Europe Cyprus 4 December 2012Macro Data Flash (Euroland) Economics Research Team Cyprus bailout - nearing a deal Peter SidorovGlobal Markets Research Economist (+44) 0 20754-70132 firstname.lastname@example.org On Monday (3 December) the Eurogroup welcomed the steps that Cyprus has taken towards agreeing on an adjustment programme. This came after earlier in the day the FT leaked the draft MoU between Cyprus and the Troika. While a deal is yet to be finalised, the loan programme could total more than EUR 17bn until the end of 2015. At close to 100% of GDP, this would be larger in relative size than previous bailouts – Irish, Portuguese and first Greek programmes - which were around 50% of GDP. The draft MoU pencils in up to EUR 10bn for bank recapitalisation. Banks’ capital needs should become clearer following the interim results of the Cypriot banks’ due diligence, which are expected this Friday (7 December). The euro area finance ministers will then discuss the Cyprus bailout at the special Eurogroup meeting on 13 December. Should a deal be approved at the meeting, Cyprus could receive the first tranche in late January. Drawn-out negotiations Monday (3 December) saw a busy day in the news for Cyprus with the FT leaking the draft MoU between Cyprus and the Troika and the euro area finance ministers discussing the assistance programme for the country. These latest developments come as the negotiations on the Cyprus bailout, after months of slow progress, have moved towards a deal in the last two weeks. It has now been over five months since the Cypriot government asked for financial assistance from the Eurogroup and the IMF in late June after being faced with having to fund EUR 1.8bn in bank recapitalisation costs for the country’s second largest lender. Following the request, the Troika replied with its draft proposals in late July. Cyprus had been somewhat slow in formulating their response. In early October the Cypriot President Demetris Christofias went so far as to say that he would not sign a bailout under the terms offered, particularly objecting to privatization of profitable state-owned enterprises (SOEs) and the abolition the inflation cost of living adjustment of public wages. Cypriot officials submitted counterproposals to the Troika’s draft proposals in late October, with the Troika returning to the island on 8 November. On Friday 30 November as the Cypriot Ministry of Finance presented the details of the 2013 budget and the 2013-15 financial framework, which incorporated the fiscal measures envisaged in the draft MoU. The size of the bailout While the leaked draft MoU does not spell out the size of bailout, this could inEconomics our view total over EUR 17bn, close to 100% of GDP (EUR 17.8bn in 2011) based on the draft MoU and our estimates: Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 072/04/2012.
4 December 2012 Data Flash (Euroland) Up to EUR 10bn (56% of GDP) for bank recapitalisation is pencilled in under the draft MoU. This would include the EUR 1.8bn recapitalisation of Cyprus Popular Bank, which was done through the issuance of a 1-year zero coupon bond to the bank. The cost of bank bailout would bring the country’s debt ratio well above 100% - the debt ratio is expected by the government to reach 76% of GDP before any bank bailout costs (86% if we include the existing EUR 1.8bn recapitalisation above). The likely size of the bank capital needs should become clearer with the preliminary Cypriot banks’ due diligence results due this Friday (7 December) according to the draft MoU. We estimate that around EUR 5.6bn may be required to refinance government debt through to the end of 2015. This includes EUR 820m of bills outstanding as of mid-November, and a further EUR 2.3bn of redemptions in 2013 and EUR 2.5bn in 2014-15. Financing the budget deficit during the programme could require between EUR 1.5bn-2bn based on our back of the envelope estimate 1 . The draft MoU only presents an overall fiscal deficit target for 2012 (at EUR 1.04bn, 5.8% of GDP), with primary balance targets for 2013-15. This is likely as the interest expense figure will be sensitive to the final size if the bank recapitalisation. The interest rate on the loans is also still to be agreed.If the assistance package were to total EUR 17bn (96% of GDP), it would be muchlarger, as a proportion of GDP, than the Irish (EUR 85bn, 53% of GDP), Portuguese(EUR 78bn, 45%) and the first Greek (EUR 110bn, 48% of GDP) programmes.Details so far, and what is missingIn addition to the bank recapitalisation of up to EUR 10bn, with the size to befinalised following the due diligence results, the draft agreement envisageswidespread changes to the regulation and supervision of banks. This includesstricter classification of non-performing loans, reduction of the timeline for seizureof collateral on NPLs, bringing the cooperative banks under the supervision of