Cyprus: No need to default.
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Cyprus: No need to default.
Cyprus: No need to default. 15 January 2013 Gas reserves will eventually trump bank debt This material should be regarded as a marketing communication and may have been produced in conjunction with the RBS trading desks that trade as principal in the instruments mentioned herein. • Cyprus will be the single largest Eurozone bailout deal relative to size of its economy at near 100%/GDP. Cyprus is about to absorb a level of banking risk on the sovereign balance sheet that would put it in the same league as Ireland. Debt/GDP will climb to over 140%/GDP, well above the IMF's benchmark for debt sustainability, and second in the Euro area only to Greece. • We do not however expect Cypriot PSI. In fact Cyprus is poised, in time, to become the strongest government credit in EMU owing to its huge natural gas reserves worth a minimum of 200%/GDP. If further excavations match the success of the first findings, these could top €530bn (2950%/GDP). Assuming a 20% profit margin on these, the value to Cyprus exceeds 580%/GDP. • Cyprus will become geopolitically important for gas pipeline routes and Europe should benefit from greater energy security away from Russia. These monies however are not readily available; the commodity spoils of Europe’s new lucky country are a medium- to long-term story. • • Factors assisting the transition to the medium term and mitigate PSI-risk are: (1) a core EMU political commitment that PSI was a one-off for Greece, (2) unwillingness to touch PSI ahead of the German elections, (3) large domestic bank ownership of debt, which mitigates the value of PSI (4) the likely new President will be more reformist and privatise firms (5) many bonds are in English Law (unlike in Greece), and critically (6) the budget is not in a shocking state: 2013 primary deficit likely sub-1%. Flexibility on the banking sector recapitalisations are probable to meet debt sustainability criteria and avoid PSI. • The risks are around the banking sector’s exposures. Short-run a much more astronomical banking sector requirement than €10bn is highly unlikely given that PIMCO, Blackrock and the IMF are combing the data. PSI risk would be driven by political accidents. Beyond this Greek exit remains the key risk. • Current delays and rhetoric both in Germany and in Cyprus are largely for electoral reasons. Germany’s refusal to rule out haircut is to ensure both that privatisations are part of the deal, and to secure greater austerity and oversight of the Cypriot banking system. A new Cypriot President will likely acquiesce to privatisations as the cost of ensuring debt sustainability. • Newsflow on the bailout will make for easy headlines in comparing Cyprus to Greece, but the endgame we believe will be far friendlier to bondholders, aided by political calendars and the huge upcoming resource bounty. Contacts: Michael Michaelides Rates Strategist +44 207 085 1806 [email protected] Harvinder Sian European Rates Strategist +44 20 7085 6539 [email protected] www.rbs.com/gbm Cyprus: No need to default. Summary Cyprus should complete its bailout deal after the February Presidential elections. The elections pave the way for a more Euro friendly, reformist government. The MoU will however deliver Cyprus a classic debt overhang problem, as the sovereign will absorb all the banking risk. Debt/GDP will ultimately surpass 140%. Does this mean PSI? We do not think so. For one, Europe wants to avoid PSI in other countries so political efforts will be made to ensure debt is deemed sustainable, most likely through flexibility on the banking numbers. Meanwhile, a new reformminded Cypriot President after the February elections will likely agree to the Troika’s privatisations demands. Avoiding a haircut is a ‘win-win’ for Cyprus and core Europe. Europe's intention to treat Greek PSI as a one-off is valid, so long as the economics make sense. It is here that Cyprus is a special case. It has huge gas reserves, worth at least 3x and feasibly 29x GDP. These are not yet exploitable but loans to Cyprus can be money good absent a political accident. Cyprus’ Financial Assistance Package How much is needed? Cyprus will require loans of as much as 100%/GDP Cypriot banks suffered major losses in the Greek PSI (over €4bn or 20% GDP) The results of the PIMCO bank stress test study are due on Friday 18 January We ultimately do expect some flexibility to remain in the