Options for Cyprus

Cypriot government officials and members of parliament face major choices in the next few hours: the European Central Bank (ECB) has concluded that it will not be able to support Cypriot banks after Monday, the last day of the current bank holiday, if there is no proper agreement between European lenders and Cyprus on a comprehensive adjustment programme that guarantees the viability of Cypriot banks and the sustainability of Cypriot public finances.

The ECB has made the right call. It cannot support banks with such a major capital shortfall. Some observers satirically recalled the earlier speech of President Draghi in which he promised to save the euro, and accuse him now of doing the opposite. But this is incorrect. Mr Draghi said in July 2012 that "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro." Supporting banks that have a capital shortfall of about 50 percent of the GDP of their country is not within the mandate of the ECB.

The Cypriot government is designing a new plan. The details are unclear at the moment, but most likely there will be a combination of a “small” levy on deposits above €100,000, and the creation of a holding company with state assets, including gas rights, central bank gold reserves and church properties. The holding company would borrow against these assets and may turn the bond into equity later. This is in fact privatisation, and it amounts to using the national wealth to bail out depositors who have benefited enormously from years of low Cypriot taxes and high deposit rates. This may be socially unfair, but it is up to the Cypriot parliament to decide.

There are also talks about quickly enacting a bank resolution framework, allowing a swift split of failed banks into “good” and “bad” banks, enabling the continued operation of “good” banks, probably in line with the Danish bank resolution regime, as I described here. This sounds like a good proposal, yet the devil is in the details.

So what are the options for Cyprus?

The first-best option is to get an agreement with euro-area partners. As I argued previously, for many reasons, euro-area partners cannot agree to significantly higher financing for Cyprus: that would endanger fiscal sustainability at the expense of European taxpayers. Also, that would be seen as a victory for blackmail. Greeks might wonder, for example, that if Cyprus can say no so easily to the conditions attached to financial assistance, why can’t they do the same? Backtracking by euro-area partners could wreck existing and future financial assistance programmes.

The question is if the current Cyprus proposal is sufficient to restore both fiscal sustainability and bank viability. Probably we will know the views of euro-area policymakers only by the weekend. If the proposal is not sufficient, the Cypriot parliament will have to agree to a revision of the plan. Yet even in this benign scenario, a massive bank-run is expected in Cyprus the first day the banks open. With the support of the ECB and euro-area partners, the situation may be manageable, though the prominent role of Cyprus’s financial services is probably over anyway.

The second option is to turn to Russia for help. Such help does not seem to be forthcoming, but Russian politics are not always predictable. One can never exclude a last-minute intervention.

The third is a chaos and possible euro exit (“Cyprexit”). If Cyprus does not reach an agreement with the euro-area partners and does not get help from Russia, then the ECB will turn off the tap for Cyprus’s banks. When there is no money, even ordinary transactions between businesses, or the purchase of food by people, cannot be done. Nobody would pay taxes and therefore the government would not be able to provide public services once the current cash reserves are gone. The use of euro cash will be limited further by the attempts to store the remaining euros under the pillows, so that they can be exchanged for an eventual new currency at a good price. Even though there is no formal process for leaving the euro, the lack of money in circulation would make it necessary to introduce a new currency.

The impact of an exit would be dramatic for the Cypriot people. The impact on the rest of the euro area would depend on expectations: would depositors consider the exit of Cyprus to be a precedent? If so, a massive deposit flight can start and then the ECB will need to lend a lot of money to banks in other euro-area countries. The ECB has the capacity to do so and will do this, in my view, but it would be a major period of turbulence with unpredictable consequences. If instead depositors consider the Cypriot case to be truly exceptional, then the situation would be manageable after initial turbulence.

People and politicians of other euro-area countries, seeing the dramatic impact of the Cyprexit on the Cypriot people, might conclude that it is better to do everything to keep all other countries in. It could therefore accelerate integration efforts, such as the banking union. Other issues, such as a euro-area fiscal capacity, could also be put back on the table. And perhaps the austerity debate would gain a new impetus. Indeed, irrespective of the Cyprus drama, the economic outlook of the euro-area is so weak, and is even desperate in southern member states, that a new direction is needed in euro-area macro policies. I hope that such a change will come, but it should come for reasons of economic principles, not because of a dramatic Cyprexit. The Cypriots have to make wise choices. After containing the first wave of shock, euro-area partners should also think more seriously about the future.