Europe

Cyprus has reached a tentative agreement with the IMF-EU-ECB team (Troika) on the economic program that will be backed by its €10 billion rescue package.  The IMF will put €1 billion, small in absolute terms and relative to the one-third share that it has had in most of its European programs but a very high share (563 percent) of Cyprus’ contribution, or quota.  The plan is for European political approval in coming days, followed by legislative approval where needed during the course of April, and IMF Board approval in early May.  If Cyprus passes all the prior actions required in the program, it could get the first drawing on the package in mid-May, well ahead of their early June debt maturities. The critical prior actions are fiscal.  On top of a 5 percent of GDP multi-year fiscal consolidation already underway, the government has committed to pass an additional 2 percent of GDP in new, permanent measures for this year as a condition for receiving its first drawing under the program.  In future years, 4 ½ percent of GDP in measures will be passed, and if performance falls short of targets, the government must stand ready to take additional measures (though presumably slippages due to a larger-than-expected recession, rather than incomplete policy implementation, may be excused).   The prior actions include significant increases in taxes on corporate income (from 10 to 12 ½ percent), interest income (from 15 to 30 percent), property, and banks, as well as higher fees for health care and government services. There are also a broad and ambitious set of structural reforms, including fiscal management, privatization/commercialization of state-owned agencies, and pension reform.  While not prior actions, it does look like they have to take substantial steps by the first review (presumably slated for this summer, though it could be delayed), and this is another reason to question how long the program can remain on track. Overall, it’s hard to take this program very seriously as a document of what can and will happen, rather than what creditors would like to see happen.  It further will play right into the hands of those who criticize Europe for ignoring the contractionary effects of excessive fiscal consolidation in the crisis.  The Fund anticipates this criticism:  “The second pillar entails an ambitious and well-paced fiscal adjustment that balances short-run cyclical concerns and long-run sustainability objectives, while protecting vulnerable groups.” However, against the backdrop of a frozen banking system that will need major further deleveraging and a sharp fall in economic activity already in train, it’s hard to square that judgment with the numbers. To put the fiscal point in context, a rough guess is that the fiscal drag in the program for this year alone will be on the order of 4 ½ percent of GDP.  The effect on the economy will be multiplied: the Fund’s work suggests a multiplier of 1.7 or so in a declining growth and low interest rate environment, resulting in a GDP hit of perhaps 7 ½ percentage points.  This doesn’t account for capital controls that make it even harder for individuals and firms to smooth or adjust to the effects of these new taxes, so this estimate may be low. It will be interesting to see if the government has trouble mobilizing support in parliament for this package.  The presumption of analysts wiser than me is that the hard decisions have been taken with the bank restructuring, and incentives in Cyprus and elsewhere in Europe are strongly supportive of getting this deal done.  The one caution in this regard comes from a recent survey that found that support for the euro outstripped opposition in all countries in the Eurozone…except Cyprus, where sentiment was balanced (see below).  If it goes down to the wire, we may find that Cyprus event risk isn’t over yet.   Source: Eurobarometer data

