In Cyprus Bailout, Questions of Whether Depositors Should Shoulder the Bill

http://www.nytimes.com/2013/01/11/business/global/the-cyprus-bailout-question.html

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LONDON — On their Web sites, the largest of Cyprus’s failing banks brag that their client representatives are fluent in Russian. No indication, though, whether strizhka — Russian for haircut — is part of their lexicon.

As negotiations with Europe over a bailout for Cyprus near an end, the country’s banks, flush with Russian deposits, hope they do not have to force haircuts, or losses, on some of their wealthiest depositors.

Europe, struggling to complete a potential 17 billion euro, or $22.2 billion, rescue package for Cyprus, is under intense pressure to make private sector investors, rather than European taxpayers, pay a bigger share of the bill than in past bailouts. Officials in Brussels and Berlin are said to be considering a controversial plan that could require depositors in Cypriot banks to accept losses on their savings. Russians, who hold about one-fifth of bank deposits in Cyprus, would take a big hit.

That step would be a radical departure from the bailouts of Greece, Portugal and Ireland. In those rescues, while investors holding Greek bonds were eventually forced to take haircuts, it was largely loans from European countries that financed the bailouts, with bank deposits held sacrosanct.

In a Europe where big banks hold outsize political and financial power — Cypriot banks wield assets eight times the size of the country’s economic output — any move to punish depositors is certain to attract bitter opposition.

And though the plan may have some merit on paper, it would be hard to carry out in practice, given the ties that bind Cyprus to Russia.

Demetris Christofias, the Cypriot president, is a Communist who received his higher education in Russia. What is more, Russia provided Cyprus with $3.3 billion in emergency financing last year. And the largest individual shareholder of the Bank of Cyprus is Dmitry Rybolovlev, a billionaire Russian businessman.

But European officials see Cyprus as a new opportunity to censure banks for what they describe as their too-big-to-fail sense of entitlement, according to some people involved in the bailout discussions. Cyprus’s loosely regulated and tax-friendly banking climate has long made it a favorite destination for Russians seeking to place their rubles in a euro zone bank that does not ask too many questions.

People in favor of forcing depositors to share the cost of the bailout make this argument: It was an unusually high, $14.4 billion spike in Cypriot bank deposits in 2010 — as much as half of it from Russia — that prompted the banks to make the bad lending decisions that led to their collapse. The banks put much of the money into Greek government bonds, only to absorb big losses when those bonds were restructured last year.

Of the $22.2 billion needed to keep Cyprus afloat, at least $13.1 billion would need to be pumped into the country’s banks.

European officials caution that while it may still be a long shot, a move to force large, uninsured depositors to share the pain with Europe’s taxpayers would send a powerful message to the market that risky financial conduct has consequences.

“If it is just the official sector that does this, then what you end up doing is bailing out Russian oligarchs,” said Alessandro Leipold, chief economist of the Lisbon Council, a research organization in Brussels, and a former top executive at the International Monetary Fund. “I would be very surprised if there is no private sector involvement here.”

German lawmakers have said they will reject any deal that has the effect of bailing out Russian depositors. And Chancellor Angela Merkel, who plans to visit Cyprus on Friday, said Wednesday that the country would be given “no special conditions.”

Forcing losses on bank depositors is a last-ditch measure taken by bankrupt governments when all other measures have been exhausted. During the debt crisis in Latin America in the ’80s, depositors lost money when their dollar accounts were changed into the local, devalued currency. Another way to make depositors share the pain would be to convert long-term deposits into bonds with stretched-out maturities.

In Europe, such an action is rare. That it is being discussed at all underscores how serious international creditors have become in ensuring that any coming euro zone bailouts will extract a toll from private investors.

European attitudes have hardened in recent weeks in the wake of the sky-high profits that hedge funds locked in when Europe decided not to try to force investors to accept a lower price for their bonds in the buyback of Greek debt last month.

No final agreement on the Cyprus bailout is expected until after the country’s presidential election on Feb. 17. Mr. Christofias, who opposes tough austerity measures like selling state assets, is not running for re-election. The favorite to succeed him, Nicos Anastasiades of the center-right DISY party, is seen by European officials as a better negotiating partner.

Other possibilities for extracting a price from private investors are also being examined, people involved in the discussions say. Those include steep write-downs in the value of the senior bonds in the country’s two largest financial institutions, Bank of Cyprus and Cyprus Popular Bank.

Another possibility is imposing losses on foreign investors holding Cypriot government bonds.

“All options are on the table,” said a senior European official who is participating in the talks but spoke only on condition of anonymity.

Of course, going after depositors carries significant risks. As much as $18.3 billion of Cyprus’s $91.5 billion in deposits is said to be Russian-held, and any hint that savers will have to take a hit could prompt a bank run and seriously damage its standing as an offshore banking hub. Russia, as the country’s largest creditor, would no doubt raise strenuous objections. Euro zone countries with fragile banking systems, moreover, would worry about the risk of contagion.

But the main alternative — loading losses onto investors holding government bonds — has its own drawbacks. The country’s banks own about $2.6 billion of the $4.97 billion worth of government bonds outstanding; hedge funds and other foreign investors hold the rest.

The banks’ bond losses, in the meantime, would be added to Europe’s bailout bill.

Analysts also argue that with a ratio of debt to gross domestic product of just below 80 percent — lower than Germany’s or France’s — Cyprus is not guilty of the sort of borrowing excesses that forced the Greek government to seek a bailout. Instead, it was the reckless conduct of its overambitious banks, which lent aggressively to Greece.

Unlike larger euro zone economies, Cyprus’s bonds are governed by the investor protections of English law — something Cyprus had to agree to in order to lure investors to its smaller, inherently riskier economy. English law makes it easier for private investors to sue if their bonds are restructured as part of a bailout.

And experts argue that with foreign funds now willing once again to make substantial investments in European banks and government securities, there is no point in testing the fragile nerves of portfolio managers.

Better that Europe pinch its nose and write Cyprus a $22.2 billion check, some analysts say — and if that means happy returns for hedge funds and Russian depositors, it is a small price to pay when the stability of the euro zone is at stake.

“If you did not do this in Ireland, then it is not worth doing now that Europe is on the mend,” said Gabriel Sterne, an analyst at Exotix, a securities house in London. “Cyprus is so small and piddly — why bother?”

But there’s the rub. Ireland, as part of an $111 billion bailout in 2010, granted a blanket guarantee to its depositors and investors who owned the senior bonds of its collapsed banks. That decision quickly rendered the country insolvent. Even now, having passed a raft of austerity measures, Ireland has a debt-to-G.D.P. ratio just below the 120 percent level that most economists, including the I.M.F., say is unsustainable for a country to bear.

The cost of making a Cyprus bailout an official-sector-only affair would push its debt-to-G.D.P. ratio above 140 percent.

“What you have here is an insolvent banking system that you are deliberately turning into an insolvent government,” said Adam Lerrick, a sovereign debt specialist at the American Enterprise Institute.

That might well be. But the Cypriot government “will fight deposit haircuts to the death,” said Alexandros Apostolides, an economist in Cyprus.

If the country gets its preference, when its Russian-speaking bankers say strizhka, they will be referring only to a trip to the barbershop.