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On 16 March, the Cyprus government (Caa3 negative) agreed on terms with the Eurogroup for a €10 billion support package from the European Stability Mechanism (ESM). The package will require Cyprus to impose an 'upfront one-off stability levy' on resident and non-resident depositors in Cypriot banks. Junior bondholders will also be 'bailed in.' The losses are credit negative not only for Cypriot bank creditors, but also for other European bank creditors since this is a significant step toward limiting or removing systemic support for bank creditors across Europe. The credit implications for sovereign creditors are more finely balanced and less clear.
Cyprus' parliament must approve the agreement, as must various euro member nations. The Eurogroup expects to formally approve the proposal for a financial assistance facility agreement by the second half of April.
Banks. Cypriot banks affected by the deposit and junior bondholder haircuts include Cyprus Popular Bank Public Co Ltd (Caa2 negative, E/ca), Hellenic Bank Public Company Ltd (Caa2 negative, E/caa3), Bank of Cyprus Public Company Limited (Caa2 negative, E/caa3) and Russian Commercial Bank (Cyprus) Ltd. (Caa1 negative, E/caa1 stable).
Depositors in Cypriot banks will incur losses of nearly €6 billion, imposed via a 'one-off levy,'which we would classify as a default. This amount is reported by Eurogroup officials to be 6.75% for deposits of less than €100,000 and 9.9% for deposits greater than €100,000. Junior bondholders will be bailed in for some as yet unspecified amount. Senior bondholders' position is unclear. It is also unclear how the levy will be applied, but Monday 18 March is a public holiday in Cyprus, which may give the authorities and banks time to make the necessary deductions.
The depositor levy also has negative implications for European bank creditors. The decision to impose losses on depositors is a significant departure from past instances of support from national or Eurogroup authorities - including recent support of Spanish banks and of Dutch insurer SNS Reaal N.V. (Ba2 on review for downgrade) - in which losses were contained to junior creditors. While policymakers' preference to impose losses on senior creditors to protect taxpayers has become increasingly clear, to date their willingness and ability to do so has been constrained by limitations in bank resolution frameworks and concern over contagion.
However, pressure from electorates and national parliaments to act forcefully to protect taxpayers is growing. Even if the risks of contagion in this case are limited somewhat by the fact that the banking system's problems - exposure to the Greek economy and to domestic real estate - are clearly limited to Cyprus, the decision to impose losses on depositors signals euro area policymakers' willingness to risk triggering wider financial market disruptions in pursuit of other policy goals. Notwithstanding statements from policymakers playing down its precedential nature, the step is significant and may have negative implications for supported bank ratings across Europe.
Cyprus and Stressed Sovereigns. The support package reduces the immediate risk of a Cypriot debt restructuring. The announcement of the support package states that the sovereign's debt-to-GDP ratio will reach 100% in 2020, which in combination with the size of the support package suggests only limited fiscal consolidation beyond what has already been legislated in a low-growth environment. The Eurogroup also want Cyprus' banking sector to shrink to the EU average, which the European Central Bank estimated at year-end 2011 at 354% of GDP versus Cyprus' 697% of GDP. If this happens, Cyprus' economic growth will be weaker than previously anticipated. In the near-term, the levy on deposits will also dampen growth by negatively affecting sentiment, consumption and investment. The implementation of the programme and the resulting sustainability of the sovereign's debt position will also be affected by the feasibility of the government's privatisation programme as well as by the value of revenues from gas royalties that come on stream later in this decade.
While raising the risk of deposit flight out of peripheral banking systems, the agreement reflects euro area policymakers' desire to avoid sovereign defaults in addition to Greece's, and is consistent with statements in recent months about that default being unique. By removing the risk of a sovereign restructuring for now, the agreement reduces contagion risk for sovereign credit markets and supports our base-case assumption that policymakers in the euro area will act to preserve the monetary union in its current form, as they have done so far.
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