bank recapitalisation Cyprus will require financial assistance of potentially €17bn-17.5bn, almost 100%/GDP. Cyprus has already agreed a MoU with the Troika in December and a final deal will be signed post-election. The Republic requires €7.5bn for the public finances (€6bn to rollover maturing debt and €1.5bn in deficit funding), whilst the final figure for the recapitalisation of the banking sector has yet to be resolved. The Cypriot banking system suffered major losses in the Greek PSI (more than €4bn, exceeding 20% GDP) and its two major banks continue to have significant loan portfolios (135%/GDP) in Greece. The preliminary memorandum outlines up to €10bn for potential bank needs and the final figure is contingent on a stress test of the Cypriot banking system. The results of the PIMCO bank stress test study are due on Friday 18 January. Press reports indicate this final amount from PIMCO will be close to €10bn, and this will likely be used as the basis for negotiation of the final bailout deal. There are reported disputes on the methodology used for the bank stress test between members of the Steering Committee overseeing the PIMCO review. The Steering Committee is composed of the Cypriot authorities, the ECB, EBA, ESM, European Commission and the IMF (as an observer). Indeed, Blackrock Solutions has been appointed to review the assumptions and methodology of the PIMCO study at the request of the Cypriot Central Bank. The €10bn for the banking sector would increase debt by 55%/GDP 1, more than any other developed market banking crisis bar Ireland (73%/GDP). Nonetheless, we ultimately do expect some flexibility will likely remain in the package, possibly with regards the timing and level of capital ratios required, if this is necessary to ensure Cyprus’ debt sustainability (probably after privatisations) and avoid PSI. Costliest Banking Crises since 1970: Addition to Debt Stock (%/GDP) Source: IMF, RBS 120% 108% 103% 88% 100% 83% 82% 80% 73% 72% 68% 65% 63% Tanz. (1987) Nigeria (1991) Cyprus (2013) 60% 40% 20% 0% Gineau (1995) Congo (1992) Chile (1981) Uruguay (1981) Ireland (2008) Iceland Indones. (2008) (1997) 1 Page 2/10 Cyprus: No need to default. Debt Sustainability and Privatisations • Debt/GDP in Cyprus at year end is projected at 85.8%/GDP according to the Cyprus’ Budget Balance (%/GDP) 2 government’s 2013 budget. With €11.5bn of additional debt from the bailout, this means debt could peak at above 140% in 2014, after which debt/GDP is expected to decline to near 100% by 2020 3. Source: Eurostat, RBS 2011 • This is higher than the debt/GDP peak envisaged by the Troika in Portugal -6.3% (124%) and Ireland (122%), and even above the IMF forecast for Italy (128%). -5.3% 2010 • Nonetheless, the public finances remain in relatively good shape; the problem 2009 0.9% 2008 3.5% 2007 Memorandum Targets for Cyprus -1.2% 2006 -2.4% 2005 -4.1% 2004 2003 is primarily the banks. The forecast primary deficit in Cyprus is less than 1% for 2013 and is expected to be in primary surplus from 2014; reaching 4% in 2016. Debt sustainability is at risk because of the jump in the debt stock caused by injecting money into the banking sector. -6.1% Primary Balance Targets (% GDP) Fiscal Consolidation (%/GDP) 2013 -0.7% 3.0*% 2014 +1.0% 1.75% 2015 +2.7% 1.5% 2016 +4.0% 1.0% -6.6% 2002 -4.4% 2001 -2.2% 2000 -2.3% -10% -5% Source: IMF, RBS (*including 0.25%/GDP of measures already taken in late 2012) • Out of the total fiscal adjustment of 7¼ %/GDP of adjustment, 5½%/GDP has already been incorporated in the MoU and all agreed provisions have already been passed in Cyprus’ Parliament, even including measures beginning in future years. 0% 5% • The Memorandum signed by Cyprus and the Troika reads that “if necessary to restore debt sustainability, the Cyprus authorities will consider a privatisation programme for state-owned and semi-public companies.” • However, current Cypriot President Dimitris Christophias has rejected privatisations on principle and had strongly resisted them during the drawn-out bailout talks over Cyprus. The current government in Cyprus claims debt is sustainable even without privatisations. • There are Presidential elections in Cyprus in February, in which Mr Christophias is not standing and the Communist party candidate is highly unlikely to win (see the more detailed section below). • Opposition to the current bailout deal for Cyprus emanating from the SPD in Germany is primarily for political reasons in our eyes, aiming