Nightmare scenario awakens euro zone from slumber

The spectacular unravelling of the Cypriot bailout deal this week has awoken the euro zone crisis from its slumber.

Having enjoyed a period of relative calm, euro zone officials were back in crisis mode.

While European authorities spent most of the week on the back foot, the troika appeared to have seized back control yesterday, aided by the lack of any substantial progress on a potential deal with Russia. The ECB's announcement yesterday morning that it would cease providing emergency liquidity assistance to Cypriot banks from Monday if an "acceptable" plan was not in place, imposed a time-frame on events. As the clock ticks down to Monday, Cypriot authorities were locked in talks with troika representatives in Nicosia.

Possible scenarios
Despite the diplomatic language from Brussels, with officials stressing that it was up to Cyprus to bring forward a deal, the key question is what will be acceptable to the troika of lenders. A number of possible scenarios to make up the €5.8 billion demanded by the troika as part of the bailout package are now on the table. Cyprus is keen on a plan to nationalise some semi-state pension funds, while the idea of issuing an emergency bond linked to future natural gas revenues has been mooted. Other possibilities include a dramatic restructuring of the banking system, which could include the merging of the country's two largest banks, Laika and Bank of Cyprus, or the splitting of one or more of the banks into a "good" and "bad" bank.

Sticking point
A key sticking point in the discussions is the controversial tax on deposits. Euro group president Jeroen Dijsselbloem said yesterday that it was "inevitable" that the final deal would include some kind of levy, and restated his preference to exempt deposits of less than €100,000. A levy on deposits is something that Cyprus has resisted, amid fears that it would damage the island's financial industry. It would also be unpopular with Russia, whose citizens stand to lose disproportionately from such a tax. As a result, any decision on the deposit tax is likely to depend on the level of Russian involvement in a revised deal. European Commission president José Manuel Barroso met Russian prime minister Dmitry Medvedev as part of a scheduled visit to Moscow yesterday, while discussions continued between Cypriot finance minister Michael Sarris and his Russian counterpart, although neither set of discussions appeared to yield results.

Pointing out that the euro group had consulted with Russia on the terms of its €2.5 billion loan to Cyprus ahead of agreement on the bailout package, Dijsselbloem said yesterday that another loan from Russia would be unacceptable as it would push Cyprus's debt-to-GDP ratio to unsustainable levels.
Meanwhile, as banks remained shut in Cyprus and ATMs dispensed limited amounts of money, plans were under way in Nicosia to guard against deposit flight on Tuesday when banks are expected to open.

Crucial concern
This is the crucial concern for the ECB and euro zone authorities, as it strives to contain any possible contagion fallout.

Discussions were under way in Cyprus to introduce laws on capital controls to prevent money flowing out of Cyprus when the banks reopen, which would have to be passed by parliament. The prospect of Russian investors withdrawing their money is a major concern, with or without Russian involvement in the bailout proposal. It will fall on the ECB to fill the plug.

With the troika back in a position of power, the key question now remains how far the euro zone and ECB are prepared to go to sustain the Cypriot banking system. If a deal is not reached, Cyprus’s banking system will fall and bring down all depositors with it. An exit from the euro zone would then become viable. As discussions develop by the hour, the next few days will be crucial.