David Frum

01.25.13

Not if, But How, Cyprus Defaults

Big news from Davos, where it has been made apparent Cyprus will default. All defaults are rough ventures, but Felix Salmon worries this will be particularly tricky:

If there’s any hint that Cyprus might force foreign depositors to take some kind of haircut, of course, there will be a massive run for the exits, and Cyprus’s current solvency problem will become a much more serious and immediate liquidity problem. The last thing that Cyprus or any other country needs is a bank run, which will leave the national balance sheet in the classic pinch where “on the left, nothing’s right, and on the right, nothing’s left”. What’s more, in many ways the precedent of forcing depositors to take a haircut would be even more damaging than the precedent of imposing a haircut on Greek bondholders: at that point there would be really no reason at all to have deposits in any Mediterranean country.

That said, foreign deposits in Cyprus amount to some €30 billion: the opportunity cost of protecting them in full, while imposing a substantial haircut on Cyprus’s bonded creditors, would be huge.

So even if Europe has made its first big decision — to force Cyprus to default — it still faces many more. Should it amend the ESM treaty to make any restructuring easier? Should it impose a haircut on Cyprus’s uninsured depositors? And how can it structure the process to minimize the chances of a messy bank run, default, and possibly even exit from the euro? It’s easy to dismiss Cyprus as too small to worry about. But it’s still an important sovereign state. And if the EU missteps on Cyprus, that would bode very ill for any similar problems in bigger eurozone countries in the future.