to expose Merkel’s reliance on the SPD to pass key legislative votes on Euro crisis policy. • Meanwhile, the German Chancellor’s comments that there can be “no special treatment for Cyprus” and that there are “common rules for Europe” imply that privatisations will be a prerequisite of any deal. • Merkel’s comments that bailout talks are “by far not over yet” strongly resonate with the desire for further conditions/concessions in any deal with Cyprus. • We believe that the final deal will be agreed in March. Delaying will ensure the final details are agreed with the new President. This will most likely be Ms Merkel’s favoured candidate Mr Anastasiadis. It will also allow maximum pressure to be exerted on Cyprus in the meantime. 2 3 including funds to refinance via unfunded government bonds disbursed to recapitalise banks. according to the Cypriot government. Page 3/10 Cyprus: No need to default. PSI risks and divisions in the Troika • Press reports have suggested that the IMF is pushing for a direct Cyprus’ Credit Ratings S&P Moody’s Fitch CCC+ neg Caa3 neg BB neg- recapitalisation of Cypriot banks by the ESM, as envisaged in the spirit of the June 2012 EU Leaders’ Summit (even if at the later date). If the recapitalisation of the Cypriot banking sector did not fall exclusively on the sovereign balance sheet, Cypriot debt would be far lower and sustainable. This would in turn also protect any IMF loan, as IMF lends only for budget requirements and not for banking sector requirements. Source: Bloomberg, RBS, (neg= negative outlook) • Germany, the Netherlands and Finland, which have subsequently declared their opposition to direct ESM bank recapitalisation for ‘legacy assets’. This issue is due to be resolved in the first semester of 2013. • Alternatively, other press reports suggest the IMF has considered a partial default to ensure lower debt levels in Cyprus before any bailout funds are disbursed. This would protect official creditors from the probable rise in the debt/GDP once frontloaded austerity measures as part of the MoU are implemented. The rating agencies have downgraded Cyprus on this concern. “We didn’t say all Greek-speaking countries, we said Greece. It is part of the credibility to stick to the signals you have sent” Jean Claude Junker (speaking to German radio Deutschlandfunk) • The Cypriot Finance Minister has claimed that PSI has never been raised in the negotiations 4. Olli Rehn and Jean Claude Junker have both stated that a haircut will be avoided. The German government has refused to rule out a haircut, though we consider this an exertion of pressure than a policy position. • The Cypriot Central Bank has received a letter from the IMF, which notes that the main criterion on debt sustainability is the ‘ability to make debt repayments’ rather than an arbitrary level of debt/GDP • We think a final bailout deal will be signed, including privatisations. • Our interpretation of the delay and the political noise from Germany is not that there will be a haircut, but instead that this is a means of increasing pressure to ensure that privatisations are part of the deal, as well as securing greater transparency/oversight of the Cypriot banking system. • We do not expect PSI in Cyprus. IMF involvement is a prerequisite for Germany and a number of other core countries. The German government spokesperson has refused to rule out PSI, however we consider that Germany will reject any deal with PSI given: (1) PSI would shatter the credibility of the post-Greek PSI pledge that Greece was a “unique” case. Eurogroup chief Mr Juncker and Commissioner Rehn have both strongly argued this point. (2) Ms Merkel has no incentive to rock the boat ahead of the German Federal election, given the current relatively benign OMT-induced environment in sovereign bond markets. Indeed a Cypriot PSI is unlikely on moral hazard grounds as it would probably bring Cyprus’ debt/GDP below the levels of Ireland and Portugal. (3)There is near unanimous pro-reform political consensus in Cyprus (4) A large share of the debt is under English law, making PSI legally more difficult (debt under the EMTN programme). Collective Action Clauses in this debt mean a 25% share of bondholders can block a restructuring deal agreed with a subset of creditors then being imposed on all bondholders. (5) The high share of domestic debt ownership (55%) implies PSI would necessitate further bank recapitalisation, whilst Cyprus primary deficit in 2013 will be below 1%/GDP (6) Significant gas reserves available means given the maturity of EFSF loans, there is no doubt the loans are money-good (see below) 4 http://www.cyprus-mail.com/cyprus/shiarly-no-issue-haircut/20121221 Page 4/10 Cyprus: No need to default. Cypriot Public Debt Ownership Source: Cypriot Finance Ministry, RBS (Note: Prior to Cypriot bank recapitalisation bond) Foreign Creditors 45% Domestic Banks 48% Domestic Ins/Pension Funds 4% Other Domestics 3% The role of Russia as a potential facilitator • Russia is heavily involved in the Cypriot bailout. Russia loaned Cyprus €2.5bn in October 2011 as Cyprus (with the experience of Greece in mind) avoided applying to the EFSF after losing market access in 2010. • The maturity of this loan was initially four to five years; however Cyprus has requested a five-year extension to 2021 with a 2 year grace period (i.e. capital repayments to begin in 2018). This is currently under consideration by Russia 5. Cyprus’ Debt Redemptions Source: Bloomberg, RBS 3,500 3,061 3,000 EUR bn 2,500 2,292 2,000 1,469 1,500 1,154 900 1,000 287 500 20 11 2018 2019 0 2013 Bonds 2014 Russian Loan 2015 2016 2017 2020 2021 Proposed Russian Loan Extension • The current Cypriot government had sought a second loan from Russia; however Russia was only willing to participate alongside any EFSF/ESM aid. However, Russian Prime Minister Vladimir Putin has made clear Russia has not ruled out joining a deal alongside the ESM/EFSF. • The role of Russian depositors in the Cypriot banking system is controversial in Germany- with political and press allegations about supposed money laundering within the Cypriot banking system. Cyprus is in full compliance with EU and International money laundering laws but any deal is likely to press for greater European oversight on Cypriot banks to allay political criticism. 5 http://www.cyprus-mail.com/25-billion-euros/more-lenient-terms-russian-loan-possible/20130112 Page 5/10 Cyprus: No need to default. Long-term prospects for Cyprus are much better The medium and long-term prospects for Cyprus are better than the debt stock infers for a numbers of reasons: (1) Political developments. Presidential elections in February look likely to deliver a new President more willing to undertake privatisations. The Presidential frontrunner is openly backed by Ms Merkel and is committed to implementing the Memorandum. (2) Potential direct ESM recapitalisation in line with the spirit of the June Summit agreement would be hugely beneficial for Cyprus given the scale of its bank needs. Full retrospective ESM recap now seems unlikely given the ‘legacy asset’ debate but any compromise deal for retrospective bank recapitalisation of viable banks would have very strong positive read-across for Cyprus (as in Ireland). (3) Most importantly… Cyprus has very substantial gas reserves. The value of these reserves makes bailout repayments pale in comparison, even if the gas reserves remain at the early stages of development. (1) Politics: Pro-reform agenda across the political spectrum Remaining Presidential Debates: Date Topic 28 January Cyprus Problem 11 February Domestic Affairs & Economy Source: RBS Crucially across the political spectrum, there is little anti-Euro sentiment amongst Cypriot politicians. Despite the wide spectrum of views on the Cypriot politics, maintaining Euro membership and Cyprus’ place in the EU have unanimous political support. The 2013 Budget and the reforms stipulated in the December MoU were passed almost unanimously by the Cypriot parliament (51 in favour/2 against). Current President Christophias (of the Communist AKEL party) initially looked to Russia for aid, given the party’s close ties to the unions and given the catastrophic impact on the Greek economy of the Troika reforms. He has also subsequently resisted privatisations. In any case, he is coming to the end of his five-year term and is not standing for re-election. Nonetheless, even his AKEL party supported the passage of reforms in the MoU and in any case is a minority in parliament. There are only Presidential elections in February; the next legislative elections are not due until 2016. Cyprus’ House of Representatives Cypriot Parliamentary Election Results 2011 Source: Government of Cyprus, RBS Source: Government of Cyprus, RBS European Party, 2 Green, 1 2% 4% 2% EDEK 9% EDEK, 5 DISY (Centre-right) DISY (Centre-right) 34% DIKO (Centrist) EDEK (Socialist) DISY, 20 DIKO, 9 AKEL (Communist) DIKO (Centrist) 16% European Party (Right-wing) Greens Others AKEL, 19 AKEL (Communist) 32.7% Page 6/10 Cyprus: No need to default. Presidential Elections Presidential elections are scheduled for 17 February, with a run-off if no candidate secures 50% of votes. Any run-off is scheduled for the following Sunday (24 February). There are three candidates: (a) Nikos Anastasiadis is the frontrunner, who has secured support from across the political spectrum. He is leader of the centre-right DISY party but is also supported by the centrist DIKO, right-wing European party, and the Greens. (b) Stavros Malas is the Communist (AKEL) party candidate and health minister under the current government. (c) Georgios Lilikas is an independent candidate, backed by Socialist party EDEK. He was foreign minister under the previous Presidency. Polls show Nikos Anastasiadis to be far in the lead but a run-off remains likely. The latter two candidates are effectively battling to get into the second round. Polls suggest both would be defeated in any case. Cypriot Presidential Elections Polling Run-off #1: Anastasiadis vs. Malas Runoff #2: Anastasiadis vs. Lilikas Source: Fileleutheros, RBS Source: Fileleutheros, RBS, (*Abstain/Spoil ballot) Source: Fileleutheros, RBS, (*Abstain/Spoil ballot) 50 40.3 Don’t' know, 4% 40 20.5 17.9 20 Anast., 46% Anast., 50% 5.8 Won't vote Others Lillikas Malas Anast. 0 % Won't vote*, 17% 15 6.1 10 Don't know 30 Don’t' know, 7% Won't vote*, 18% Malas, 28% Lillikas, 30% Anastasiadis is the strong favourite and polls indicate the economy is the most important factor in the election. Nonetheless, should independent candidate Georgios Lilikas get into the final round, Communist AKEL would likely throw their support behind him. This could make the run-off closer, particularly since many supporters of the centrist DIKO party will vote Lilikas despite the party line (he was former foreign minister in the previous DIKO-led government). The frontrunner Nikos Anastasiadis is considered weak on foreign policy grounds (notably on the Cyprus problem) having supported the 2004 re-unification plan rejected by 74% of Cypriots in the Anan-plan referendum. This could make an Anastasiadis/Lillikas run-off closer. Anything but an Anastasiadis victory however will be a major surprise. (2) ESM Bank Recap and Legacy assets As in the case of Ireland, direct ESM bank recapitalisation would strongly benefit Cyprus’ debt sustainability. Indeed, if the spirit of the June Summit agreement were honoured, debt sustainability would not even be in question. Nonetheless, the current bailout envisages all bank-bailout costs falling onto the sovereign balance sheet. The issue of legacy assets is due to be resolved in the first semester of 2013. Full removal of bank bailouts from debt numbers is unlikely- however any ‘legacy asset’ relief agreed as a compromise at the Eurozone level will be of significant benefit for Cyprus given the massive share of its bailout composed of banking sector needs. Nonetheless, the risk here is that Ireland’s debt sustainability is aided via a refinancing of the promissory notes (which would not provide headline debt relief but would ease refinancing needs). This is likely more attractive for the core as it could reward Ireland but not have any read through for other peripheral countries. Page 7/10 Cyprus: No need to default. (3) Cypriot Gas Reserves are enormous and will turn Cyprus into a net international creditor Cyprus Natural Gas Timeline Date Event Feb Cyprus and Egypt sign 2003 Agreement on Delineation of EEZ. Jan 2007 Cyprus and Lebanon sign 2007 First licensing round for Agreement on Delineation of EEZ Exploration rights Oct 2008 Licence for exploration Dec Cyprus and Israel sign 2010 Agreement on Delineation of EEZ Nov 2011 Second licensing round for Dec Noble Energy announces 2011 natural gas discovery in Block 12 Spring 2013 Further exploratory drilling on Block 12 2013 Negotiations for concession awarded to Noble Energy for Block 12 gas reserves in remaining 12 Blocks for further exploration in blocks 2, 3, 9 and 11 Debt dynamics from 140% debt/GDP level can look scary but Cyprus is sitting on huge reserves of natural gas and potentially oil reserves too. How much are these worth? Initial gas reserves discovered are likely worth 300% of GDP. This could rise to 2950% GDP. Cyprus will also become more important geopolitically. Given this backdrop, (a) Europe does not need to force a PSI, and (b) Europe would be smart to strengthen its energy security. This