The ECB meets tomorrow and is expected to remain on hold.  Of the 44 market participants surveyed by Bloomberg, only one thought that the ECB would lower interest rates at this week’s meeting.  Markets do seem to hope, and may be pricing in to some extent, a more dovish tone from Governor Draghi, but at a time when the Fed is continuing expansionary policies, and the Bank of Japan is set to join them, the unwillingness of the ECB to do more stands out. I see the case for a rate cut as powerful.  Weak activity indicators, deflationary pressures, and tightening financial conditions suggest that the euro area will continue to stagnate through 2013 and into 2014.  This lack of euro-area growth, if it persists, represents a bigger threat to the survival of the Eurozone than Greece, Cyprus or the next financing crisis.  A 50 basis point (bp) cut in rates would send a strong message regarding the ECB’s commitment to "do whatever it takes."  It is all the better if it brings about a necessary weakening of the euro. A threat that the ECB does acknowledge arises from the growing fragmentation of European financial markets.  A small-to-medium sized company in Spain or Italy, especially if it’s normally funded by a second tier bank, will find credit difficult to get and if available, they will pay up to 300 bp more than a similar company in Germany (see chart).  Some portion of the premium is justified by the higher risk of doing business in the periphery, and it’s worth remembering that excessive spread compression during the years following creation of the euro was central to the buildup of imbalances.  But another portion presumably is an “excessive” risk premium that would not exist if European banks and financial markets were functioning smoothly. For the ECB, this is a job for financial policy, not monetary policy--a separation principle that most major central banks would not see as appropriate in current conditions.  From this perspective a rate cut should not be chosen if the rate is already appropriate for some hyopothetical average.  That said, the case can be made that the first best policy response is a measure targeted directly at the market imperfection that threatens fianncial stability, which in this case is the financial intermediation channel in the periphery.  The question is then how best to create incentives for banks to lend to these firms.  Central banks are understandably skeptical of the directed credit schemes in normal times, but in stress periods such as the present they need to be considered. It’s worth noting we have two recent models on which the ECB can draw.  The first is the Bank of England’s (BoE) July 2012 Funding for Lending Scheme.  The BoE scheme provides lower cost funding for banks and building societies that increase lending to U.K. households and businesses.  For additional lending up to 5 percent of total loans, participating institutions can receive 0.25 percentage point loans, provided they have sufficient eligible collateral.  While evidence on the effectiveness of the scheme is mixed (we don’t know what lending would have been absent the scheme), the BOE sees the program as successful.  Gavyn Davies is among those recently advocating that this approach get a serious look from the ECB. When asked whether the ECB would consider such a scheme, Mario Draghi argued that the existence of long-term refinancing operations, or LTROs, coupled with an easing of collateral requirements late last year, in essence replicated the effects of Funding-for-Lending.  That’s true in a sense, but its hard to make the case in current conditions that there isn’t more that can be done.   A targeted easing of collateral requirements for financing for new loans in periphery (for banks in countries where spreads are above some level?) – combined with a new LTRO -- would be a better parallel. A second recent model is the Term Asset-Backed Securities Loan Facility (TALF) that was created by the Fed in November 2008 to spur consumer lending by supporting the issuance of asset backed securities (ABS). The sharp decline in new ABS issuance in September 2008, coupled with sharply rising spreads, was the basis for the program.  The program extended loans on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans. Though the borrower retained the first loss, the program was seen as effective in restarting the ABS market and keeping the flow of loans going. What both these approaches share is a targeted change in incentives to lend in the periphery.  My suspicion is, if not this week, then soon, the growing fragmentation of euro financial markets will call for a change in policy. It’s worth remembering we have models for what could come next.

The banks in Cyprus reopened today, with severe capital controls in place.  Withdrawals by residents are limited to €300 per day; local businesses are limited to a maximum of €5,000 per day.   Cross-border credit card transactions are limited to €5,000 per month, and border controls prevent travellers from taking more than €1,000 in bank notes out of the country per trip.  Beyond these totals, payments for imports are subject to strict documentation. The Cyprus stock market remains closed until next week. The Cypriot government and central bank have defended the controls as temporary, but they could be in place for months.  Given the financial pressures that exist, and the difficulty any Cyprus bank will have reestablishing credibility after the events of the last two weeks, the controls will not be able to come off until the ECB is willing to fully back the banks, regardless of adequacy of collateral or credit quality.  (Iceland, which does not have the ECB standing behind it, still has controls in place from the crisis.) European policymakers, including the ECB, have endorsed the controls, and it’s expected the IMF would do so when it approves the program.  Under the Fund’s Article VIII(2)(b), it can approve (and potentially provide additional legal protection for) controls its sees as necessary for successful completion of the program. The experience of many emerging markets putting controls like these in place during crisis is that they can be effective, though evasion increases with time, and that the political and economic costs of maintaining such controls is high. Policymakers in Cyprus and Europe thus face a tough balancing act in finding the right timeline for removing the controls. The events in Cyprus have been a reminder that, despite market calm over the last few months, the crisis in Europe is far from over.  Periphery banking systems remain vulnerable, the conditions for a healthy monetary union remain a distant hope, and the framework and policies Europe has in place for crisis resolution remain inconsistent and, at times, incoherent. What lessons can we draw for how Europe will respond to periphery countries facing crisis in the future, as well as for other offshore centers with financial systems many multiples of their host countries? One view is that the Cyprus rescue package is a template for future rescues. Eurogroup president Jeroen Dijsselbloem called the deal a “model” of “pushing back the risks” of paying for bank bailouts from taxpayers to private investors.  He later pulled it back a bit, and periphery finance officials have sought to distance their own situations from that of Cyprus, but he may be right. Cyprus could set a precedent for a US-style bank resolution system, in which large banks can be allowed to fail and be wound down, and creditors assigned losses based on traditional creditor rankings.  Private sector involvement would be established as policy well ahead of the 2018 deadline earlier envisaged. The ESM would still be needed for cases where sovereign debt remained too high, but in the first instance would be a backstop to the sector itself. The attraction of this approach for bailout weary European creditors seems obvious. The alternative argument is that Cyprus’s solution represents more evidence of a new tougher line with small, poorly performing countries in the periphery, and not a precedent for Portugal, Spain or Italy. In either case, Cyprus shows European policymakers willing to tax depositors because, as Willie Sutton famously is quoted as explaining why he robbed banks, “that’s where the money is.”  In contrast, the government still maintains it will make payments on its external debt, though it may be hard to explain after the events of the last few weeks why it would continue to pay external creditors in full while domestic depositors suffer losses.  In this respect, it’s a reminder that local law is weak protection for creditors when the European’s willingness to provide financing fails to fill the gap. In sum, compared to the initial proposal that taxed insured deposits while leaving more junior creditors untouched, the final deal gets the creditor prioritization right, hits uninsured deposits at the two top banks hard while leaving insured depositors untouched, and gives the government broad powers to restructure banks and impose capital controls.  In sum, about as good a job of getting out of the hole European policymakers dug for themselves as could be hoped for. Still, the contagion to investors elsewhere is likely to be significant.  Uninsured depositors, especially from outside the EU, are likely to flee, while even insured depositors are likely to be wary given events of the past week.  Further, the freeze and subsequent rapid deleveraging of the banking system likely will drive a sharp decline in activity in Cyprus.  There is no clear roadmap for restarting the banking system and getting lending going without massive capital flight. The risks that the program will fail are high.

