Cypriot bail-out struggles continues – Capital Economics (Barcelona) - The Troika and the Cypriot Government have reached a stalemate, with the latter refusing to agree to the terms for a vital bail-out.

Jennifer McKeown, Senior European Economist at Capital Economics feels that an agreement should be reached after next month´s election and Cyprus has reportedly enough money to last until then. However, meeting the criteria for future bailout payments will be a huge challenge and the risk of an eventual default remains.

She notes that after intensive talks, the Troika left Cyprus yesterday apparently little closer to reaching an agreement on conditions for a proposed bail-out of around EUR 17bln. The Government needs approximately EUR 10 bln to recapitalise its banks which have suffered from huge exposure to Greece, and the remainder to meet its day to day operating costs.

McKeown feels that in relative terms the amount is small when considering bailouts elsewhere in the region, but the principle is the main sticking point. Any such bailout should come with conditionality, otherwise a dangerous precedent is being set for the rest of the region. She writes, “The Troika has demanded extra budget savings of €1.2 billion, above the €975m that the incumbent Cypriot AKEL Government deems manageable. President Demetris Christofias has completely ruled out further privatisation of state-owned companies which Germany, in particular, considers absolutely essential to any deal.”

Another contentious area is the countries perceived status as a tax haven and money laundering capital. EU policy makers, especially in Germany, are demanding an overhaul of the countries money laundering regulations to ensure that rich Russians, who reportedly hold deposits of circa EUR 20bln in Cyprus, are not the main beneficiaries of EU support. Again, the Cypriot Government has refused to play ball.

All is not lost though however and McKeown can see a way forward out of the stalemate. She notes that Mr Christofias is not planning to run for re-appointment at the election on 17th February and his most likely successor, Nicos Anastasiades of the DISY Party, is more open to accepting the Troika’s terms. He has the explicit backing of German Chancellor Angela Merkel. Only one independent candidate, George Lillikas, has said he would not submit to the Troika’s terms and opinion polls currently suggest that he will win about 20% of the vote compared to Anastasiades’ 37%. This suggests that a new Government might achieve a deal in a month or so. And in the meantime, Cyprus reportedly has enough money to last it until the end of March.

However, even then, she believes that bailout money would presumably only be provided in tranches on the basis that the Government continued to meeting its austerity conditions. She writes, “The Government’s target for the budget deficit to be reduced from last year’s estimated 5.5% to 4.4% this year and 3.2% in 2014 assumes an economic contraction of 3.5% this year and a 1.3% fall in 2014. This is better than the contraction of 4.5% currently predicted by the EC Surveys Economic Sentiment Indicator. And with exports accounting for nearly half of Cypriot GDP, it will be a tall order for the downturn to ease markedly if Eurozone GDP falls by anything like the 1% that we have forecast in 2014.”

McKeown notes that this implies that, like Greece, Cyprus would need to implement more and more damaging austerity to continue to receive ESM support. Accordingly, there is a risk of a Eurozone departure. After all, she adds, given Russia´s exposure to Cypriot banks, it might be prepared to take over as the economy´s financier in the event of an exit. While it provided a €2.5bn bilateral loan to Cyprus in 2011, it has hinted that it will only participate in an EU-led bail-out for now, perhaps preferring not to become too involved in Eurozone politics or hoping that it will not have to shoulder too much of the burden.

McKeown finishes by concluding that, “Even the extreme scenario of a Cypriot departure from the Eurozone (which we are not predicting) need not be a disaster. Given its small size and peculiar financial situation, financial markets might shrug off such an event. But the confirmation that it was possible for countries to leave the currency union would prove a real test to the remaining membership. “

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