Mario Draghi denies that he is an actor. But in July last year he is reported to have paused, with great effect, between two sentences in an interview for the Financial Times. The two sentences were, ‘Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.’ On the basis of these two sentences, which were followed by a spectacular rebound in the euro on the foreign exchanges and in European share prices, the FT made Draghi its ‘Person of the Year’ for 2012.* But Mario Draghi, like King Canute, is not omnipotent. He cannot break the laws of arithmetic and the principles of accountancy which depend on those laws. He cannot – by mere pronouncement – conjure up the real resources required to fill the hole in Cypriot banks’ balance sheets. Equally, if that hole is €17b. (or about 80% of Cyprus’s GDP of €22b.), the Cyprus Parliament cannot by rejecting the terms of an international bail-out make the people of Cyprus richer in any meaningful sense. The cost of filling a hole of €17b. is the cost of filling a hole of €17b. It was supposed to be met by an increase in Cyprus’s public debt of over €10b. and the highly controversial deposit haircut of €5.8b. The Cyprus Parliament’s unanimous rejection of the haircut does not mean that – automatically, immediately, magically and finally – the €5.8b. has fallen like manna from heaven.
We have a stand-off. The ECB has indicated that, on the provision of the appropriate collateral (Greek government bonds?), it will lend to the central bank of Cyprus sufficient amounts for it to meet cash calls from the commercial banks. These banks would then have enough cash to repay depositors with legal-tender notes. But do Cyprus’s banks have appropriate collateral in sufficient amounts? Do they, in Draghi’s terms, have ‘enough’?
Numbers must add up: the laws of arithmetic are immutable
Across the Eurozone legal tender notes are worth their stated nominal value by law. Despite the haircut on Cyprus bank deposits intended by the planned (but now apparently aborted) international bail-out, no one has suggested that euro notes held by Cyprus residents/citizens are to be worth less than that nominal value. The deposit haircut is now mentioned in the front-page headlines. So deposits, understood to be freely convertible into notes in normal circumstances, will not be worth their stated nominal value. A run on Cyprus banks therefore seems inevitable, as and when they re- open. (Talk about the deposit haircut has been in the financial pages for weeks, for anyone with the interest and energy to flick through to them. By late February Ambrose Evans-Pritchard of The Daily Telegraph had already written several stories about the haircut risk. How can anyone be surprised? It seems that millions of people are. What a strange world we live in.)
Cypriot banks can continue to pay out euro notes to depositors if they have positive sums either in their vaults/safes or in their cash balances at the central bank of Cyprus, which is part of the Eurosystem. (A commercial bank’s cash reserve at the central bank is – supposedly – totally convertible into legal tender notes.) The vault cash is tiny. So payments can continue to be made as long as central bank of Cyprus in turn has a positive balance on deposit in the Eurosystem, in the so- called Target system. (It may be a net debtor to the rest of the Eurosystem, because its borrowings exceed its deposit. But it can keep on making payments as long as there is something in the deposit.)
The Cyprus central bank’s cash balance at the ECB falls if Cyprus banks’ cash payments to other Eurozone banks exceed other Eurozone banks’ payments to them. Around the Eurozone (and indeed around the world), non-banks are now demanding cash payments from Cypriot debtors, putting downward pressure on the Cyprus central bank’s cash balance (i.e., the balance in the Target system). If the Cyprus central bank’s balance goes negative, Cyprus banks can no longer make cash payments to other Eurozone banks. In this extremity how can normal payments be maintained? The ECB has to replenish the Cyprus central bank’s balance by lending to it. (Or the ECB/Eurosystem has to lend to Cyprus’ commercial banks as such.) Such loans must of course be repaid in due course, at least in principle. To ensure that they will be repaid the ECB takes collateral, with a detailed set of rules determining whether the collateral is eligible.
So what does the Cyprus central bank balance sheet look like? The table above gives us the answer, at least for the end of January. (Much has no doubt happened since then.) The balance sheet is surprisingly large for a small island with a GDP of €22b. In fact, the balance sheet total approached 70% of GDP at end-January, with loans to Cyprus’ banks at about €9b (i.e., over 60% of the central bank balance sheet and over 40% of GDP). These of course are not suitable as collateral for an expanded ECB loan. Government debt holdings – which ought to be suitable – were €1.4b. at end- January. However, the central bank’s net intra-Eurozone debtor position, the position that has arisen largely because of transactions by the commercial banks under its wing, was then almost €6½b.
No doubt some government securities are held by the commercial banks and these could be made available to the central bank as well, but the balance sheet above shows that at end-January the commercial banks were already ‘on the hook’ for about €9b. that they had borrowed from the central bank. The commercial banks must have lodged their own government securities with the central bank as collateral for these facilities, and we need to remember that the securities in question were and remain to a larger extent claims on the governments of Greece and Cyprus. This avenue appears to be closed too.
The conclusion seems to be that the Cypriot banking system cannot borrow further from the ECB. The central bank cannot receive loans from the ECB to replenish its own note holdings. The commercial banks’ balances with the ECB are likely to go negative as and when payments between them and other Eurozone banks resume, and they too cannot borrow from the ECB because they do not have appropriate collateral. Several news stories say that ‘Germany’ (whatever or whoever that means) has given warnings that, unless Cyprus accepts the deal (i.e., the deal with the deposit haircut) or somehow finds money from elsewhere (i.e., ‘Russia’, whether in the form of the Russian state or Gazprom), Cyprus’ banks will not reopen. Quite so. The laws of arithmetic are the laws of arithmetic, whether the Cyprus Parliament likes it or not.
What now happens?
As noted above, in July Draghi said
Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.
He was prudent to insert the proviso ‘within our mandate’ and very foolish to offer the second sentence. The phrase ‘within our mandate’ gave his institution scope to say ‘no’ to the banking system of a nation that was totally insolvent and, of course, to the nation hosting and sponsoring that banking system. He did not need to say anything final about covering every potential or conceivable contingency. The banking system of Cyprus has a hole of about €17b., attributable to investing in bad assets (Greek government bonds, Greek and Cyprus real estate). It cannot recover from its borrowers, in legal tender euros of today, enough to repay its depositors, also in legal tender euros of today.
Given time, low-interest or zero-interest loans and inflation (which will increase the nominal value of the real estate), it might return to solvency at some future date. But a run is now under way. The depositors want those legal-tender notes, of certain nominal value, now; they want the notes now with as little fuss as possible. Cypriot banks have no time to sort themselves out unless they can receive a great deal of help from their central bank, the ECB, with the support of their own government and other governments in the Eurozone.
King Canute could not stop the waves lapping over his feet. Similarly, neither the ECB nor Mario Draghi can eliminate the €17b. hole merely by wishing it away.
Tags: Bank of America Merrill Lynch, Central bank, Europe, European Central Bank, European Union, Federal Reserve System, Interest rate, Mario Draghi, Milton Friedman, Quantitative easing