The midget and the mighty
The debt saga keeps sucking in new countries
Aug 6th 2011 | from the print edition the economist
IT STARTED in Greece, and has spread steadily since. This week’s episode of the euro-zone crisis has focused on Spain and Italy, but other countries, at both ends of the size spectrum, keep coming into view. Cyprus, a midget within the monetary union, has been pushed to the brink of a bail-out. France is still in the rescuers’ camp, but it, too, is starting to attract attention.
Cyprus’s outsize banking sector, with assets of more than seven times GDP, is heavily exposed to Greece. In a “mild” stress scenario, featuring a haircut on Greek government bonds and losses on private-sector loans, Moody’s, a ratings agency, estimates that Cypriot banks will require a capital injection worth 16% of the island’s GDP. Domestic deposits were down in four of the first six months of the year, including a particularly steep drop in June. The shares of the largest listed banks have lost around half of their value so far this year.
The government’s ability to support the banks is in doubt following an explosion on July 11th that destroyed the Vasilikos power station, taking out half of the country’s electricity supply. The blast was triggered by seized Iranian munitions stored in containers at a nearby naval base. Amid regular power cuts, Cyprus will be lucky to eke out any economic growth this year. Progress on reform of Cyprus’s bloated public sector, already faltering, has broken down completely following the explosion, with President Demetris Christofias dismissing his cabinet on July 28th and the junior party in the ruling coalition leaving the government on August 3rd.
At first glance, the island’s fiscal situation does not look particularly precarious. Cyprus’s 2010 budget deficit, at around 5% of GDP, was akin to that of the Netherlands. But electricity shortages and political gridlock could drive it to 7% of GDP this year, or higher. The finance ministry insists that it can cover debt repayments for the rest of the year but a daunting €1.1 billion ($1.6 billion) of debt matures in January and February next year. Refinancing this at current yields (see chart) would be impossible. Bank of Cyprus, the country’s largest lender and a crucial investor in government debt, warned this week that the sovereign faced an “imminent” bail-out.
Help may yet come from outside the euro zone. Thanks to amenable bankers and double-taxation treaties, Cyprus has long served as a hub for businesses in Russia, with revenues flowing freely through “brass plate” firms on the island en route to subsidiaries elsewhere. The scale of the trade is such that tiny Cyprus appears in official statistics as the largest source of foreign investment in Russia. Despite a small outflow in June, deposits from outside the euro zone are still twice what they were five years ago. A few billion euros in return for Cypriot stability could be decent value for Russian firms. “It’s a big buffer that’s difficult to measure,” says Benjamin Young of Standard & Poor’s.
If Cyprus were added to the euro zone’s bail-out bill, at least it would not tax the European Financial Stability Facility (EFSF), the euro zone’s rescue fund. The same is not true of Spain or Italy. Europe’s bail-out fund, whose lending capacity will soon be raised to €440 billion, would probably be big enough to rescue Spain if push really came to shove, but would not be able to take on Italy. And expanding the fund to a size that would be big enough to fund Italy could create problems for France, which is second only to Germany as the EFSF’s biggest guarantor.
Explore our interactive guide to Europe’s troubled economies
Germany could probably shoulder its share but France, with public debt of over 80% of GDP, would sag. Under its current guarantee to the bail-out fund, France has a contingent liability of 8% of GDP (if the fund were to be drawn down in full). According to analysts at Deutsche Bank, giving the fund sufficient firepower to help Italy would raise France’s contingent liability to almost 13% of GDP. If the guarantees were triggered, its public debt could balloon to more than 100% of GDP. The markets have noticed: spreads between French and German ten-year bonds hit a euro-era record this week. The gap between saved and saviour is shrinking.