thecentral bank and setting up an asset management company (AMC) to segregateNPLs and non-core assets i.e. a bad bank.The one aspect of bank reform that does not appear to be to be explicitlyaddressed in the draft MoU is mitigation of the risks posed to Cypriot banksby exposure to Greece going forward. The Greek loan book is arguably thebiggest risk facing the Cypriot banking sector – the country’s three largest bankshad Greek loan portfolios, net of provisions, totalling EUR 18.9bn (equivalent to106% of Cyprus GDP) as of 30 September 2012. A credible recapitalisationrequires a strategy to reduce the risks posed by this exposure in the event of afurther deterioration of the banks’ Greek operations. The draft MoU does state that‘an AMC or other vehicles will be able to acquire loans and other claims, includingforeign exposure from credit institutions in Cyprus that have received or will1 This estimate based on the cumulative EUR 540m primary surplus over 2013-15 agreed in the draftMoU), our estimate of the fiscal deficit for Q4 2012 that is yet to be funded (c. EUR 300m) and anestimate of future interest expense based on estimated debt levels before further bank bailout costs,estimated at c. EUR 15bn by the end of 2012, multiplied by the current average interest rate paid byCyprus (4.5%). The estimate of interest rate expense is uncertain - the level of debt post bank bailout willbe higher but the average interest rate will decrease as existing funding is replaced by the programmeloans - the Finance Minister Vassos Shiarly has suggested that an interest rate of 2.5% on the bailoutloans is being discussed.Page 2 Deutsche Bank AG/London
4 December 2012 Data Flash (Euroland)receive state aid’. This suggests that a spinoff of banks’ Greek operations into abad bank could be on the cards. However, we await more details as to how therisks posed by the Greek loan books will be mitigated.On the fiscal side, close to EUR 1.3bn (7.25pp of GDP) of fiscal consolidationmeasures is planned by end-2015, with 0.25pp of GDP adjustment in theremainder of 2012, 2.75pp in 2013, 1.75pp in 2014, 1.5pp in 2015 and 1pp in2016. This would bring Cyprus to a 4% primary surplus in 2016. Around 5.5ppof GDP worth of measures have been set out in the 2013-15 medium termfinancial framework, with another 2pp yet to be determined.The draft MoU does not spell out the overall fiscal targets, only those for theprimary fiscal balance, and is relatively silent on debt sustainability. This is likelydue to the uncertainty over the size of the banking recapitalisation, to which thepublic debt and interest expenditure figures will be sensitive.Ensuring debt sustainability will be a crucial element for a finalised deal. The draftMoU suggests that privatisations may be used to plug any gap, although no detailsare provided – ‘If necessary to restore debt sustainability, the Cyprus authoritieswill consider a privatisation programme for state-owned and semi-publiccompanies’. Debt sustainability considerations may also be important indetermining the interest rate on the bailout loans.That said, in the long-run it is Cyprus’s gas reserves that will likely be key toaddressing the country’s high debt in the long-run. The plan is to establish aresource fund which would manage revenues from gas exploration, althoughthese are expected no earlier than 2018, according to previous reports.Next stepsThe preliminary bank due diligence results, expected this Friday (7 December), willbe crucial to determining the size of programme. Should the size of a bank bailoutput debt sustainability in doubt, finalising a deal could become challenging asadditional contentious measures such as privatisation of SOEs and the use of gasrevenues, may be required.The fiscal side of the bailout has now been agreed with the measures presentedlast Friday by the Finance Ministry. The government is expected to submit anumber of bills relating to the MoU to parliament, with the aim of approving themin time for the 13 December Eurogroup meeting. Were this meeting to approvethe Cyprus package, the country could receive the first bailout cash in late January2013 after necessary euro area parliamentary approvals and the final results of thebank due diligence, which are expected in mid-January.Deutsche Bank AG/London Page 3
4 December 2012 Data Flash (Euroland)Appendix 1Important DisclosuresAdditional information available upon requestFor disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please seethe most recently published company report or visit our global disclosure look-up page on our website athttp://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.Analyst CertificationThe views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, theundersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view inthis report. Peter SidorovPage 4 Deutsche Bank AG/London
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