The Cypriot Government's Latest Scheme To Avert Disaster Is Already Falling Apart

Bloomberg TVCypriot parliament votes down controversial bank bailout deal on TuesdayThe Cypriot government is in last-ditch efforts to come up with a plan that will raise the 5.8 billion euros demanded by the EU as the tiny island nation's contribution to a bailout of its own banking system.

Today, they had an idea.

Initially, the government was going to impose a "tax" on all of the deposits in Cypriot banks. This effectively meant that a certain percentage of everyone's bank accounts would be confiscated, and it forced a nationwide banking shutdown and long lines at ATMs in Cyprus this week as depositors scrambled to withdraw whatever cash they could.

The controversial plan failed to pass in the Cypriot parliament. In fact, there were exactly zero votes in favor of the deal, showing just how little political appetite in Cyprus there is to impose such a levy on depositors.

This morning, the ECB told Cyprus that it would cut off liquidity to the Cypriot banking system if no deal is reached with the EU and approved in Cyprus by Monday.

So, Cypriot politicians came up with a new plan that they think they can pass in parliament: a "solidarity fund," reportedly composed of nationalized pension assets, church property, and bonds backed by future state revenues from natural gas production.

The plan is already coming under fire outside of Cyprus.

Hans Michelbach, a German lawmaker in Chancellor Angela Merkel's CDU political party, cited reservations about the new plan, saying it raises "a row of questions" and appears to come up 1 billion euros short of the necessary 5.8 billion euros.

Finally, Michelbach said it would add to Cypriot government debt. That is not good in the eyes of the "troika" of ECB, EU, and IMF creditors, because the argument is that it makes the whole bailout that much more unsustainable. The IMF previously said it would refuse to chip in to any bailout that would contribute to a big rise in Cypriot government debt on these grounds.

These concerns were echoed by others, including fellow German lawmaker Priska Hinz, who said today that the new plan fails on debt sustainability.

And guess who else is staying away from loaning money to Cyprus because of its debt levels: Russia.

According to Bloomberg, Cypriot finance minister Michael Sarris – who has been in Russia this week trying to negotiate aid – said that Russia couldn't help with a loan because of the country's outsized debts.

Russia wants to invest in this solidarity fund instead because they're looking for hard assets, but the point is that an increase in Cypriot sovereign debt levels is worrying for creditors (the largest, in this case, being the troika).

That's what this new plan does in a way that the unfair haircuts on depositors doesn't, and it illustrates the complex dilemma facing Cyprus and other negotiators in the process.

The bail-in of depositors clearly seems like the preferred route by the troika.

Citi Chief Economist Willem Buiter thinks that sort of approach is the way the euro zone is headed:

The proposed tax on bank deposits in Cyprus also opens up prospects of wider one-off fiscal measures and/or bank debt and other private debt restructuring as an alternative or accompaniment to PSI on sovereign debt and/or OSI on official debt. The greater willingness in the euro area to bail in bank creditors should, in addition to raising default risk on all unsecured bank debt (including deposits), reduce sovereign default risk in countries with large and weak banking sectors.

Unsecured creditors of banks and other financial institutions like insurance companies that have weak balance sheets and capital needs that cannot be met by the markets are right to be concerned that they are now more likely to bailed in as part of a resolution and recapitalisation programme. In addition, asset holders or cash-rich companies in other periphery countries may — with good reason — worry that they too may face one-off “taxes” to fill fiscal shortfalls if policymakers still seek to avoid PSI on sovereign debt, or wish to avoid imposing heavier burdens on more conventional and more politically sensitive tax bases or beneficiaries of public spending.

This may be especially likely if official debt holders are unwilling to tolerate large NPV losses and are capable of enforcing these views, or for cases where OSI is inadequate to restore fiscal sustainability, or where asset holders lack political support in periphery countries. To be sure, Cyprus is “unique” in having such a large banking system. But, each euro area country is unique in its own way. Cyprus is certainly not unique in having an unsustainable position of its consolidated banking sector and public sector.

These are the complicated dynamics underlying the Cyprus bailout talks right now.

The Eurogroup of euro zone finance ministers will hold a conference call on Cyprus at 2 PM ET. Observers will be watching closely.