One of the striking features of the Cyprus crisis is the extent to which the ECB is driving the process.  It was their threat to stop the flow of easy money to Cyprus that forced agreement on the earlier failed tax plan.  Now, their threat to cut Cyprus’ access to Emergency Liquidity Assistance (ELA) if the government does not have an EU-IMF approved program in place by Monday accelerates events. With the banks closed and cross-border payments suspended, the immediate impact of a decision to terminate ELA would be muted.  But without such funding, it will be virtually impossible for the major banks to restore normal operations, and reopening the banks would result in cascading failures through the entire financial system and the real economy.  The intent clearly seems to be to force the government to the table. Will it do the trick?  By next week, we may well know if there is a path for Cyprus to remain in the Eurozone. The ECB is right in emphasizing that the ELA is only for solvent banks, but that hasn’t stopped them in the past from fudging the criteria to support countries during often protracted negotiations with the Troika.  ELA funding to the banks in turn financed the purchase of government paper.  So, while such a facility is and should be in the ECB’s monetary toolbox, in circumstances like the present its primary effect is to provide fiscal financing (and often the only financing available to governments).  It is a dangerous game in that, along with the other facilities provided during the crisis, it exposes the ECB to a great deal of credit risk.  With the ECB having already extended €9 billion in ELA credit to Cyprus, I understand why they want to change the rules, but it’s worth asking why now. More bad ideas Now that the Cypriot government’s effort to raise emergency financing from Russia and pressure Europe to soften terms has run out of steam, reports are that it has developed a new financing plan. Insured deposits would be exempted from tax, the large, non-insured deposits in solvent banks would be taxed 5 percent (down from 9.9 percent in the original proposal), and any insolvent bank would be split into a good bank and a bad bank (uninsured deposits presumably would go with the bad bank, rendering them worthless).  The government also would issue a bond backed by natural gas. The remainder of the needed financing would come from the transfer of the reserves of the state pension fund (€2.5 billion) and other state assets. Wait a minute.  State pension funds now hold reserves and invest in government debt.  By seizing these funds, the government swaps debt claims for a contingent, future liability to retirees.  It may produce lower debt on paper, and it does provide cash for the government now that the ELA ATM has been turned off, but in economic terms its does nothing to produce a more sustainable debt profile.  Similarly, an oil linked bond may be worth considering (though a case like this with such high uncertainty, markets may not pay much for the link to natural gas) but it also boosts debt above levels the troika has firmly stated is more than the country can handle.  On these grounds, I would hope that the Troika promptly rejects the plan.

The EU and IMF should loosen the austerity requirements of Greece’s bailout package to allow the indebted country to implement needed growth-enhancing policies, says former prime minister George Papandreou.

Over the weekend, Cyprus agreed to a package of measures in order to receive a €10 billion rescue package.  Most significantly, they agreed to a tax of 6.75 percent on all bank deposits under €100,000 while accounts over that threshold would be hit with a 9.9 per cent levy. Following broad unrest, and without the votes in Parliament to pass the tax, the government is today considering revising the tax to put more of the burden on the large, uninsured deposits.  The Cyprus parliament has called an emergency session, and a bank holiday remains in effect.  Euro markets are down 1 to 2.5 percent today. The Cypriot government, and European leaders more generally, appear to have badly misread public opinion. Russia, whose involvement is critical to the deal, called the tax "unfair, unprofessional and dangerous."  A decision to reduce the tax on small deposits and put more of the burden on large (mostly Russian) deposits likely will not be well received in Moscow. This should be an interesting week.

