Buiter’s manifesto on a new eurozone world order, post-Cyprus

1. Private creditors of euro area sovereigns are safer now than before, because they are politically senior to most unsecured bank creditors, including unsecured senior bond holders, but excluding depositors.

2.Insured/guaranteed depositors are most likely safe, even if the national deposit insurance/guarantee scheme is not backed by a fiscally strong sovereign.

3. Noninsured depositors will soon be legally senior to unsecured senior bond holders.

4.Noninsured depositors are at risk in countries with: (a) large banking sectors, (b) a large share of deposits in total bank liabilities and (c) very poor bank asset quality.
 
5. The troika continues to be willing to fund sovereign adjustment programs despite a very low likelihood of achieving the hoped-for restoration of sovereign solvency. Future sovereign debt restructuring in Cyprus, Greece and other euro area member states is therefore likely to involve more OSI and less PSI.

6. The Eurogroup, the ECB and the European Commission are willing to force a euro area member state to exit from the Eurozone, if there is perceived to be insufficient willingness to: (a) restructure insolvent banks through bail-ins of unsecured creditors, (b) implement sufficient austerity to support a medium-term restoration of fiscal sustainability, (c) implement the minimal structural reforms necessary to relax the supply-side constraints to sustained economic growth to a degree sufficient to make the medium-term restoration of fiscal sustainability a reasonable prospect.

7. We believe that the extent of tension and conflict between the European Commission, the Eurogroup and the ECB on the one hand, and the IMF on the other hand have been exaggerated. For starters, the Eurogroup and the ECB are hardly homogeneous entities speaking with one voice. The IMF is a natural ally in many ways of the ‘hard core’ Eurozone member states. The fact that the IMF decided to co-fund the Cyprus bail-out suggests that the inevitable divergences of views and conflicts of interest remain manageable in our view.

8. On balance, the accelerated restructuring of insolvent banks initiated in Cyprus should speed up the arrival of the day that excessive leverage of banks, sovereigns and (in some member states) households, is a thing of the past, thus removing demand-side impediments to sustained growth.  

While the possibility of anticipating future gas revenues is an upside risk to sovereign solvency, the downside risks, from much weaker than officially projected economic activity to the risk of a potential ‘Cyprexit’, dominate, in our view, and a restructuring of Cypriot sovereign debt, both through PSI and through OSI (the €2.5bn Russian loan and the €10bn ESM-IMF loan) during the next year or two is very likely. Statements from Eurogroup finance ministers, heads of state and heads of governments, from EC officials and from central bankers that there will be no more PSI for sovereign debt are simply not credible, in our view, because the arithmetic of funding needs, political limits to austerity and political limits on mutualisation through the front door (fiscal facilities like the ESM) or through the back door (quasi-fiscal transfers by the ECB/ Eurosystem) are still likely to leave a gap that can only be filled by sovereign debt restructuring.   

the ability of a two-thirds majority on the ECB’s Governing Council to stop ELA funding means that the continued membership of Cyprus in the Eurosystem is dependent on it maintaining the support of a blocking minority on the ECB’s Governing Council. Without the access of its banks to the balance sheet of the Eurosystem, either through the normal liquidity facilities or through the ELA, we believe Cyprus would have no choice but to exit from the Eurozone. Even though political pressures no doubt have been, continue to be and will be brought to bear on the Governing Council as regards Cypriot bank access to the facilities of the Eurosystem and the ELA, we find it extraordinary that so much political power rests with unelected technocrats. It is reminiscent of the Emminger letter episode, when in a secret document drawn up in 1978, the German Bundesbank President Otto Emminger was granted power by the German Chancellor Helmut Schmidt to ignore formal obligations to support weaker countries via (potentially open-ended) foreign exchange intervention during European currency turmoil.    

Under EU rules, domestic banks and subsidiaries of foreign banks domiciled in the EEA (European Economic Area) fall under the domestic/host country regulator and supervisor and are covered by the domestic/host country deposit guarantees. Branches of foreign banks are not. Specifically, they are regulated and supervised by home country regulators and supervisors and are covered by home country deposit insurance. Depositors of foreign branches of Laiki and the Bank of Cyprus therefore should have been treated the same way as depositors of these banks at branches in Cyprus. Yet depositors of the Greek branches of Laiki will be spared because these branches were, at the last minute, taken over by a Greek bank – Piraeus Bank. Even if the letter of the law and the rules were observed, we feel the spirit was not upheld here.