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Reduced bailout deal still set to leave Cypriot debt to 130% of GDP

15 Mar 2013

Summary: Though progress has been made, Eurozone finance ministers are unlikely to reach a final deal on the Cypriot bailout at their meeting this evening. Even if they do, any deal is likely to be another fudge, shying away from more radical options such as significant bank restructurings or depositor write downs. Amid political resistance in Germany and elsewhere to another bailout, Eurozone leaders will seek to shrink the size of the €17bn bailout by up to €7bn. However, we estimate that even in a best case scenario, only around €4.5bn could realistically be cut, due to practical and political constraints. This will leave Cypriot debt to GDP at 130% - a level that remains wholly unsustainable. In turn, this makes further financial assistance for Cyprus likely, reminiscent of developments in Greece.

Fundamentally, the row over Cyprus – which accounts for only 0.2% of Eurozone GDP – illustrates that firstly, three years into the Eurozone crisis, the block still has no effective tools to restructure debt and repair banks amid the complicated politics of the eurozone. Secondly, the stand-off between the creditors in the Eurozone north and the austerity-fatigued south could well be hardening.

Despite accounting for only 0.2% of eurozone GDP, Cyprus continues to cause problems for the single currency. Eurozone finance ministers will hold an emergency meeting this evening in Brussels in an attempt to shrink the size of the bailout from €17bn (almost 100% of Cypriot GDP) to around €10bn.

However, bringing down the cost of the Cypriot bailout will be tricky. Without a significant tax on depositors, the debt to GDP ratio will still likely reach around 130%, with taxpayers footing most of the bill once again.

Recap – conventional write downs look tricky
As we have noted before, writing down bank or sovereign debt looks very difficult to achieve in the Cypriot case. There is limited bank debt to be written down (circa €3bn against €128bn in assets).[1] The full €10bn recapitalisation required by Cypriot banks would take debt up to 140% of GDP, which is completely unsustainable. A sovereign debt restructuring would be equally difficult (see table below).

Source: JP Morgan, Cyprus Ministry of Finance and OE calculations[2]

Moving from writing down to taxing depositors
One option which has been widely discussed is writing down unsecured foreign depositors (similar to what happened in Iceland). Around €20.8bn (30%) of the total €68bn deposits are from the rest of the world (ROW) – a very large chunk of which are thought to come from Russia and are widely seen to be there for “illicit” purposes.[3] However, the precedent and potential contagion effect here could be significant, other struggling countries (Italy, Spain, Greece etc.) could see a rapid outflow of foreign deposits. Politically, this has also been dismissed by the Cypriot government, which believes taking this action would ruin any possibility of Cyprus remaining a financial services centre.[4]

Thoughts have therefore moved to taxing deposits, possibly retroactively.[5] However, it would be difficult for Cyprus to tax foreign depositors under such an approach, short of seizing a percentage of their deposits – a very aggressive move, which depositors could easily avoid since under EU rules Cyprus cannot impose any capital controls. A tax on solely domestic depositors could raise a good chunk of revenue but would hit GDP, which is already set to decline 3.5% in 2013. It would also likely amount to significant double taxation, since much of this money would have already been subject to income tax. That said, a 10% tax here could raise up to €4.3bn. A tax on the interest on deposits seems more likely but the revenue would only be a few hundred million.

Increasing the corporate tax rate
Corporate tax is very low in Cyprus at just 10% - holding onto this seems impossible. An increase to 12.5% (where Ireland currently is) seems likely. However, this has limited revenue raising potential. Revenue for corporation tax in 2012 was €723m, meaning a 2.5% increase could yield €181m annually – around €543m over the course of a three year bailout.[6]

Larger and quicker privatisations
Cyprus has 13 large state owned enterprises (SOEs), and around 20 others.[7] These obviously provide a significant potential revenue stream. However, the government has already attempted to delay this process by up to three years. We expect some privatisations will be included, however, as in Greece we expect delays. The estimated €2bn revenue from privatising the largest banks also seems overly optimistic since they will remain unprofitable and saddled with bad loans for some time.

Using Cypriot banks and pension funds to purchase government debt
This is at best a very temporary fix. Firstly, it offers no help in making Cypriot debt sustainable in the medium and long term. Secondly, it significantly increases the domestic sovereign banking loop meaning if either side gets deeper into trouble (very possible) the other will be dragged down. As the massive bank bailout shows, banks have limited cash. Cypriot pension funds do run an annual surplus worth 1.5% of GDP, but only thanks to government sponsorship.[8] If this surplus was used to purchase additional government bonds, they could fund around €300m.

Tapping gas reserves
Recent exploration has suggested Cyprus may have between €18.5bn and €29.5bn (103% - 163% of GDP) in untapped gas reserves lying in its territorial waters (according to Deutsche Bank).[9] There have been rumours that this future revenue stream could be incorporated or used to backstop the bailout somehow. Although an appealing idea, there is still a huge amount of uncertainty around the real value of these reserves and how soon they can begin producing revenue.

Russian involvement
It is now looking increasingly likely that Russia will play some role in the bailout (if its loan is given the same seniority status as the eurozone's). Having already given Cyprus €2.5bn, Russia could provide a similar amount again, especially if it secures protection against any write downs on Russian private sector depositors. More likely though, it will reduce the rate and lengthen the maturity of the existing loan. The eurozone remains torn on this issue somewhat, between reducing the cost of the bailout and pushing Cyprus closer to Russia. Last summer there were already rumours of Russia seeking a naval base in Cyprus (after its only Mediterranean base in Syria came under threat).[10] See here for a discussion on whether other EU states could contribute to the bailout - currently this seems a remote possibility.

For more information please contact the office on 0044 (0)207 197 2333 or the author Raoul Ruparel on 0044 (0)757 696 5823.


[1] Figures combine the €1.2bn in subordinated bank debt and the €1.7bn in senior bank debt. See the draft Memorandum of Understanding for Cyprus and the ECB statistical data warehouse:
[3] Data taken from Central Bank of Cyprus, see:
[4] Cited by Kathimerini, ‘Cyprus FinMin says must protect integrity of deposits, 6 March 2013:
[5] Cited by the WSJ, ‘Cyprus Central Bank head urges ‘solidarity’ levy’, 5 March 2013:
[6] Figures taken from the Cyprus Ministry of Finance, Inland Revenue Department, see:$file/EN%20MonstPub%202012.pdf
[7] US Department of State, 2012 Statement on Investment Climate in Cyprus:
[8] IMF Country Report, Cyprus: Selected Issues Paper, November 2011:
[9] Deutsche Bank, Global Markets Macro Research, Focus Europe – Cyprus: Intricacies aplenty, 18 January 2013.
[10] For more details on the Russia-Cyprus geopolitical situation see Gatestone Institute, ‘Russian Masterstroke: bailing out Cyprus’:

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