makes Cyprus a very different animal to any other EMU sovereign and particularly Greece. The new lucky country The massive positive medium-term for Cyprus is the offshore gas reserves found in the Levant Basin. There are 13 of offshore gas blocks within the Cypriot Republic’s Exclusive Economic Zone. Block 12 Excavation has begun in the first field (Block 12) and is being managed by US-energy firm Noble Energy. Estimates from Noble Energy, the firm responsible for excavations in Block 12 are that there are there are natural gas reserves of:5-8 trillion feet (142-227 billion cubic metres), with a mean estimate of 7 trillion 6. At current market values this could be worth €60bn+. The Republic of Cyprus’ share of these revenues from excavation is reported to be around 60% 7, which would equate to over 200%/GDP. After the first exploratory drilling found gas reserves last year, a second round of drilling in Block 12 is due in spring this year. The government hopes to begin natural gas production by 2017/18 and exports by 2019. 8 Noble has recently noted that its initial estimates on the gas reserves in Block 12 may have been quite conservative 9. Cyprus’ Exclusive Economic Zone Source: incyprus.com.cy Source: UN, Noble Energy, Cyprusgasnews, RBS Presidential Candidate Lillikas when in government was intimately involved in agreeing maritime borders with Cyprus neighbours, a precursor to the gas findings. He has suggested that Cyprus could disengage from the Memorandum by selling some of the rights for Field 12 of the gas reserves. 6 http://investors.nobleenergyinc.com/releasedetail.cfm?releaseid=635912 7 Source: http://www.cyprus-mail.com/block-9/bidder-was-switched-over-differing-gasestimates/20121221 8 http://www.globes.co.il/serveen/globes/docview.asp?did=1000776382&fid=1725 9 http://www.cyprus-mail.com/block-12/noble-block-12-could-have-lot-more-gas/20121025 Page 8/10 Cyprus: No need to default. How much more? • Negotiations are ongoing on selling concessions for the remaining blocks of natural At current market prices, total value of gas reserves could be worth, €620bn; 34x Cyprus’ (current) GDP gas. Exploratory drilling in some of these blocks is expected as early as 2014. • If similar gas finds are made in the remaining offshore Blocks in Cyprus, officials at the Commerce Ministry have said that as much as 60 trillion cubic feet of reserves could be within Cyprus’ Exclusive Economic Zone. • At current market prices the total value of gas reserves could be worth around Assuming a 20% profit margin, the value to Cyprus could exceed of 580%/GDP $825bn or €620bn; more than 29 times Cyprus (current) annual economic output. How much this would be worth in terms of net profit is unclear, even to experts in the field. Assuming a 20% profit margin, the value to Cyprus would be in the region of €106bn, in excess of 580%/GDP. • There is also the strong prospect that below the gas reserves there could be oil. There is also the strong prospect of Cyprus also finding oil. Noble energy estimates 25% chance of finding oil reserves below the gas. The second round of (deeper sea) drilling on Block 12 this spring could shed further light on this. Noble estimates there is a 25% chance of a successful oil find. Obviously, any oil findings would increase Cyprus potential hydrocarbon wealth further still- particularly as oil excavation and distribution is easier and more profitable. Geopolitics: • Israel has also made substantial gas finds in the Eastern Mediterranean, namely the Tamar and Leviathan fields. Alongside the finds in Cyprus, these are amongst the largest natural gas finds worldwide in the last decade. • Cyprus’ findings could be amongst those to supply natural gas to the EU, via existing pipelines in Turkey. Moreover, Cyprus has raised the possibility of a gas pipeline to supply gas from Israel and Cyprus, via Greece, to the EU. • If Cyprus’ potential significant gas reserves are proven to be anywhere near the top of the estimated range, it could become increasingly important for the EU’s energy security, potentially reducing the EU’s reliance on Russian gas exports. Europe’s Gas Supply Network Source: UK Parliament, RBS • Ultimately newsflow on the bailout will make for easy headlines comparing Cyprus to Greece, but the endgame we believe will be more bondholder friendlier, helped by political calendars and the staggering resource bounty. Page 9/10 Cyprus: No need to default. 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