March 22, 2013

Zugzwang in Cyprus

March 22, 2013

Zugzwang in Cyprus

The German word zugzwang means “compulsion to move.” It is used by chess players to describe a situation where any move a player would make will weaken his position. Cyprus may be in zugzwang.

Cyprus is a tiny little country somewhere in the eastern Mediterranean Sea. Cyprus joined the EU in 2004. For the size of its GDP Cyprus has a very large banking system. In this sense Cyprus is a typical island tax haven. Tax havens are places where, at present, large and profitable U.S tech companies shelter their income from U.S. taxes. Recent stories about the Cypriot situation state or imply that some significant part of Cypriot bank deposits are from Russian criminals. This seems to me to be seriously weak justification for the seizures.

Because of it ties to Greece, Cypriot banks were providers of loans to the profligate Greek government and took a loss of about 3.5 billion Euros when Greece went through its managed, not-technically-a-default default.

That loss was equal to about 20% of the GDP of Cyprus. Government debt is 150% of GDP. Cyprus nationalized one of the banks in 2012 but the fact is that the two large Cypriot banks are essentially insolvent. To get help from the outside Cyprus had to go to the troika to seek assistance. The troika consists of the EU, the ECB and the IMF which manages lending to troubled EU members.

Trying something never tried before, the troika decided to tell Cyprus that they would lend them 10 billion Euros with the condition that the banks seize parts of the accounts of their customers to the tune of 5.8 billion Euros. The details of how Cyprus and the troika will work thing out aside, this suggestion of seizure of assets as part of the solution is just plain dumb. If precedent is established this could cause massive withdrawals of money from banks in, say, Italy and any other EU country which has fiscal problems.

Cyprus is a small country which for the size of its economy has a lot of bank deposit liabilities or which a large part, according to the media, are held by wealthy Russians.

Over the past few years I have read hundreds of articles about bank bailouts. The people complaining about what happened in the U.S. with TARP and the Fed’s liquidity interventions missed the point that the bailouts we had here were of depositors. The other liability holders were those who owned bank equity (stock) and they took heavy losses. Bond holders for the most part took few losses. Depositors took no losses, bond holders took very small losses, equity holders (the owners of the banks) took large (in some cases near total) losses, and taxpayers took losses.

Depositors not only did not lose a penny but they were made whole beyond the limitations of deposit insurance. In Cyprus the suggestion that depositors take a haircut made the notion that borrowers really had deposit insurance suspect.

Large U.S. banks such as WaMu were handled by having another bank take them over with an agreement that the federal government (the taxpayers) would take any loss above a certain amount.

If a depositor in any country be it Cyprus or elsewhere has reason to believe that his deposit insurance will not be honored then there will be bank runs and entire banking systems could be destroyed. Making a case that depositors would make smarter decisions about where to bank if they can take losses presumes that depositors can do something which regulators cannot.

Here in the U.S. FDIC adopted temporary waiver of the limit for deposit insurance for 2 years to discourage bank runs.

What are the lessons to be gleaned from Cyprus?

1) the EU’s problem are not even close to being solved

2) the troika apparently had no viable plan and its actions were as that of one of the suspects on the TV show COPS who starts improvising when pulled over.

3) Fiscal irresponsibility by governments makes them unable to provide for emergencies.

4) A problem which is small in size in a country with a very small GDP can move world markets simply because it is a reminder that Cyprus is far from being the only country lacking a plan for fiscal sustainability of its nation’s government.

5) Large, powerful entities are capable of pulling out of the air the idea of not honoring deposit insurance as a condition for future lending to a fiscally troubled nation.

6) Too few people are addressing long-term fiscal sustainability which I define as keeping more or less constant over the medium term the ratio of national debt/GDP.