“Something to ponder while hoping for the best”: Cyprus and the IMF | FT Alphaville

“Something to ponder while hoping for the best”: Cyprus and the IMF

Quite a lot to ponder really. Members of the IMF’s executive board were set to meet on Wednesday to discuss whether to approve lending to Cyprus, more or less behind closed doors.

But maybe not so much this time. It looks like Stockwatch in Cyprus has obtained a copy of the members’ comments on the Cypriot bailout — a rather high-level internal document to find its way to the public… and it makes for fascinating reading.

Within the doc, there’s what’s called a ‘buff’ statement by officials, setting forth the outlook, then (preliminary) comments by members.

The stakes are high here. The IMF is endorsing the first capital controls on a eurozone member economy (particularly in light of Article VIII of the IMF’s Articles of Agreement). Fund staff’s growth forecasts for Cyprus are also being closely watched after the depositor haircuts, and its internal workings are in question again, given the debacle of the original bailout plan.

Many executive board member comments are also highly damning on the origins of the Cypriot crisis, and the role of the eurozone authorities. Though in fairness, they’re also realistic about the mess IMF staff have to sort through in Cyprus.

So, some fairly weighty excerpts follow…

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From Paulo Nogueira Batista (a strident critic of IMF governance in the past):

We start by acknowledging that this program is better than the first purported “sustainable solution” with “appropriate allocation of burden-sharing” that was fortunately shot-down by the Congress of Cyprus on March 19th. However, that is not a difficult mark to meet… It should have never been endorsed by Management, especially before consulting with the Board…

An over-dose of optimism? Staff is projecting a cumulative drop in output of 13 percent for 2013 and 2014. Staff is also projecting that the primary fiscal balance will move from a deficit of 5.6 percent of GDP in 2012 to the surplus target of 4 percent of GDP in 2018. This huge fiscal effort would be quite difficult to materialize in any country, but even more in Cyprus that needs to find a new business model in the midst of the deepest crisis it has ever had, in an unfavorable international environment and while its euro-zone partners are themselves striving for more fiscal adjustment. Every program needs a pinch of optimism but in this one the required dose of good-will – or suspension of disbelief, if you will –goes way beyond the average…

We would appreciate staff’s comments on the following: a) what industries could replace the share of banking in Cyprus’ GDP and in what period of time could this happen?; b) are there any fiscal support measures for start-ups contemplated in the program; c) what happened to tourism in Greece after the crisis? does Greece’s experience provide any indication of what to expect in the case of Cyprus?

Capital restrictions: devaluation without benefits? Due to restrictions in capital outflows, one euro in Cyprus can buy less goods or services than one euro in any other partner of the monetary union. How long can this go on before creating a parallel market where a euro in Cyprus is traded for less than 100 cents in Germany? Wouldn’t this be tantamount to devaluation without recovering the independence of monetary policy? How could this affect the program? We would appreciate staff’s views. Assuming the Board approves this program, capital restrictions will need to be phased out with extreme care and adequate support from the ECB. The IMF may need to request Cyprus to impose restrictions on capital transfers in order to avoid the misuse of Fund resources (Article VI, Section 1 (a) of the Articles of Agreement).

From Tao Zhang (China’s rep):

Special vigilance is warranted when lifting the temporary administrative controls. At this time, we can support the authorities’ request for approval of the exchange restrictions under Article VIII. Eurosystem liquidity is critical on this front for the Cypriot banking sector to withstand a potential reinforced capital flight. While recognizing the drawbacks by imposing payment limitations in the economy, we invite staff to take caution that failure to lift controls by a target date could exacerbate market fears. Staff comments are welcome…

The Cypriot bank crisis is not a segregated issue. Domestically, a downsized banking sector—associated with liquidity stress—is undermining the roots of the economy. A few other economies are subject to some common features although it will not necessarily translate into deeper concerns. In this respect, immediate priority should be given to contain risk contagion by putting in place a unified resolution mechanism and banking supervision at an early stage…

From Pablo Garcia-Silva (Argentina’s rep):

