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Creative solutions can help Cyprus avoid bailout

Reuters Breakingviews delivers agenda-setting financial insight. Its global correspondents react to stories as they develop, delivering sharp and provocative commentary on big financial news as it breaks.

Euro zone and IMF officials working on a bailout for Cyprus worry that the island's debt load might become unsustainable in the process. The most obvious and traditional solutions are risky and controversial. But a mix of half-measures, boosted by some optimism, could help the small state through its financial straits.

Cyprus needs up to €7.5-billion ($10.1-billion) to finance maturing debt and fund fiscal deficits. Another €7-billion to €10-billion – depending on the assumptions – are needed for bank recapitalizations.

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In the more adverse scenario, Cyprus would need up to €17.5-billion. That's roughly the size of its gross domestic product, and would push debt to 150 per cent of GDP – a level the International Monetary Fund considers unsustainable. A debt-to-GDP target has not yet been determined but assuming Greece's 120 per cent number also holds for Cyprus, the island would need to fund a €5-billion gap to make its debt sustainable.

One solution is for the banks to borrow the €7-billion required under the baseline scenario and raise any additional capital that may be needed later through the direct intervention of the European Stability Mechanism, the euro zone's bailout fund. Getting European lenders on board will be difficult, but not impossible. In that case, Cyprus's bailout would amount to €14.5-billion, pushing debt to 135 per cent of GDP.

There aren't many other ways to leave Cyprus with a debt it can honour. Hair-cutting depositors could trigger a bank run. Hair-cutting sovereign bondholders would first hurt domestic banks and state-owned enterprises. Besides, euro zone leaders vowed Greece would be the only country to be allowed to do this.

Bailing-in junior bank debtholders can reduce its capital needs, but only by about €1-billion. Another €1-billion to €3-billion can be raised from privatizations. So that would leave a gap of at least €1-billion, or 6 per cent of GDP. This is not a staggering amount to raise, if Cyprus is given some time.

The key here is that the small island's gas reserves could soon give its economy enough of a boost to eliminate sustainability concerns. At current prices, reserves could be worth as much as €80-billion. Only a fraction of that number would end up as state revenue, but this shows that in many respects, Cyprus's bailout could indeed be more like a bridge loan.

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