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Ok, I'm done. Nick, there is no need to recover my comment from the spam filter - I already posted its contents as two separate comments.
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"Have you thought about the best course of action for Cyprus once the unilateral transfers stop, the country must finance itself and its own current account?" In one of my previous comments I described a scenario where Cyprus balances its trade in about five-years' time (with zero economic growth), so that's one possible answer. "I agree with you that, so long as the ECB is happily financing a substantial CA deficit, it causes less short-term disruption for the Cypriot economy to keep adding debt. If this is debt on which the country eventually defaults, then this is basically free consumption courtesy of other EU taxpayers" In the short-term, the Troika is supposed to make sure that the level of debt is sustainable (using forecasting models they have). In the long-term, nobody knows what level of debt is sustainable - it depends mostly on global economic trends - and a default is certainly possible, but we'll cross that bridge when we get to it.
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And still one of my comments was caught by the spam filter, so I'll try to break it down into two parts: "Correct me if I'm wrong, but isn't it hard to predict the total amount of aid that Cyprus can hope to extract from the EU and ECB?" As long as a bank has adequate capital and adequate collateral, the ECB should be willing to lend to it. If we assume that a bank would normally be able to borrow about 50% of its assets, then the limit on borrowing from the ECB would be about 200% of GDP (30-35 billion euros). At the end of January, total ECB loans to Cyprus banks stood at 9.1 billion euros (slightly over 50% of GDP), but now I think it must be closer to 100%, so there must be still a reserve of about 100% of GDP. As for the government, if we add the outstanding loan from Russia (2.5 billion euros) and the Eurozone rescue package (10 billion euros at 2.5-2.7% repayable in 12 years, with a grace period of 10 years, according to the latest government info), that would add up to a total external financing of about 75% of GDP.
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"Regarding hyperinflation, don't forget that while the increase in the monetary base might seem alarming, this is the context of massive deleveraging which is simulataneously collapsing the monetary multiplier. While short-term currency controls make sense during the transition, I don't agree that the public shift from money into hoarding real goods is likely to be nearly as widespread as you suggest and I don't think that this was the experience when, for example, the Argentine currency board collapsed and Argentina defaulted on its debt (to take one example.)" Don't forget that about one-half of all deposits belong to non-residents, who would have no use for CYP. If you combine this fact with heavy dependence on imports (50% of GDP compared to 15% of GDP for Argentina) and general capital flight, the threat of a currency collapse and hyperinflation looks very real.
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Simon, I'll try to keep my comments short so as not to fall foul of the spam-filter. "Throughout, I've been assuming a unilateral legislatively-forced redenomination of *all* existing contracts into CYP" But is it a good assumption? As I said, the reach of the Cypriot law is limited, and we should not expect it to apply to international contracts (like loans form Greek banks). In the specific case of the ECB loans, the situation is more complicated because the Eurosystem includes the ECB and the national central banks, so an ECB loan is actually a loan from the national central bank to a local commercial bank (so it can in principle be converted to pounds). However, when the national central bank makes such a loan, it increases its intra-Eurosytem liabilities, so converting the ECB loans to pounds would bankrupt the national central bank, rather than commercial banks.
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Simon, "It is, you know, an "independent" nation, isn't it?" No, it isn't. Not in any meaningful sense of the word. It's a divided country, whose government is not recognized by its most powerful neighbor (Turkey); its economy is so closely interconnected with the rest of the world that there is no real "domestic" economy to speak of; it has a very large population of foreign citizens (at least 20% according to the last census); and the reach of its legal system is limited because of the EU membership (and because of the globalized nature of its economy). So, if we look at the problem from this perspective, it makes sense to ask why would a county like this need a national currency in the first place?
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Simon, Nick has already saved it, so there's nothing more (actually, I have some more stuff, but I decided not to post it for now).
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To summarize: 1) If Cyprus stays in the eurozone it will probably experience about 5 years of zero growth and 15-20% unemployment (maybe less if the unemployed more somewhere else or retire), but the banking system will survive, the savings will remain intact and the standard of living will be maintained. 2) If Cyprus leaves the eurozone, its banking system will be bankrupt; the GDP, employment , the standards of living and the real value of savings will collapse; and inflation will be in the double digits even in the best case scenario (considering that imports are at 50% of GDP).
