The risk of a Cypriot default has fallen with the decisive victory of the centre-right candidate, Nicos Anastasiades, in the presidential election on 24 February. However, the risk has not entirely gone away and tough bail-out negotiations lie ahead for the new president.
The leader of the opposition centre-right Democratic Rally (Disy), Nicos Anastasiades, took 57.48% of the vote against his rival, Stavros Malas, the standard-bearer of the outgoing communist Progressive Party of Working People (Akel). Mr Anastasiades has said that his first priority will be to secure financial assistance of some €17bn from the European Stability Mechanism (ESM) to cover maturing debt and to recapitalise the banks that were hit by the 2012 write-down of Greek government debt.
However, because a €1.4bn Eurobond payment is due by 3 June, Cyprus will default if the ESM funds are not received by that date, setting a dangerous precedent both for the country and the euro zone. The risk of a default is lower with Mr Anastasiades in power than it would have been under Mr Malas, because he and his party are seen as more credible by eurozone leaders, and also because he enjoys the support of the German chancellor, Angela Merkel. Disy belongs to the European People's Party (EPP), the same European political grouping as Ms Merkel's Christian Democratic Union. During a visit to Cyprus for the EPP conference in January, Ms Merkel made it clear that she supported Mr Anastasiades.
Default and debt-sustainability risks remain
Nevertheless, the risks surrounding Cyprus's debt have not entirely been dissipated, for two reasons. First, there is no consensus at eurozone level on the actions that must be taken to ensure that the debt, which could reach 145% of GDP after the bail-out, is sustainable. Second, because any bail-out requires a vote in the German parliament, Cyprus will have to convince the German opposition Social Democratic Party that it is serious about tackling its concerns about money-laundering. The two are connected, as those who perceive Cyprus to be a rule-breaker tend to prefer the more painful options for debt sustainability.
It appears that a bail-in of sovereign bondholders, who would take a cut on the face value of their bonds, is already off the table. The amount available to cut - €3.8bn, including domestic bondholders - is too small for such a legally tricky operation. As the bonds fall under English law, it would take several months to negotiate a deal with bondholders. Given the 3 June deadline, it is probably already too late for that process to be launched. Moreover, a bond bail-in is not favoured by eurozone leaders, who pledged that the private-sector involvement for Greece was an exception, as a haircut could rattle the financial markets.
For this reason, attention has focused on the most drastic option, a bail-in of bank depositors, whereby deposits over the uninsured threshold of €100,000 would be cut and either turned into collateral against loans or somehow (the details are not clear) turned into bank equity. The deposit idea has been mooted because the banks hold little debt but have a large amount (estimated at about €70bn) on deposit. However, a bail-in of bank depositors would also pursue a political aim, namely to target Russians or the Cypriot professionals who do business with them, as a result of the money-laundering perceptions.
It is for this reason that we believe that the deposit haircut will not be implemented. Russia has been asked to extend the maturity of its €2.5bn loan due in 2016 and has also been asked to contribute directly to the bail-out. It is unlikely that it will agree to such a move when its own nationals will also take a hit.
The more likely indirect political way of targeting Russians and punishing Cypriots is to squeeze Cyprus to ensure that the Cypriot authorities fully implement money-laundering legislation. The eurozone leaders want to send in a private firm to check Cyprus's record. MoneyVal, an agency affiliated with the Council of Europe and which works with the Financial Action Task Force, has checked Cyprus four times since 2008 and the IMF checked Cyprus in 2011. Neither organisation noted any serious concerns. However, those seeking a private audit argue that these organisations check only the legislation, rather than the implementation, and that a deeper probe is needed. So far, officials and the government have been resisting such action, arguing that it would breach not only laws on banking secrecy but also laws on privacy. However, faced with a choice between a deposit haircut and a private audit, we believe that Mr Anastasiades will opt for the latter.
If this satisfies money-laundering concerns, the chief obstacle remaining will be to address the IMF's concerns about debt sustainability. Here, developments may be turning in Cyprus's favour. The investment firm charged with calculating banks' recapitalisation needs, Pimco, has already cut the figure from €10.1bn to €8.9bn. The primary budget deficit on a cash basis was €140m (0.8% of GDP) in 2012, compared with €646m (3.1% of GDP) in 2011 and the overall budget deficit fell, despite a recession, to an estimated 5% of GDP, from 6.3% of GDP in 2011.
Now that Mr Anastasiades has the election behind him, he can be more open about his plans for privatisation. Given the small size of the Cypriot economy, it would take only a few billion euros to bring the debt/GDP ratio below 120%. If the estimated value of the list of assets targeted comes to €2bn or more, as is likely, this could go a long way to address sustainability concerns. If this is not sufficient, Mr Anastasiades has another plan to avoid default in the short term. Last week he announced that he is in talks with non-EU countries and investment funds about a bridging loan. Around €2.5bn should be enough to see him past the debt payments due in June and also July, with a little to spare for ongoing budgetary spending.