Cyprus and its international creditors were in tense
negotiations into the early hours Monday trying to hammer out a
bailout deal that would preserve the country's place in the euro
zone.
But political chaos in the island nation's capital fanned doubts
about the government's ability to secure approval for any deal,
putting the stability of the currency bloc in doubt.
Tensions nearly boiled over during meetings on Sunday evening,
when Cypriot President Nicos Anastasiades threatened to resign amid
demands from the International Monetary Fund and European officials
for a deep restructuring of Cyprus's banking system, an official
familiar with the incident said.
Cypriot officials and politicians have spent much of the past
decade cultivating the country's status as an offshore tax haven,
its banks swollen with deposits--mainly from Russia. With the rest
of the euro zone now insisting that economic model can't continue,
resistance from the Cypriot government and members of its
parliament is running high.
Cyprus has kept Europe on tenterhooks over the past week, after
its parliament rejected an initial EUR10 billion ($13 billion)
bailout agreement it had reached with the euro zone and the
International Monetary Fund. That agreement would have required
Cyprus to impose a tax on depositors to raise EUR5.8 billion to
help stabilize its two biggest banks.
Since then, communication between Europe and Nicosia has been
strained. Officials in Brussels and other euro-zone capitals have
complained about being left in the dark over the Cypriot
government's plans and feared Nicosia's hunt for alternatives was
wasting valuable time.
"Nobody seems in a position to call the shots," said a senior
euro-zone official.
On Sunday night, officials from the IMF and the euro zone held
parallel talks with Mr. Anastasiades, and the country's finance
minister, Michalis Sarris.
But they didn't have much time. The European Central Bank has
said it would cut off emergency liquidity to Cyprus's banking
system on Monday night if there is no clear plan by then. That
would prevent banks on the island from opening as planned on
Tuesday and would quickly send Cyprus's financial system into free
fall, potentially forcing the country to leave the euro zone. ECB
officials insist the deadline can't be extended, because the
central bank's rules prevent it from lending more to Cyprus's
insolvent banks.
Even if the bailout goes through, the country faces a recession
so deep that it may need even more money to survive inside the euro
zone.
With its banks closed since March 16 and one or both of its two
major lenders unlikely to survive the coming days, Cyprus--already
more than a year in recession--is just beginning down the painful
path being walked by Europe's crisis-ridden south.
Economists are fast dialing back their forecasts for the
country's tiny, EUR17.5 billion economy, which until a few days ago
was officially forecast to shrink 3.5% this year. Some now predict
that the blow to Cyprus's financial sector, which accounts for
about half of economic activity, combined with an existing credit
squeeze made worse by the proposed bank-deposit levy, will send
output into a tailspin.
"The [deposit] haircuts will have a calamitous impact on Cypriot
output, leading to a decline in gross domestic product of 10% this
year and 8% in 2014," said Gabriel Sterne at Exotix, a hedge-fund
advisory. "We think the peak-to-trough decline in annual real GDP
will be in the order of 23%, similar to Greece, but we see risks
more on the downside than the upside."
As with the rest of Southern Europe, Cyprus faces crippling job
losses, rising business bankruptcies and slumping tax collections,
said economists.
That could imperil the country's ability to meet budget targets,
something that in turn could call forth even harsher measures and
once again stoke fears about the island's long-term future inside
the euro zone.
Officials said they believe the financial and political gridlock
has done long-term damage to the Cypriot economy. Restrictions on
money transfers and possibly cash withdrawals now may need to be in
place for weeks or months until Cypriot banks stabilize, officials
said. And the government and its banks are likely to need more
financing than they did a week ago because of the deteriorating
economic climate.
"We are a week further and substantial damage has been inflicted
on the Cypriot economy," said Dutch Deputy Finance Minister Frans
Weekers as he arrived in Brussels. "So I wouldn't be surprised if
[Cyprus's financial needs] will be more" than the amounts set out
last week.
"The numbers haven't changed; if anything they have gotten
worse," German Finance Minister Wolfgang Schauble said.
Amid the uncertainty over the island's financial future, the
government has severely restricted the free flow of money to and
from the island. Late Friday, the Cypriot parliament passed a bill
that would allow it to shut the country's second-largest lender,
Cyprus Popular Bank PCL (CPB.CP). The government was still fighting
to keep its biggest bank, Bank of Cyprus PCL (BOCY.CP), alive.
Underlining the seriousness of the situation, the two banks
imposed limits on cash withdrawals from automated-teller machines
on Sunday. Georgios Georgiou, the spokesman for Cyprus's central
bank, said the limit was EUR100 per day. However, at least one Bank
of Cyprus ATM in Nicosia had a withdrawal limit of EUR120. ATMs of
other banks in Cyprus dispensed cash normally, he said.
Cyprus's financial system is in trouble because of losses from
Greek government bonds, inflicted during a euro-zone-led debt
restructuring last year, and a quickly deflating real-estate
bubble. The effects have been magnified by the large size of
Cyprus's financial system relative to its economy.
Wealthy foreigners--many of them Russian--have used the island's
lenders to store cash, taking advantage of lax banking laws and low
corporate taxes. It was because of this reliance on deposits, which
have reached about four times the size of Cyprus's economy, that
the euro zone and the IMF insisted that bank-account holders
contribute to the cost of saving the country and its banks.
In an initial deal reached March 16, the Cypriot government
agreed to levy a tax of 6.75% on deposits with less than EUR100,000
and 9.9% on those above that amount--a one-time move that was
supposed to raise EUR5.8 billion.
Since Cyprus's parliament voted down that deal, the government
has failed to find other sources for that money. A trip to longtime
ally Russia yielded no results and the euro zone rejected plans to
nationalize Cyprus's pension funds and tap other domestic
resources, arguing that would only further raise the country's debt
load. But finance ministers, including Germany's Mr. Schauble, said
they were ready to find a deal for Cyprus at Sunday's meeting.
"We are here to find a solution with Cyprus kept in the euro
zone," said French Finance Minister Pierre Moscovici.
Whether a new deal will be able to keep Cyprus's debt-to-GDP
ratio under 100% in 2020--the target that the IMF has set as a
precondition for joining a bailout--is another question.
"Weaker GDP performance implies a higher debt-to-GDP burden,"
noted ratings firm Standard & Poor's. Last week, the firm cut
Cyprus's sovereign-debt rating a notch to triple-C from
triple-C-plus, saying it sees the economy now shrinking 6%,
heightening the risk that Cyprus may not be able to meet the terms
set for the loan.
"In light of building economic and financial-stability
pressures, the terms of any support package are likely to be
unpopular and challenging to implement in the context of a severe,
protracted economic downturn and an extended bank holiday," the
firm added.
--Tom Fairless and Maarten van Tartwijk in Brussels and Joe
Parkinson and Matina Stevis in Nicosia, Cyprus, contributed to this
article.
Write to Gabriele Steinhauser at gabriele.steinhauser@wsj.com,
Matthew Dalton at Matthew.Dalton@dowjones.com and Alkman Granitsas
at alkman.granitsas@dowjones.com
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