We strongly believe that a proper assessment of the shortcomings in our surveillance will be necessary at some point in the future. Now, however, is the time for crisis resolution and we hope that its design and implementation properly address the challenges. One of the key aspects is related with the critical need of having realistic assumption and projections. Policies, reforms and targets should not be based on wishes, but on their economic, political and social feasibility and their likely results…

We would like to know the staff’s view on the sources of growth for Cyprus over the medium-term, which although modest, still depends on a considerable 4 percent from “confidence effect unwinding” by 2015. A pick-up of growth only a couple of years after such a massive financial disruption, and without the boost from a significant nominal exchange depreciation, is too optimistic in our view. May the staff provide some more arguments to figure out the logic of these assumptions?…

Meanwhile, underscoring that “alternative strategies were either unavailable or undesirable (or both)”, the staff notes that “a proposal to impose a large one-off levy on both insured and uninsured deposits in all banks operating in Cyprus did not differentiate between solvent and insolvent institutions and conflicted with the aims of deposit insurance”. However, this strategy was endorsed by the Fund in its March 16 press release. We believe that this kind of statement has the potential of damaging the Fund’s credibility and thus should be avoided…

From Fahad Ibrahim A Alshathri (Saudi Arabia’s rep):

The Cypriot crisis will always be associated with the unsuccessful attempt to involve in bank resolution and for the first time holders of insured deposits, even in solvent banks. If such scheme had gone through, after the agreement reached on March 16, 2013 by the Troika, the Fund could have been subject to serious reputational risks…

Among all recent crises that affected the euro area, the Cypriot crisis is perhaps the least unexpected. Cyprus lost market access almost two years ago and the fragility of its oversized banking sector was clearly put at risk as a result of the Greek PSI. The Cypriot and euro area authorities could have avoided the exacerbation of the crisis if decisive and sustainable actions were taken at an early stage of the crisis.

From Aleksei V. Mozhin (Russia):

The Cypriot economy suffered a major blow from the collapse of its two largest banks. It is often said now that the whole business model of Cyprus relying on an over-extended financial sector was unsustainable and doomed to fail. We believe this conclusion is not fully supported by the facts, at least at this stage…

Looking at the DSA for the public sector, we are very much concerned by a high sensitivity of the debt trajectory to growth risk. Also noteworthy is the vulnerability to contingent liabilities risk, which may materialize in a low-growth scenario through additional losses in the financial system. Other than that, we would not read too much into the presented scenarios of debt dynamics as well as fiscal accounts, since these are impossible to predict at this point (remember the first Greek program)…

Finally, we observe that in the context of the EFF the Fund will cover only 10 percent of Cyprus overall financing needs in 2013-2016, with the rest being provided by the ESM. This is different from the ratios between the IMF and EFSF financing in previous programs with the euro area members. In this regard, we would like to know if the Fund has reached an ex ante understanding with the EC/ECB on burden sharing in financing euro area countries, or the Fund’s contribution is still determined on a case-by-case and ad hoc basis. If the latter is true, we wonder if the Fund’s staff and management see merit in more structured approach to cooperation/co-financing with the ESM.

From Thomas Hockin:

Staff’s candid acknowledgement of downside risks is welcome, but we would have appreciated staff to exercise further discretion in modeling deeper shocks in the DSA in light of the high degree of uncertainty facing Cyprus. The shock scenarios run for the Cypriot DSA are relatively benign considering the difficulty in forecasting and the astonishing shrinkage of the financial sector that is expected to take place. It is difficult to ignore how gentle the shocks are in the Cypriot DSA when they are compared to DSAs in other programs, particularly large precautionary FCL programs.

And finally — From Jafar Mojarrad:

Overall, when considering the proposed program for Cyprus, it is difficult to avoid a feeling of déjà vu with the Greek experience still vivid in mind. The key question going forward is what options would be available if growth and debt scenarios follow the pattern of the initial Greek program. Something to ponder while hoping for the best…

Related link:
Guest post: Time for a transparency revolution at the IMF – FT Alphaville