Days after agreeing to a punitive bailout, the citizens of Cyprus are getting ready to witness the end of a flawed business model. Successfully preventing a sovereign default and euro exit was just phase one of the controversial rescue operation. Cyprus is now bracing itself for phase two: reinventing its economy. It will be a very painful affair.
However, on the European mainland, hardly anyone will be paying much attention to the fate of the Mediterranean island for long. The attention of financial markets, European leaders and the media is about to shift back to the country with the biggest potential to disrupt the euro area: Italy. More than a month after its parliamentary election, the third biggest member of the euro area is still looking for a new government.
Whatever the final outcome of the Italian crisis, one thing is clear: the fractured, Italian political establishment is doing its utmost to confirm widespread skepticism that it is capable of unifying behind a common agenda. Attempts by the leader of the center left alliance, Pier Luigi Bersani, to form a minority government have failed, but so has the proposal made by former Prime Minister Silvio Berlusconi to form a grand coalition. Italy’s President, Giorgio Napolitano, is determined to untangle the political knot. But his term is expiring in a few weeks, and Italy’s time window for a deal is shrinking fast. Over the Easter weekend, Napolitano called Mario Draghi, the head of the European Central Bank, looking for advice. We don’t know what was said, but it is hard to imagine Draghi telling the 87 year-old Italian president not to worry. It is true that, for now, most foreign observers and international investors still believe that the situation in Italy can be described as one of controlled chaos. Nevertheless, things could change quickly, particularly if Italian citizens are asked to go back to the polls in a few months.
Draghi is not in a position to determine the outcome of the Italian crisis. But the ECB should get ready to react to the fallout. Napolitano is constantly reminding us that Italy is not without a government—indeed, Mario Monti is still the prime minister. Napolitano’s aim is not only to calm jittery markets. He is also implying that if the situation were to deteriorate and markets were to mount massive speculative attacks against his country, Monti could still officially ask for ECB support via the ESM (European Stability Mechanism). But the ECB’s bond buying program known as OMT (Outright Monetary Transactions) would come with strings attached. They would also bind the future government, de facto reducing the maneuvering room of any new prime minister.
In fact, the European Central Bank (ECB)’s tough position on the Cypriot crisis should be seen in this context. Despite public assurances that Cyprus represents a one-off and should therefore not be seen as a blueprint for future rescues, the central bank’s stern approach actually suggests the opposite.
First and foremost, the Cyprus case has shown that bail-ins are the new normal, with massive bailouts simply moving out of the equation. Of course, this does not mean that in the future depositors will be asked to capitulate as the first line of defense. However, it is now clear that shareholders and both junior and senior creditors will be asked to contribute to future rescue operations of fragile banks. The remarks made by the new head of the Eurogroup, Dutch Finance Minister Jeroen Dijsselbloem, describing the Cyprus rescue as a blueprint for future bailouts have spooked markets. But seen in this context, they make a lot of sense.
The Eurogroup deemed the timing right to make good on its promise to protect taxpayers and to break the vicious cycle between sovereigns and their banks. Was this a risky move? Sure. Was it partly dictated by the German electoral calendar? Most certainly. Did the finance ministers shoot themselves in the foot by asking small depositors to contribute as well? Absolutely: after all, small depositors are the very taxpayers who should be protected. All across Europe, in both creditor as well as debtor nations, depositors were frightened by what they perceived as the first step towards a raid on their money. However, the guiding principles behind the bailout or bail-in of Cyprus are not necessarily wrong. They should not have come as a total surprise. Once again, the ECB played a central role. In Cyprus, the central bank acted with one eye on the fragile situation in Spain and Italy and the other focused on its future role as the single supervisor of euro area banks in the euro area banking union.
By threatening to withdraw liquidity for Cypriot banks (the emergency liquidity assistance provided by the ECB known as ELA), ECB negotiators – both its German executive board member Joerg Asmussen as well as its President Mario Draghi – sent a brutal reminder to European political leaders that they should not be complacent. For Rome, this represented a simple warning: assistance comes at a price. Did Italian politicians get the message? Napolitano certainly did. Whether or not he can convince the Italian political class to draw the right conclusions is still not clear.
But there was a message for Germans as well. Given their lukewarm support for the various components of the planned banking union, in particular the need for a common deposit insurance scheme, Cyprus demonstrated the need for a comprehensive approach. For the future system to work, it needs a strong supervisor, a central resolution authority, and last but not least, a common deposit scheme. In Cyprus, the ECB acted as the strong supervisor that it needs to be in the future. Moreover, it also helped to wind down failing banks, and so co-starring in the role of a central resolution authority that does not yet exist. Unfortunately, the lack of a deposit scheme not only jeopardized the deal, it also risked wreaking havoc on the rest of Europe. One can only hope that both Berlin, the dominant creditor nation in Europe, as well as its debtor counterparts in the periphery, have learned an important lesson.
On Thursday of this week, Draghi will convene the governing council of the ECB. In his public remarks which follow the meeting, we will learn what lessons he drew from the experience of the past few weeks. I think we will see a Draghi who continues to take a tough line especially on Italy.