial assistance programme of up to 10 bn EUR After a week of intense negotiations with all the stakeholders, the initial deal was altered in the favour of small depositors (below 100.000 EUR), which remain insured under the deposit guarantee scheme, while investors and large deposit holders of Laiki and (to a lesser extent) Bank of Cyprus will pay for the recapitalization of their banks Potential contagion via the breach of the deposit guarantee scheme has been curbed, although the option of bailing-in depositors seems now no longer a taboo. Senior bondholders are now also involved. As a result, senior bank debt has become more risky, as the principle of bail-in rather than bail-out with tax money, has been established Cypriot debt sustainability will depend on the future growth performance, which may be problematic as its role as offshore financial centre with close links to Russia could be done for

1. The problem
The initial Cyprus bailout deal, as was discussed last week (GCEs assessment 18/03), was rejected by the Cypriot Parliament. The deal, by which deposits on all Cypriot banks would have been subject to a oneoff stability levy of 9.9% above 100.000 EUR and 6.75% below 100.000 EUR (insured deposits), thus generating EUR 5.8 bn to recapitalize the Cypriot banks, was widely contested. Economists feared this would be seen as a dangerous precedent of the breach of the deposit guarantee scheme, which could trigger a silent bank run throughout Southern Europe, or even a loud' one in case of a bank getting into financial difficulties. After the rejection of the initial deal, Cyprus argued it would have a plan B, that would also generate EUR 5.8 bn, but without placing any haircut on Cypriot deposits. This would halt popular unrest against the levy on insured deposits but also shelter the larger deposits, which are for a large part from Russian investors. As a result, the Cypriot government and parliament hoped to preserve the Cypriot status as an offshore financial centre, which is next to tourism Cyprus main economic activity. However, the core of plan B, the investment fund (or solidarity fund) that was set up and that was to be securitized with social security fund reserves, state assets, church property and expected natural gas revenues, was

rejected by the Troika. Moreover, negotiations with Russia in order to obtain a new or extended loan or investments in the Cypriot banking sector or energy sector did not produce any results. As the ECB threatened to cut off emergency lending (ELAs) to the Cypriot financial system, most Cypriot banks would by Tuesday March 26th be bankrupt, as would the Cyprus sovereign if insured depositors would have to be paid out. The Cypriot government and parliament thus had to find a deal before the start of this week, and therefore return to plan A, in order to obtain a EUR 10 bn euro area loan, while accepting the strong EU/IMF conditionality.

2. The proposed solution

In order to resolve this Gordian knot, Cyprus first introduced some new legislation in parliament last Friday, so that the appropriate tools were in place to start the final discussion with the Troika. Cyprus introduced a new Bank Resolution Framework to deal with its failed banks, agreed with a split-off of Cypriot bank subsidiaries in Greece and voted for capital controls, but also agreed on the investment fund, so that plan B would still be possible. In the end, the Cypriot president headed to Brussels on Sunday to conclude the negotiations with the president of the EU, ECB and IMF. Technical details were then further discussed inside the Eurogroup, resulting in the following agreement: Laiki Popular bank (2th largest lender of the country) is to be resolved immediately, with full contribution of equity shareholders, all bondholders and uninsured depositors. Insured deposits (below 100.000 EUR) are transferred to the countrys largest lender (Bank of Cyprus). Bank of Cyprus is to be recapitalized through a deposit/equity conversion of uninsured deposits (with estimates of the haircut of up to 40%) with full contribution of equity shareholders and all bondholders, with a capital ratio of 9% to be reached at the end of the EU/IMF programme (probably 2020). No EU/IMF money is to be used for recapitalizations. Other Cypriot banks and deposit holders are not to be hit. Nevertheless, the Cypriot domestic banking sector has to be downsized to EU levels. Depending on the measure used, this would be a downsize of about 250 to 400% of GDP (assets of domestic banks stand at 450% of GDP, while assets of all banks in Cyprus (including foreign owned subsidiaries) stands at 750% of GDP). All subsidiaries of Cypriot banks in Greece are split off and sold to Greek lenders (which are already nationalized and under EU/IMF control) to avoid contagion. Reform measures announced last week (increase of the withholding tax on capital income and of the statutory corporate income tax rate) remain in place. In return for this conditionality, the EMU (via the ESM) will support the Cypriot programme with up to 10 bn EUR, while the IMF may also participate by up to EUR 1 bn.

