What the Cyprus Bailout Could Mean for Europe’s Debt

The Cyprus bailout is perhaps an even bigger deal than it first seemed, and not for bad reasons.

When Europe announced details of its efforts to rescue Cyprus, it was immediately seen as contentious. The bailout imposes a tax on bank deposits to help pay the cost of shoring up the country’s fragile finances. The plan doesn’t just aim at foreign depositors, largely Russians, who have placed money in Cyprus’s bloated banking sector; it is also expected to hit ordinary Cypriot savers who thought their government was backstopping their deposits.

As things stand, Cypriots with smaller savings will pay a smaller percentage on their money than people or companies with larger amounts deposited at Cypriot banks.

But the fact that Europe’s leaders blessed depositor haircuts at all has relevance well beyond Cyprus. It shows that the European Union is still grappling for ways to reduce the region’s debt levels, a process known as de-leveraging. Some experts think Europe’s economy and employment levels won’t grow in earnest until debt is substantially reduced. As a result, they are, with some reservations, optimistic after the moves taken in Cyprus.

“You will not have a recovery in the euro zone that puts a serious dent in unemployment unless we get a de-leveraging,” said Willem H. Buiter, senior economist at Citigroup. “The bad news is that in Cyprus, they went about it in a stupid way by including small depositors.”

After the 2008 financial crisis, the governments of Europe and the United States faced the same problem: What to do with t! he large amounts of dubious debt in their economies They couldn’t just default on large amounts of it, as that could create a cycle of panic and even greater economic pain. But just leaving the debt pile at close to its original size could stifle economic activity and create doubts about the financial sector’s viability.

The United States in some ways had it easier. Most of its bad debt was related to housing. The cascade of mortgage defaults reduced housing debt in the economy, providing some relief. And American authorities tried to quickly offset the pain and panic those defaults set off with fiscal and monetary stimulus.

But in Europe, the problem was more complex. Government debt levels, rather than subprime mortgage debt, has been the main issue. There, reducing government debt has the potential to be far more destabilizing than restructuring private obligations.

Even so, Europe eventually blessed haircuts on Greece’s government debt, because those obligations were egregiously urdensome. At the same time, however, the European Union and the International Monetary Fund have wanted to get Ireland and Portugal through the crisis without default. And the European Central Bank moved forcefully last year to head off government debt routs in Italy and Spain.

This approach means the sovereign debt pile remains a brooding burden on the Continent. Recent events show that some of Europe’s policy makers are not comfortable with this. When the opportunity arises, they look for ways to impose haircuts on debt.

Bank debt has come into the cross hairs. Bank debt can bec! ome gover! nment debt if a government decides to take over an ailing bank without applying haircuts to the bank’s creditors, as happened on a large scale in Ireland.

In recent months, the Netherlands and Spain have forced losses on so-called junior bank creditors during bailouts. But in doing so, they spared senior bondholders, who have a higher standing in the credit pecking order and lend far more to banks than the junior bondholders. The fear was that hitting senior bondholders could stoke contagion.

But with Cyprus, the treatment of depositors show that the haircut is back with a vengeance. There are reasons specific to Cyprus for this. If Europe had paid the full bailout bill itself, it would have meant adding even more to Cyprus’s government debt. It would also have prompted outrage. A large share of Cypriot bank deposits are from Russians, who may have parked their money there to avoid money laundering screens in other countries. The country’s banks have $27 billion of foreign deposits, accordng to the central bank of Cyprus. Moody’s Investors Service estimated last year that there were $19 billion of Russian deposits in Cyprus.

Despite the situation in Cyprus, Europe’s approach has deepened the fear that bank creditors stand a greater chance of being targets in future bailouts. “This is quite a significant step to impose losses on any sort of senior bank creditor,” said Alastair Wilson, chief credit officer at Moody’s Investors Service, who views depositors as a type of senior creditor. “It raises the possibility that they’ll do it elsewhere.”

There are powerful forces that will resist any attempts to force losses on debt issued by European banks and governments. They have persuasive arguments. Haircuts can set off panics and that may deepen the cost of a rescue.

But the! counter ! case is that, by not aggressively cutting bank debt, the financial system in Europe remains vulnerable. In the euro zone, bank liabilities are equivalent to around 320 percent of the region’s economy. In the United States, that ratio is much smaller at 83 percent. What is more, once new laws come in that are intended to make haircuts more orderly, the likelihood of panic may diminish.

“Europe is blundering toward a much-enhanced level of senior bank debt restructuring and sovereign debt restructuring,” Mr. Buiter, the economist, said. “The recognition of reality in Europe can be a drawn-out process.”