Cyprus measures 0.2 percent of the Eurozone economy.  A proposed rescue package is only €17 billion, of which perhaps €9 billion will be used to recapitalize banks weighed down by bad loans and losses on the Greek government debt.  A new government has signaled its commitment to reform, and creditors want to get a deal done by end month, before government cash reserves run out and well ahead of a €1.2 billion June debt maturity.  Yet, as European leaders meet, negotiations look to be deadlocked.  What happens next matters:  because of concerns about contagion and for what it tells us about the future course of European policy, Cyprus punches above its weight. The problem, which we have seen before through the periphery of Europe, is that the proposed package will leave Cyprus with an unsustainable debt level and an economic reform path neither markets nor policymakers believe can be sustained.  If the entire package is financed with new lending, Cyprus’ debt rises to from just over 90 percent of GDP today to around 140 percent GDP. Optimists note that Cyprus has large natural gas reserves that will ultimately provide the resources to make good on the debt, but there are significant political and economic hurdles to overcome to make that happen.  Given fiscal and structural imbalances and negative growth, it’s hard to make a convincing argument the program will succeed. A restructuring of Cyprus’ liabilities would both reduce the near term financing needs and provide a sustainable level of debt in the medium term, as well as help creditors with the politics of a bailout of a banking system alleged to have facilitated tax avoidance and money laundering.  The debate appears centered on uninsured or large value deposits, and subordinated debt of the banking system. Deposits could be haircut through a domestic “solidarity tax” or restructured through a conversion of demand deposits to term deposits.  This seems the most likely scenario, but substantial concern about contagion to deposits in other periphery countries has prevented agreement. A second option would be for Europe, concerned about contagion and loathe to admit that Greece was not unique, to kick the can down the road with a financing package that leaves bank and sovereign creditors untouched.  The problem, in addition, to the optics of rewarding bad behavior, is financing the larger gap. A better approach would be to look at the full range of liabilities that make Cyprus’ position untenable, including the sovereign as well as the banks.  That would point to both a restructuring of the government’s private external debt (PSI), and for relief on its official sector claims (OSI).  The former seems unlikely given Europe’s concerns about contagion and precedent, while the latter is a red line Europe will not cross, at least not before German elections this fall. An external debt restructuring could be done quickly, would allow the burden sharing to be spread more broadly, and even if done on relatively market friendly terms would have the advantage of keeping private creditors “at the table.”  In contrast, delaying the restructuring with a series of short-term financings allows private creditors to exit, putting more of the cost of restructuring on European governments.  Some would welcome that as part of their federal vision for Europe, but it’s hard to see how that helps Europe to get to the governance reforms necessary for better crisis management. Cyprus is pressing for agreement on a package by the end of the Month, before the government runs out of funds.  During this period, the primary source of funding for the government is likely to come from domestic banks, which in turn are funded by the Emergency Liquidity Assistance (ELA) facility through national central banks.   The harder deadline is a June 3 external debt amortization. Finally, here are five issues or questions to keep in mind while watching the debate unfold Mind the Gap.  There has been talk of assuming a smaller gap, perhaps E10 billion, through rosy assumptions and perhaps delaying the full recapitalization of the banks.  This likely would be resisted strongly by the IMF and experience suggests that would be counterproductive, further undermining the credibility of the package. Imf – In or Out?  In addition to the financing challenge, the IMF reportedly has serious concerns about the sustainability of Cyprus’ debt, and wants debt to GDP to be reduced to around 100 percent no later than 2020, and perhaps sooner.   If the program goes ahead, without any bail-in or on unrealistic assumptions, the IMF could withdraw its financial support for the program (while continuing to provide technical assistance and an assessment).  As with Spain, an EU-only financing package provides Europe with more flexibility to kick the can, at the risk of a loss of credibility. What’s the “adjusting” finance?  Recall that, in Greece, the financing gap was not filled until the last minute, and the residual or adjusting finance came from an increased haircut on private bondholders.  Similarly, this negotiation is likely to noisy, contentious, and come together only at the last minute.  How will the financing gap be closed at the end? There are hopes in Europe that it will be the Russian government, given the involvement of their citizens in the Cyprus financial system.  I’m not sure why Russia should agree, beyond perhaps an extension of maturing claims.  For this reason, the debate on PSI is not over. What does it all mean for Greek banks?  Greek banks could be hit hard by any restructuring in Cyprus, and a desire not to undermine the recent bank recapitalization there would work against a bail-in of private creditors, or lead to a Greek carve out. How does Italy figure in?  There is little question that the Italian elections have changed the political dynamic in Europe.  But how will this play out here?  Public reaction against austerity argues for more gradual paths for fiscal adjustment, and thus more financing.  Facing significant Italian uncertainty, some feel policy should take unnecessary risk off the table, so why go for PSI now?  On the other hand, one could argue that Italy makes it all the more important that Cyprus be held to a strong program, with burden sharing.  To do otherwise would suggest that bad behavior is rewarded while serious efforts to adjust are not.