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The Eurozone rescue package (60% of GDP) will also help to some extent to finance the current account deficit. However, since those intergovernmental loans will reduce the level of publicly held Cyprus government debt, this will reduce the limits on borrowing from the ECB (since government bonds are used as collateral), so the net effect on total eternal borrowing may be not very big.
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Nick, could you please fish the second part of my reply out of the spam box?
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OK, to add a bit of realism to your model, let’s start with bank balance sheets and consider two exit scenarios: 1) Soft scenario: no conversion of existing asset/liabilities (including government debt) 2) Hard scenario: conversion of all assets/liabilities (except interbank loans) to pounds Scenario 1: If revenues and real asset prices are set in local currency then after a strong depreciation most borrowers will find themselves underwater and/or not being able to service their debt and will default on their loans. With an initial 50% depreciation of the currency (totally realistic, given uncertainty and capital flight), total loans at about 400% of GDP and loan-to-collateral-value ratio already close to 100%, we might easily expect losses on the order of 100% of GDP or more. However, the central bank's and the government’s ability to provide liquidity and recapitalize the system would be limited by demand for (rapidly depreciating) local currency and financial assets denominated in local currency. Monetary base would most likely be below 10% of GDP, while the level of publicly held government debt denominated in local currency may be only slightly higher, and so the government may not be able to recapitalize the banking system without triggering a currency collapse and hyperinflation. Scenario 2: If interbank liabilities (loans from the ECB) are at 100% of GDP (e.g. Laiki alone was able to borrow about 50% of GDP), then after an initial 50% depreciation banks will lose the same 100% of GDP as in Scenario 1 (euro-denominated debt goes form 100% of GDP to 200% of GDP) . However, this scenario is even scarier because the public now has a lot of local currency deposits which it is not willing to hold, so the exchange rate may continue to decline as depositors try to get their hands on foreign currency. If the CB responds with currency controls, then the public will most likely switch into buying real assets/goods, triggering hyperinflation. If the CB tries to increase short-term rates, this will create another huge problem for banks, which have long-term assets and short-term liabilities. On the other hand, if Cyprus stays in the Eurozone, there may be a slow decline in revenues and real asset prices, but the deleveraging process will be much smoother and less disruptive.
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Simon, "No, anonymous lurkers like yourself certainly don't.." I use a consistent identity, and I provide some personal background if I feel it is relevant, but I have pretty good reasons to remain anonymous and it has nothing to do with my reputation in economics - or lack thereof.
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Simon, "And, although many banks in Euroland have gone bankrupt or restructured in recent years, what you say is "typical" does not seem to have been happening." Where did I say it was typical for the Eurozone? I said "that's what a bankruptcy/restructuring looks like". If other Eurozone countries chose not to take a normal bankruptcy path(at least in other high-profile cases), or depositors just got lucky, it is a different issue.
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Simon, "When people show me that I've made a mistake, I say "You're right!" What do you do?" I clarify my position. If Krugman first strongly attack the ECB in late 2011, and later uses a cagey phrase like "I now think a breakup of the euro, with major players, not just Greece, being forced out, is up to more or less even odds" - I interpret it as "the euro could disappear before the end of 2011" and I admit it's my interpretation. If I'm not sure something actually happened but in principle it should happen (depositor losses) I usually modify my statement with "I think",and then clarify what I meant. "so why bring your master's thesis into it?" Why not - it's relevant to our current debate (current account crises vs adjustment within a common currency area) and shows that I have at least some theoretical background. So when I criticize your theoretical model, you should not assume that I simply misunderstood it, but rather that I have doubts about its real-world validity.
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I mean because YOU have some famous classmates and teachers. Anyway, I've got no reputation to lose, but you have, so let's be polite and objective.
