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The deal's fundamentals are clear enough.1 In order for the government in Cyprus to receive European rescue funds, it will, effectively, have to collapse its financial system. The bond and shareholders of Cyprus's two largest banks will lose all. Depositors will get the protection of insurance up to the first €100,000. Thirty to 40% of the amounts above that will be converted into shares. The smaller insured deposits and viable assets of the island's second largest bank, the Popular Bank of Cyprus (also known as the Laiki Bank) will migrate to the Bank of Cyprus—an infusion of liquidity and assets that should make it viable. Meanwhile, the Laiki Bank will be dissolved. It is a classic "good bank/bad bank" model of resolution. The plan expects to raise €5.8 billion from the banks in this way, the majority, €4.2 billion, from Laiki Bank's larger deposits. The more authorities can get out of Laiki's depositors, the smaller loss they will impose on large depositors at the Bank of Cyprus. In return, the government will receive €10.0 billion in rescue funds from Europe, and the rump of Cyprus's financial system will remain eligible for the usual support of the European Central Bank.
This approach contrasts with past European settlements, which have relied more on taxpayer funds and savaged bondholders and depositors less. It is little wonder, then, that stock markets retreated initially when the plan was announced—and also responded badly to remarks by Netherlands' finance minister Jeroen Dijsselbloem that this practice should become the eurozone's default approach to ailing lenders.2 But otherwise, the solution calmed market fears. The euro—which had fallen more than 5% against the dollar during the uncertainties preceding the settlement—stabilized, albeit at its low level. The rates on Italian and Spanish debt, which had jumped under the initial uncertainties, fell back to levels that prevailed before the crisis, as did the yields paid by other vulnerable members of the eurozone.3
While this approach offers a welcome predictability, it likely will instigate capital controls with all their negative consequences Depositors in Cyprus banks, having lost, will naturally want to withdraw what remains of their assets and place that them in safer locations. Finance Minister Dijsselbloem's remarks may convince depositors in other vulnerable nations to do the same thing. To block this disruptive flow, Cyprus and other peripheral countries will likely further capital controls to limit the amount depositors can withdraw or send out of the country. Such restrictions may only need to last a short time, until people's most intense fears dissipate. But even temporary restrictions will likely prevent the movement of funds to where they can best be used and so further stymie growth prospects. The controls are expected to also penalize depositors even more by enabling financial institutions to hold onto funds while paying a lower interest rate than they might otherwise. Worse still, capital controls in some member nations would raise questions about the universal nature of the euro, for euro deposits in places without controls will offer more value than those in places with controls.
However the details work out, especially on the question of capital movements, there can be no mistaking that Cyprus will suffer severely. There are, to begin, all the austerity strictures Europe will impose on government policy as a condition for the €10 billion in aid. These, with very little variation, have been a consistent part of the otherwise very different European rescues during the past four years. But more, this settlement, particularly its resemblance to bankruptcy, will utterly destroy Cyprus's economic model.4
But then, the island's model was never sustainable. Cyprus, largely through the Laiki Bank, had actively presented itself as a place for Russian oligarchs to bank and conduct their other business. The Cypriot government facilitated this business by establishing a thorough tax treaty with Moscow. Russia also supported the arrangement in 2011 by extending a €2.5 billion loan to the island nation. The flow of oligarch deposits, amounting by some estimates to as much as €28 billion in an economy of less than €20 billion, dangerously inflated the size of the financial sector.5 For a while, the excesses of capital created a remarkable prosperity, as did the oligarchs' luxury living, fostering a jobs boom in finance, obviously, but also in expensive goods imports, tourism, and the hospitality industry. Some in the media have speculated that the special burden placed by the settlement on Laiki deposits aims at these oligarchs. Certainly, that was the initial response of Moscow. Russian prime minister Dmitry Medvedev referred to the settlement as "stealing."6 But in the end, President Vladimir Putin signaled his acceptance by extending the official loan for five years and reducing its interest rate from 4.5% to 2.5%.7
A collapse in Cyprus, hard as it will be on the Cypriots, will do little to make matters much worse in the eurozone generally. Even Cyprus's inflated economy amounted to less than 1.0% of the eurozone as a whole.8 Meanwhile, for all the drawbacks of capital flight and credit controls, this Cyprus solution, by drawing on something close to standard bankruptcy practice, offers some hope that Europe will handle future financial challenges better than in the past. By abandoning the tendency to create new procedures at each turn and instead relying on this familiar approach (not as a rigid template but as a guide), Europe may well avoid the unnecessary uncertainties and market turmoil of the past. The Continent is far from done with this crisis, but the relative calm offered by better understood, more predictable procedures would alone raise the prospects of success and make the authorities' jobs easier.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.