U.S. and EU policymakers see multiple signs for a free-trade deal that could stimulate halting economies on both sides of the Atlantic and spur global talks, says expert Jeffrey Schott.

Germany’s Bundesbank remains an influential actor in eurozone policymaking, and its recent disagreements with the ECB raise concerns about managing the zone’s debt crisis. This Backgrounder explains.

If you are interested in the frontier thinking of European debt restructuring, you need to read the latest from Buchheit, Gulati, and Tirado.  In it, they propose an amendment to the European Stability Mechanism (ESM) that would make future European restructurings easier by strictly limiting the rights of holdout creditors.  It’s designed with an eye to the smaller countries of Europe, which have significant debt issued under foreign law.  With the prospect of a restructuring in Cyprus on the horizon, and concerns about debt sustainability across the periphery, it’s a timely proposal.  While a treaty change seems far fetched, some European policymakers will find it appealing.  That doesn’t mean it’s good policy. I have earlier written on the revival of support for a Sovereign Debt Restructuring Mechanism (SDRM) and this proposal would create a SDRM-like mechanism, within Europe, for European sovereign debtors.  In the Buchheit et.al. plan, if a country was adhering to an ESM-supported program,  their assets would not be subject to attachment in the ESM-member country. Thus it creates a safe harbor in Europe from holdout creditors seeking to enforce judgments obtained abroad.  The idea is modeled after the 2003 restructuring of Iraq’s debt, where a UN resolution protected Iraq’s oil assets against attachment in UN-member states. The appeal from a policy perspective is obvious:  it ensures that when a country is receiving extraordinary support from its European partners and restructures its debt,  that money isn’t going to holdouts.  By making restructurings easier, it gives policymakers confidence that the necessary financial objectives set out by the Troika (the International Monetary Fund, European Central Bank and European Commission) will be achieved.  And while the official European position is that the Greece restructuring was a unique event, debt is unsustainable across the periphery and a full bailout by the core looks neither economically nor politically feasible.  Restructurings will be needed. A few cautions to keep in mind, though: The protections only exist while the country owes the ESM money.  In that sense, it’s a rule to protect creditor countries rather than the debtor.  Further, the protective shield created here covers transactions only within the euro area.  For a European bank with operations in New York, for example, it is unclear how their assets and operations would be protected from U.S. court judgments.  The upcoming U.S. Appeals Court ruling on claims against Argentina will go some way to answering that question. Part of the appeal of this plan comes from the ongoing mess in Argentina.  The analogy for Argentina, had the SDRM been created, would have been protection from creditor judgment as long as it owed money to the IMF.  Sadly for this analogy, Argentina repaid the IMF long ago, so they wouldn’t have been covered.  The broader question, though, is whether a country that abandons its adjustment effort and aggressively refuses to negotiate with its creditors should continue to receive protection. Creditors will understand the intent of the law–to make restructurings easier and more successful.  Further, as Greece showed, its tempting to squeeze private creditors for that last euro of financing when official creditors are deadlocked.  So the innovation will make debt more expensive, much as an emerging market country pays a premium to issue locally (the problem of “original sin”).  The cost much of the time will not be great–certainly we see that during periods of easy credit availability, domestic versus foreign-law spreads can be quite narrow–but will be high during periods of stress, when market access is most valuable. More generally, most of the major debtors of Europe have majority local-law debt, where such a rule is not needed to reschedule.  Where foreign-law debt is significant, market-based exchanges backed by moral suasion from governments should be able to limit holdouts.  In this sense, the problem for Europe is the unwillingness to approach debt sustainability in a comprehensive fashion, rather than threats from holdouts.

Even with signs of the euro crisis abating, Europe’s political landscape remains fraught with fracturing alliances and unresolved questions regarding national sovereignty, says CFR’s Charles Kupchan.