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Simon, 1)I did not say it was typical for Eurozone bank restructuring - I said that's what happens in a bankruptcy. And I explained why in this particular case the depositors suffered such huge losses. I can't give you specific precedents because bank supervision is national and there are almost ten thousand banks in the EU, but it is certainly supposed to happen within the current regulatory framework (and I think it occasionally happens in the US). 2) Before I give you a detailed answer tomorrow: do you realize how much financing can be provided by the ECB? For Cyprus the total figure is probably about 30 billion euros at 0.75% - that's about 200% of GDP. A country with independent currency would not be able to benefit from such a source of funding and at such a low rate, which would make structural adjustment much more difficult. 3) Ad hominem arguments are counterproductive. To me, at least, you so far have not demonstrated sufficiently good understanding of real-world issues (e.g. the role of the ECB in controlling capital flight, extremely limited potential for import substitution in a country like Cyprus etc), so don't expect me to treat you with a lot of respect just because you are teaching a graduate course or because I have some famous classmates or teachers.
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And returning to the subject of large depositors suffering losses (to answer your specific question). I think it happens now and then when small banks go bankrupt, but Cyprus is the first case when it happens to depositors of a systemically-important bank - that's the most important difference. Whether it will become the new Eurozone-wide policy remains to be seen.
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Simon, BTW, I did my master's thesis on the role of international capital flows during current account crises, so I'm sure I'll have a lot of fun analyzing your plan.
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genauer, "who said 50 - 100% losses here?" Makes perfect sense. There is approximately 3 billion euros worth of unsecured deposits at Laiki compared to the recapitalization requirements of 2.7-3.8 billion euros. (For the BoC it is 8 billion euros of deposits and 2.8-3.9 billion euros recapitalization requirements)
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For now, I'll only try to give you a quick answer on depositor losses. Normally unsecured depositors don't suffer losses on the scale we see in Cyprus, but it all depends on the structure of assets and liabilities and the situation in the financial markets (and large companies are fully aware of the risks - that's why we often see negative yields on short-term government bonds). There are three main reasons why depositors of Laiki and the BoC were hit so badly: 1) First, on the assets side, both Laiki and the Boc suffered huge losses due to their exposure to Greece 2) Second, on the liabilities side, both banks found it difficult to place bonds and had to rely on large depositors, paying them as much as 9% p.a.(Laiki) 3) Finally, market conditions made it impossible to sell newly issued shares (e.g. Laiki's placement in 2012 was a flop) In addition, in Laiki's case, the situation was made worse by the government's decision to exempt various non-commercial entities (municipalities, educational institutions) - so in the end large depositors of Laiki may lose close to 100% of their deposits. As for the bank of Cyprus, forced equity conversion is not nearly as bad as a real haircut, given that the BoC's equity before deposit conversion was still positive. So, while the scale of the losses is indeed unprecedented, it should not come as a surprise to anyone who saw both banks' financial statements (especially Laiki, which has been virtually bankrupt for almost a year).
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Simon, Sorry, I think your long comment got stuck in the spam filter and wasn't visible until today (which is a pity since the holidays are almost over). I promise I will read it and reply as soon as I have time - probably tomorrow.
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Just to put things in perspective. It is worth mentioning that there are powerful local business interests that think they could benefit from leaving the euro and are actually lobbying for this option (so it is by no means a purely theoretical debate). Therefore, the signing of the memorandum is not a foregone conclusion, and Cyprus may still end up in Paul Krugman's ideal world.
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On the other hand, if you are not comfortable discussing concrete scenarios and numbers (which would be perfectly understandable), we could as well stop right here - otherwise there's a risk that we'll be just going around in circles.
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The actual numbers are 37,5% and 22,5%, which is consistent with the Troika's final proposal (a 50-60% conversion to equity).
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Simon, 1) Yes, everyone realizes that Cyprus's days as a banking center are over. 2) Yes, that's what a bankruptcy/restructuring looks like - normal operations are interrupted and large depositors take huge losses and (for the BoC, the first 40% are necessary for capital adequacy and additional 20% may be necessary to insure liquidity given the limits on how much can be borrowed from the ECB). 3) déjà vu indeed. I explain to you why leaving the euro would not work and you keep telling me that there must be a way since other countries have done something in a situation that was in some respects similar. Isn't the burden of proof supposed to be on the people who propose that Cyprus should leave the euro? Let's forget the legal situation and focus just on the bank balance sheets, capital flows, current account balance and currency reserves.
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