Cyprus's Unintended Consequences

As most European officials in Brussels prepare for their summer break, some are still toiling in the steamy heat of Nicosia.
Experts from the so-called troika of the European Commission, European Central Bank and International Monetary Fund are in the Cypriot capital to check on the country’s progress in implementing the €10 billion ($13.2 billion) bailout it reluctantly accepted in March.
Progress may not be the right word. The economy is forecast by consultancies such as Ernst & Young to shrink by more than 10% this year, which would be more than the 8.7% forecast by the troika in March, and to continue contracting through 2016.
These are the predictable consequences of the experiment its lenders are imposing on Cyprus. But there are some unpredictable ones too.
For the first time since the start of the crisis, a country is being subjected to the bloc’s familiar recipe of budget austerity, together with a new dogma of bank “bail-ins,” whereby bank creditors or depositors, and not taxpayers, foot the bill for failed banks by forcibly forgoing some of their loans or deposits.
The tiny island, closer to Syria than it is to Greece, has been in financial lockdown for the last three months. For the first time in the 12-year history of the common European currency, capital controls have been imposed to keep cash from fleeing.
The conditions for the rescue included the closure of the country’s second-largest lender, Cyprus Popular; depositors with more than €100,000 at the bank stand to lose all their money. As well, the largest lender, Bank of Cyprus, is being radically downsized and has been stuck in legal limbo since March.
Large depositors in Bank of Cyprus don’t yet know how much they will lose—their deposits will in part be converted into shares in the bank—though their fate may become clearer as early as next week when the central bank is expected to make an announcement on the matter.
“It’s nothing short of shock therapy,” the country’s finance minister, Harris Georgiades, said in an interview.
At Hellenic Bank, formerly the island’s third-largest and now its only fully functioning big lender, the office of General Manager Marios Clerides is adorned with framed photographs of two bank runs—that of the U.K.’s Northern Rock in 2007 and of Cyprus Popular in 2013.
Hellenic Bank has been left intact and has avoided asking for bailout cash to raise additional capital. But the economic backdrop it faces is dire.
The economy’s annual output is €16 billion and falling. The government in Nicosia is cutting spending to meet fiscal targets, though forecasts by its international lenders and others suggest this will do nothing to bring down its ballooning debt burden.
With Cyprus Popular shut and Bank of Cyprus downsized, many Cypriot bank depositors have either lost their money or will have to wait to see how much they will get back.
“You have a Keynesian contraction in spending, a monetary contraction because of the violent cut in the money supply, a credit crunch because of the suspension of lending,” Mr. Clerides said.
As troika officials sweat into their suits at the height of a Cypriot summer, they may argue that this scale of economic contraction wasn’t part of the design. But they are discovering another unintended consequence.
Back in March, politicians from the euro zone’s creditor nations—with bailout-weary voters breathing down their necks—pushed the bail-in idea, declaring they didn’t intend to use taxpayer money to rescue Russian oligarchs who they alleged were hiding their money in the island’s banks.
Based on available data, about half of the deposits in the Bank of Cyprus belonged to non-EU interests, many of which were believed to be Russian. Most of the individual depositors were Cypriots, but the few foreign depositors had far more money in the bank.
The bail-in plan will take away part of these deposits and give their owners equity in the new, healthier and leaner bank. A significant share of the bank thus looks likely to end up in Russian hands.
While protesting it didn’t want to aid the oligarchs—suspecting them of money laundering and other questionable business—the euro zone may have managed to hand them a large slice of the biggest bank in a member state.
“The first annual general meeting of the bank will be interesting,” said Mr. Clerides.
The meeting is planned for late September. No one knows exactly who all these depositors-turned-shareholders are, and there is no reason to believe they know each other or have aligned interests by virtue of holding the same passport.
But the three or four large law firms that represent them know who their clients are and are already preparing to enable them to coordinate, several people with knowledge of the situation say.
Russian ownership of the biggest bank in a member state, while unintended, is unlikely to deter the euro zone from enforcing bail-ins in the future. Indeed, EU governments seemed emboldened by the lack of contagion from the Cyprus experiment. Weeks after the bailout, EU governments agreed on rules aimed at making bail-ins the model for dealing with bank failures.
Yet it was Cyprus’s small size and isolation that made it easier to prescribe harsh therapy. This depression-inducing combination of austerity and bank bail-ins won’t be as easy to impose on larger, better-connected economies.
Write to Matina Stevis at matina.stevis@dowjones.com

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