Cyprus: Better Designed Rescue, Challenging Implementation

After marathon and heated discussions, agreement was reached on a new rescue package for Cyprus. Compared to what had emerged a week earlier, this is a better technical outcome -- both in what it contains and in what is left out.

Yet implementation will be very challenging, especially as Europe is yet to find an answer to the most important question of all: how to improve growth and employment prospects in a significant and sustainable manner.

After a badly botched attempt, Cyprus and its "Troika" of supporters (European Commission, European Central Bank and the International Monetary Fund) agreed last night on a technically more robust rescue program which would unlock some EUR 10 billion in external support. If implemented fully, Cyprus would thus avoid an immediate financial collapse. But its economy, nevertheless, faces significant economic contraction and tremendous social costs.

The revamped approach to Cyprus centers on two important pivots: from a blunt approach to the banking system to an institution-focused one; and from taxing all depositors to safeguarding insured accounts (i.e., those below EUR 100,000).

These two critical pivots are a material and obvious improvement on what had come earlier. Indeed, many will wonder why Cyprus and its creditors failed to include them in the prior rescue iteration.

Specifically, the pivots reduce the probability that the rescue is "dead on arrival" (as was the case earlier); they enable the ECB to remain engaged; and they maintain the sanctity of deposit insurance.

The new rescue package also meets a couple of other objectives that some Europeans favored: downsizing an offshore banking center that they viewed as too lax and too large; and reducing the risk of a change in the geo-political order within Europe.

At the practical level, creditors now need to specify how they will share the burden of financing Cyprus. In some cases, contributions must be approved by national parliaments (e.g., Germany, Finland, and the Netherlands). And then there is the question of what additional burden will be allocated to Russia and how.

Creditors also need to minimize the risk of significant capital outflows from Cyprus once the banks reopen - thus the immediate focus on capital controls. They also have to convince Cypriots that this bitter pill should be swallowed given that the alternative would have been much worse. And they need to keep a close eye on contagion risk (particularly the reaction of depositors in other vulnerable European economies).

These challenges are significant, and they will not be overcome easily and immediately. Yet, as large as they are, they pale in comparison to the big elephant in the room: the rescue contains very little to enhance Cyprus's ability to grow and create jobs.

With the de facto dismantling of its offshore financial industry, Cyprus loses an important driver of domestic economic activity. Accordingly, no one should underestimate the social costs and the related risk of political dysfunction and protests. Moreover, in addition to imposing a large levy on large foreign depositors, the bank resolution process destroys many corporates working capital and domestic wealth.

The markets are right this morning to initially welcome the latest Cypriot agreement. It avoids an immediate and disorderly financial implosion, with potentially negative contagion effects for other European countries. And it does so using a better approach to bank resolution and a less regressive burden sharing (or PSI, for private sector involvement).

For this to persist, however, Europeans still need to find a way to combine immediate financial relief for Cyprus with realistic prospects for growth and job creation. They also need to overcome the strong signals they gave out last week regarding coordination problems within the Troika, generalized bailout fatigue, breakage of all sorts of taboos, and a willingness to shoot before aiming properly.

Mohamed El-Erian is the CEO and Co-CIO of PIMCO, which oversees nearly $1.8 trillion in assets and runs the PIMCO Total Return Fund, the largest bond fund in the world. His book, "When Markets Collide, " was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year, and was named a book of the year by The Economist and one of the best business books of all time by the Independent (U.K.).

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