Cyprus banks and the road to serfdom

by George Hatjoullis

Moody’s has issued a report that concludes: “Under Moody’s central scenario, the Cypriot banks and cooperatives could face capital needs that exceed by some EUR1.5 billion the EUR2.5 billion of EU support funds earmarked for the banking sector”( Given that pre-crisis GDP was around EUR 17.5 billion this is a huge sum and it would be on top of around a EUR 10.5 billion loan package already agreed and a massive haircut on all creditors of the two largest banks. Anyone surprised by the Moody’s analysis has not been reading the Cyprus Crisis blogs.

The financing package agreed by the Republic was based on the PIMCO report on Cyprus banking. As an earlier blog elaborates at length, the quantitative assumptions and conclusions of this report were out of date before the ink was dry. For example, the PIMCO report adverse scenario assumed unemployment would peak at 14.6% in 2014. Unemployment has already exceeded this level by some margin and is still rising. The qualitative content of the report, however, is exemplary. It lays bare how the practice of extending loans on the basis of collateral and cross-guarantees, rather than capacity for debt servicing, laid the basis for the banking crisis. The losses on Greek sovereign debt may have been the log that broke the camel’s back but the camel was on its last legs in any event.

The issue is now the extent of non-performing loans. The economic conditions have deteriorated to such an extent that most loans may end up as non-performing. The collateral cannot be sold because the property market has collapsed. The guarantors cannot be tapped without precipitating bankruptcy (itself an expensive and tortuous process) because the crisis is systemic; it affects everyone. The Moody’s assessment is a ‘central scenario’. There is a worse one and that looks not improbable. So if further capital is required from where does it come?

The Republic has already committed to borrow EUR 10.5 billion in exchange for some serious austerity and privatisation.. Does it add to this amount and what will the troika demand in addition? Or does the troika insist, in line with the new direction of bank resolution within the eurozone, that the bondholders and uninsured depositors get another haircut? It has taken continuing capital controls to limit the deposit outflow and there was talk of removing them altogether by Christmas. Which Christmas is unclear. With reports such as this coming out, removing capital controls is not an option. However, the longer the capital controls remain the more confidence in the system is eroded. It is a catch 22 as previous blogs have elaborated.

So what now? The government has proceeded with the inevitable words of confidence; ‘The worst is behind us’. No it is not. Things will get much worse before they get better and the only glimmer of light is the prospect of a gas windfall. Unfortunately, this is some way off. The blogs here have pushed this reality continuously but it has not been a welcome message. Reality hurts. Cyprus has been in denial and very soon this is going to turn to anger. We have seen what anger can produce in Greece. This is not a good situation. Borrowing more or another haircut are both roads to serfdom. Cyprus needs something else.