The ECB will continue to provide liquidity to the Cypriot healthy banks, and to banks that are restructuring via Emergency Liquidity Assistance (including ELAs), including the recapitalized Bank of Cyprus, that will inherit the ELAs of Laiki

3. Assessment of the agreement

The Cypriot problem has been solved, with a solution that is definitely better than the first one. From the positive side, The immediate bankruptcy of the Cypriot banks and sovereign have been avoided. The deadline put in place by the ECB was respected, and the EU/IMF demands to address the failed bank problem were in the end accepted. The deposit guarantee scheme for insured depositors (below 100.000 EUR) was respected. Small savers are thus not hit, not even in the bankrupt Laiki bank. Uninsured depositors (above 100.000) in the other banks are also spared, so that the bail-in is not generalized. Contagion to and bank runs in other countries as a result of the Cypriot problem has thus become less likely. As only two specific banks are affected by todays agreement, the measures taken with respect to the two specific banks fit within the already approved Bank Resolution Frameworks, no further Cypriot parliamentary votes are needed. The number of senior bond holders that is affected seems to be limited in this specific case. Still, senior bank debt has become more risky, as the principle of bail-in rather than bail-out with tax money, has been established Because of the bail-in, the amount of (Cypriot and European) taxpayers money to be used in recapitalizations remains limited. According to the Troika, Cypriot debt to GDP will remain sustainable in the longer term (100% in 2020). In the end, the deal that was struck reflects mostly the demands of Germany, the ECB and the IMF, indicating that they set the agenda in the euro area. The intention of Cyprus to play it hard and obtain Russian help were unsuccessful, thus limiting Russian influence on Cyprus.

Still, some risks remain: Last weeks discussion on Cyprus have hampered again confidence in the handling of the crisis by the European leaders. There has been a lot of miscommunication, especially around the insured deposits of below 100.000 EUR that were also part of the bail-in plans, that could have been a source of contagion to the rest of the euro area. The principle of a levy on deposits is therefore no longer a taboo. The Cypriot crisis has also highlighted the need to complete the banking union and the single supervisor with both a single resolution mechanism and a single deposit guarantee scheme. Until then, the application of the guarantee depends on a national political decision, and may thus lack credibility. Also, the question of legacy assets related to the banking crisis comes in the scope here. It is our view that so far there is little prospect for a transfer of legacy assets of past crises to a more supranational level. The case of Ireland (cf. Promissory notes deal) has shown, however, that this

can be circumvented, and that the ECB plays an important role here. Such a deal is for Cyprus however less likely. Even though the further steps are not to be problematic (the Troika and the ESM board have to finalize the deal before the 23th of April and the plan has to be voted in the German, Dutch and Finnish parliament), the inability to swiftly address this small problem (Cyprus is 0.2% of EMU GDP and the total costs only amount to 17 bn EUR), cast doubts on the EU/IMF capability to solve larger problems (e.g. Italy, Spain), if the eurocrisis escalates again. It stresses the role of ECB as the main guarantor of the survival of the monetary union (e.g. via the OMT). The Cypriot economy will now go through a more severe recession than foreseen, as its status as offshore financial centre has taken a severe blow. The Cypriot economy will have to readjust to this new reality, and targeted European support will have to be put in place to prevent the Cypriot economy from going into a Greek-like depression. Such a depression could endanger the debt sustainability of the Cypriot sovereign. The question remains how the EMU will handle legacy assets in the near future.

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