Saturday, January 19, 2013

Angela Merkel’s Cypriot Headache

By Desmond Lachman
German Chancellor Merkel will want a quick resolution of the Cypriot economic and financial crisis so that a bailout does not become a domestic political issue ahead of her reelection bid. One has to pity German Chancellor Angela Merkel. No sooner does she succeed in keeping Greece in the euro, after very protracted negotiations with both the Greeks and the International Monetary Fund (IMF), than another euro member country, Cyprus, rears its ugly head. And it does so with economic and financial problems at least as challenging and as intractable as those in Greece. Resolution of the Cypriot economic and financial crisis ahead of Germany’s September 2013 parliamentary elections will prove to be very difficult for Merkel, since such resolution will almost certainly prove how hollow her assertion has been that official debt reduction in Greece was a special case not to be repeated elsewhere. It will also underline the uncomfortable truth that Greece will not have been the last euro member country to require a multiyear bailout program. Underlying the present Cypriot economic and financial crisis is a domestic banking sector that was allowed to get totally out of control. Aided by a large inflow of Russian laundered money, the Cypriot banks’ balance sheet was allowed to expand to around 8 times the size of the Cypriot economy. To compound matters, a substantial part of the Cypriot banks’ balance sheet was loaned either to Greece or to finance a domestic real estate bubble. The collapse of the Greek economy and the bursting of the Cypriot real estate bubble have blown a major hole in the capital adequacy of the Cypriot banks. It has also not helped that the Cypriot economy has now slipped decidedly into economic recession. According to estimates by the IMF, the capital shortfall of the Cypriot banks is presently at least €10 billion, or around 50 percent the size of the Cypriot economy. Meanwhile, there are reports that a private-sector audit of the Cypriot banks being led by PIMCO, a U.S. money-management firm, is finding that the size of the capital shortfall is more on the order of €12 billion. Merkel will almost certainly want a quick resolution of the Cypriot economic and financial crisis so that bailing out Cyprus does not become a domestic political issue ahead of her reelection bid. However, sadly for Merkel, a number of factors in Cyprus and elsewhere will militate against any such quick resolution. Among the more important of the factors is the IMF’s insistence that it needs to be reassured that Cyprus’s public finances are sustainable before it gets drawn into a Cyprus IMF–EU bailout package. The IMF is concerned that the large bailout needed for Cyprus's banks will in and of itself bloat the country’s public debt-to-GDP ratio to over 150 percent. Chastened by its unfortunate Greek experience, the IMF knows that it makes eminent policy sense to recognize a solvency crisis upfront and for what it is, rather than to pretend that the crisis is one of liquidity. This is causing the IMF to call for the early restructuring of Cyprus’s debt, which Merkel knows is anathema to many in her own party. Further complicating Merkel’s task in resolving the Cypriot crisis is the reluctance of Cypriot politicians to consider privatization as a means to reduce the country’s public debt. The current president, Demetris Christofias, and his main opponent in the forthcoming Cypriot presidential election on February 24, Nicos Anastasiades, have made it abundantly clear that privatization is not one of their priorities. At the very least, this would suggest that serious negotiations with Cyprus on an IMF-EU bailout program will need to be delayed until after that country’s elections. Yet another major roadblock to an early resolution of the Cypriot crisis is the strong domestic political opposition in Germany to bailing out the Cypriot banks. German politicians understandably bridle at the prospect that German taxpayer money would be effectively used to bail out Russian oligarch depositors at the Cypriot banks. German politicians want the Russian taxpayers to take a haircut, but such a line might be resisted in Brussels for fear of setting a precedent for other countries in the European periphery. In the end, there can be little doubt that Cyprus will be bailed out. After all, the amounts of money involved are relatively small and it would make no sense for Merkel to have bailed out Greece, despite all of its non-performance under earlier bailout packages, only to allow a much smaller country like Cyprus to set the precedent of having a country exit the euro. At least until she is safely reelected, Merkel cannot afford to have any country exit the euro, and, judging by past performance, Merkel will do whatever it takes to both save the euro and get reelected.

No comments: