Cyprus Gets New Bailout Deal

Bid to Remain in Euro Zone Imposes Bank Controls, Steep Losses on Large Depositors

By GABRIELE STEINHAUSER and MATTHEW DALTON in Brussels and ALKMAN GRANITSAS in Athens

Cyprus secured a bailout from its international creditors early Monday, ending a week of financial panic that threatened to see the small island nation become the first government to leave the euro zone.

Reuters

In Brussels, France's Pierre Moscovici, IMF's Christine Lagarde, Germany's Wolfgang Schauble and Austria's Maria Fekter worked on a bailout for Cyprus.

But lasting damage has likely been inflicted on the Cypriot economy. Officials said they believe the country will now need strict controls on money transfers in and out of the economy in the coming weeks or possibly months, cutting off its citizens and companies from much of the rest of the euro zone's financial system. And the program aims to slash the size of Cypriot banks, perhaps forever ending the country's status as an offshore tax haven and financial-services center.
Cyprus could see its economy contract by 10% or more in the years ahead, officials and economists said.
"The near future will be very difficult for the country and its people," Europe's economics commissioner, Olli Rehn, said after the negotiations ended.
The deal lines up €10 billion ($13 billion) in financing for the government and shuts Cyprus's second-largest bank, Cyprus Popular Bank PCL, imposing steep losses on deposits with more than €100,000, European officials said. The country's largest bank, Bank of Cyprus PCL, BOCY.CP +3.48% will also be downsized aggressively, with large depositors there taking a hit.
The bank restructuring doesn't need approval by the Cypriot Parliament. German Finance Minister Wolfgang Schäuble said Monday that the legislation needed to complete the restructuring of the Cypriot banking system is already in place.
He said the deal "will lead to fundamental changes" in the Cypriot banking sector and reduce its size to the European Union average.
In Nicosia on Monday, Yiannakis Omirou, president of Cyprus's Parliament and a member of the main opposition party, said the deal was a "positive" development, signaling it could enjoy broader political support.
Two officials said the level of losses for large depositors won't be clear until later Monday, when experts
from the EU and the International Monetary Fund have had time to run their calculations.
Asian stocks and the euro rose after Cyprus reached the bailout agreement.
Tensions nearly boiled over during meetings on Sunday evening, when Cypriot President Nicos Anastasiades threatened to resign amid demands from the IMF and European officials for a deep restructuring of Cyprus's banking system, an official familiar with the incident said.
Cypriot officials and politicians have spent much of the past decade cultivating the country's status as an offshore tax haven, its banks swollen with deposits—mainly from Russia. With the rest of the euro zone insisting that economic model can't continue, resistance from the Cypriot government and members of Parliament had been running high.
Mr. Schäuble said the troika of official lenders—the euro zone, the IMF and the European Central Bank will be "in contact with the Russian government."

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Xinhua/Zuma Press

In Nicosia, protesters gathered outside the EU offices.

Cyprus kept Europe on tenterhooks over the past week, after its parliament rejected an initial €10 billion bailout agreement it had reached with the euro zone and the IMF. That agreement would have required Cyprus to impose a tax on depositors to raise €5.8 billion to help stabilize its two biggest banks.
Since then, communication between Europe and Nicosia has been strained. Officials in Brussels and other euro-zone capitals have complained about being left in the dark over the Cypriot government's plans and feared Nicosia's hunt for alternatives was wasting valuable time.
On Sunday, senior EU officials, IMF chief Christine Lagarde and European Central Bank President Mario Draghi spent much of the afternoon and night huddled in a meeting with Mr. Anastasiades, as finance ministers of the 17-nation euro zone waited. The ministers began their formal negotiations early Monday, after the previous meeting yielded a deal on a few crucial points.

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Associated Press

Bank employees protested in Cyprus on Saturday. Euro-zone finance ministers met Sunday in Brussels trying to reach a bailout deal.

