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Cyprus risks fuelling contagion with capital controls

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Cyprus' economy is going to suffer terribly in the next few years. Some of that is inevitable given how bloated the banking system had become. But the disastrous handling of the crisis, especially in the past week, will make things much worse.

That said, the bailout deal that Cyprus reached with its euro zone partners in the early hours of Monday morning makes the best of an extremely bad job – both for the small Mediterranean island and its rescuers.

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It establishes three important principles. First, there will be no losses for insured deposits. Last week's aborted deal foolishly involved taxing them at 6.75 per cent. Second, uninsured creditors rather than taxpayers will pay the entire cost of bailing out Cyprus's two troubled banks – Cyprus Popular Bank (Laiki) and Bank of Cyprus (BOC). Third, Cyprus's oversized banking sector, which depended heavily on somewhat dubious Russian cash, will be slimmed down.

There are two lingering doubts. Will capital controls be imposed? And is Cyprus's debt sustainable given the economy will be clobbered?

The key to the deal was to impose the entire pain of bank restructuring on the lenders' uninsured creditors. Laiki will be "resolved" – a euphemism for being put into controlled bankruptcy. Its good assets and insured deposits will be merged with BOC. But its €4.2-billion of uninsured deposits will be kept in the remaining bad bank and converted into equity. They could lose most of their money.

BOC is being treated slightly less harshly. It will continue as a going concern and will be recapitalized so that it enjoys a capital ratio of 9 per cent. The money to do this will come from converting a portion of its uninsured deposits into equity.

Until the number crunching is finished, these deposits – which amount to perhaps €10-billion – will be frozen. It's unclear what the eventual losses will be but the Cypriot government says they could be about 30 per cent.

Meanwhile, shareholders and bondholders in both banks are going to be virtually wiped out. There are only about €1.4-billion of these.

The deal will be extremely painful for the unsecured creditors of these two banks. But they are the ones who ought to suffer the most pain. There is also a silver lining in that many of these will be precisely those Russians who poured money into Cyprus, cutting somewhat the impact on the domestic economy. That said, there's no denying that local businesses and others will be savaged too – tipping some into bankruptcy and stifling activity.

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The flip side of the decision to inflict all the cost on creditors is that taxpayers don't have to pay a single euro to bail out the two big banks. So Cyprus may not suffer a repeat of the Irish problem – where a decision to bail out its oversized banks dragged down the government too.

But Cyprus will still have big problems. Its offshore banking centre, a huge source of income and employment, has been destroyed. Confidence has been thwacked and businesses will find it hard to get credit.

All the old economic forecasts are up in the air. Exotix, the broker, is now predicting a 10-per-cent slump in GDP this year followed by 8 per cent next year and a total 23-per-cent decline before nadir is reached. Using Okun's law – which translates every one percentage fall in GDP to half a percentage point increase in unemployment – such a depression would push the unemployment rate up 11.5 percentage points, taking it to about 26 per cent.

Nicosia is getting €10-billion, about 60 per cent of GDP, from its rescuers to help it over this difficult period. Some will be used to finance a fiscal deficit, which will be worse as a result of the coming slump. The rest will be used to roll over maturing debt and bail out some smaller banks.

The International Monetary Fund thinks Cyprus's debt will still hit 100 per cent of GDP in 2020, despite the worsening economic outlook. It says the original program had some wiggle room. But it's not clear how the IMF has done its sums. If they don't add up, investors will worry that today's bailout is just the precursor to another one in six to 12 months. The fear of that will then further dampen economic spirits.

The more immediate worry is that Nicosia could impose capital controls when the banks reopen. So far no decision seems to have been taken, beyond the plan to convert Laiki's uninsured deposits into equity and freeze BOC's uninsured deposits.

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There will be a temptation to take more extensive action in order to prevent a run on all the remaining deposits. But this would be a mistake. Not only would it further gum up the Cypriot economy. It would send a bad signal to depositors in other vulnerable euro zone countries such as Spain, Italy and Greece.

The European Central Bank has said it will provide BOC with liquidity "in line with its applicable rules." It should make clear this means it is prepared to fund a run on deposits and doesn't want capital controls beyond freezing BOC's uninsured deposits. The mere act of doing so will settle nerves.

The decision to exempt insured depositors from a tax has stopped one channel of potential contagion from Cyprus. The euro zone must now remove any risk of a second possible channel: capital controls.

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