The finance ministers didn't have much time. The ECB had said it would cut off emergency liquidity to Cyprus's banking system on Monday night if there is no clear plan by then. That would prevent banks on the island from opening on Tuesday and would quickly send Cyprus's financial system into free fall, potentially forcing the country to leave the euro zone. ECB officials insist the deadline can't be extended, because the central bank's rules prevent it from lending more to Cyprus's insolvent banks.
The country faces a recession so deep that it may need even more money to survive inside the euro zone.
With its banks closed since March 16, Cyprus—already more than a year in recession—is just beginning down the painful path being walked by Europe's crisis-ridden south.
Economists are fast dialing back their forecasts for the country's tiny, €17.5 billion economy, which until a few days ago was officially forecast to shrink 3.5% this year. Some now predict that the blow to Cyprus's financial sector, which accounts for about half of economic activity, combined with an existing credit squeeze made worse by the proposed bank-deposit levy, will send output into a tailspin.
"The [deposit] haircuts will have a calamitous impact on Cypriot output, leading to a decline in gross domestic product of 10% this year and 8% in 2014," said Gabriel Sterne at Exotix, a hedge-fund advisory. "We think the peak-to-trough decline in annual real GDP will be in the order of 23%, similar to Greece, but we see risks more on the downside than the upside."
As with the rest of Southern Europe, Cyprus faces crippling job losses, rising business bankruptcies and slumping tax collections, said economists.
That could imperil the country's ability to meet budget targets, something that in turn could call forth even harsher measures and once again stoke fears about the island's long-term future inside the euro zone.
Officials said they believe the financial and political gridlock has done long-term damage to the Cypriot economy. The government and its banks are likely to need more financing than they did a week ago because of the deteriorating economic climate.
"We are a week further and substantial damage has been inflicted on the Cypriot economy," said Dutch Deputy Finance Minister Frans Weekers as he arrived in Brussels. "So I wouldn't be surprised if [Cyprus's financial needs] will be more" than the amounts set out last week.
Amid the uncertainty over the island's financial future, the government has severely restricted the free flow of money to and from the island. Late Friday, the Cypriot parliament passed a bill that would allow it to fundamentally restructure its banking sector.

Underlining the seriousness of the situation, the two banks imposed limits on cash withdrawals from automated-teller machines on Sunday. Georgios Georgiou, the spokesman for Cyprus's central bank, said the limit was €100 per day. However, at least one Bank of Cyprus ATM in Nicosia had a withdrawal limit of €120. ATMs of other banks in Cyprus dispensed cash normally, he said.
Cyprus's financial system is in trouble because of losses from Greek government bonds, inflicted during a euro-zone-led debt restructuring last year, and a quickly deflating real-estate bubble. The effects have been magnified by the large size of Cyprus's financial system relative to its economy.
Wealthy foreigners—many of them Russian—have used the island's lenders to store cash, taking advantage of lax banking laws and low corporate taxes. It was because of this reliance on deposits, which have reached about four times the size of Cyprus's economy, that the euro zone and the IMF insisted that bank-account holders contribute to the cost of saving the country and its banks.
In an initial deal reached March 16, the Cypriot government agreed to levy a tax of 6.75% on deposits with less than €100,000 and 9.9% on those above that amount—a one-time move that was supposed to raise €5.8 billion.
Since Cyprus's parliament voted down that deal, the government struggled to find other sources for that money. A trip to longtime ally Russia yielded no results and the euro zone rejected plans to nationalize Cyprus's pension funds and tap other domestic resources, arguing that would only further raise the country's debt load.
Whether the deal will be able to keep Cyprus's debt-to-GDP ratio under 100% in 2020—the target that the IMF has set as a precondition for joining a bailout—is another question.
"Weaker GDP performance implies a higher debt-to-GDP burden," noted ratings firm Standard & Poor's. Last week, the firm cut Cyprus's sovereign-debt rating a notch to triple-C from triple-C-plus, saying it sees the economy now shrinking 6%, heightening the risk that Cyprus may not be able to meet the terms set for the loan.
"In light of building economic and financial-stability pressures, the terms of any support package are likely to be unpopular and challenging to implement in the context of a severe, protracted economic downturn and an extended bank holiday," the firm added.
—Maarten van Tartwijk,
Joe Parkinson
and Matina Stevis
contributed to this article. Write to Gabriele Steinhauser at gabriele.steinhauser@wsj.com, Matthew Dalton at Matthew.Dalton@dowjones.com and Alkman Granitsas at alkman.granitsas@dowjones.com
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