Rifts Over Cyprus Bailout Feed Broader Fears
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By STEPHEN FIDLERin Davos, Switzerland,and GABRIELE STEINHAUSER and MATINA STEVISin Brussels
A flap over a potential bailout for Cyprus is heightening anxieties that the tiny island's economy could become the next flash point in the euro zone's debt crisis.
A rescue program for Cyprus will require substantially reducing government and bank debt, Olli Rehn, the European Union's economics commissioner, said in an interview Thursday at the World Economic Forum in Davos, Switzerland, in a recognition that a more-conventional bailout of the latest euro-zone country to hit financial difficulties would leave it with too much debt.
![[image]](http://si.wsj.net/public/resources/images/WO-AM477_CYPRUS_NS_20130124181203.jpg)
The rescue will also require a major restructuring of the country's banking system that may lead some banks to be wound down or merged, Mr. Rehn said.
The rescue has already been delayed by six months because of disagreements among the Cypriot government, the International Monetary Fund and governments in the 17-nation currency union.
The admission that Cyprus, which accounts for just 0.2% of the euro zone's economy, will require debt reduction came as other officials reported continuing divisions among prospective contributors to the rescue program.
Charles Dallara, managing director of the Institute of International Finance, a Washington-based trade group for international banks, said Cyprus had the potential to spark another phase of the euro-zone crisis. He said the "bailing in" of uninsured depositors would set a precedent that would have an effect elsewhere, for example in Spain.
"I don't see the key players coming together to find solutions here. It may be [small], but it is a euro-zone member and it has the potential to generate stress and contagion throughout the euro zone," he said in an interview in Davos.
"It's essential that everybody realizes that a disorderly default of Cyprus could lead to an exit of Cyprus from the euro zone," Mr. Rehn said. "It would be extremely stupid to take any risk…of that nature."
He said the challenge of the negotiations is "to combine a substantial reduction of the debt burden of Cyprus—both the sovereign and the banking sector—with the necessary ensuring of financial stability for Cyprus and its ramifications to the rest of the euro zone."
The banking system must be overhauled, as in Spain, Mr. Rehn said.
"There is going to be very substantial restructuring and even if necessary winding down of banks and merging of banks," which took a bad financial hit from Greece's debt restructurings last year, he said.
Officials in Washington and Brussels say one question dividing the negotiators is what to do about the large amounts of money held by foreigners in banks that may be wound down.
The European Commission and a majority of euro-zone governments are worried that even suggesting some big depositors might not get all their money back would prompt contagion to other countries with shaky banking systems, in particular Spain.
Germany and the IMF, these officials say, have argued that rescue loans could be reduced and the Cypriot debt left more sustainable if some depositors were bailed in and forced to swallow some of the cost of the banks' bad investments—in other words, some depositors wouldn't get all their money back. German politicians have criticized plans to bail out Cyprus, saying its banks are havens for tax evaders and money launderers.
The discussion has arisen because bank bonds—which in a regular bank restructuring would be the first candidates to be bailed in—account for less than 1.5% of the assets in Cypriot banks, according to analysts at Citigroup C +0.26% . The analysts say there were €70 billion ($93.2 billion) of deposits in the banks at the end of November, of which 38% was held by foreigners.
Cutting debt means the euro-zone and IMF would lend Cyprus substantially less than the estimated €17 billion European officials previously said would be needed to right the government finances and stabilize the banks, which were hurt by Greece's debt restructurings last year. Cypriot banks had invested heavily in Greek government bonds as well as loans to Greek households and companies.
European officials say an extra €17 billion in official loans would bloat the Cyprus government's debt load to between 140% and 145% of gross domestic product, from around 84% at the end of the third quarter of 2012, the most recent figures available.
An IMF spokeswoman said the fund is seeking "to develop a durable solution to Cyprus's banking sector problems at low cost to the taxpayer and consistent with debt sustainability. Preserving financial stability in Cyprus and the euro zone is also an essential goal of this work."
Euro-zone finance ministers said Monday that there wouldn't be a bailout deal until after general elections in February, with final agreement unlikely before March.
Cyprus has been unable to raise money on international markets for more than 1½ years, surviving on a €2.5 billion loan from close ally Russia it secured in 2011. But after the Greek restructuring ate up much of the capital cushions of Cypriot banks, Nicosia requested financial help from the rest of the euro zone and the IMF last summer.
The euro zone has discussed using its bailout fund directly to boost the capital of struggling banks, so that governments don't have to take on debt to do it. But, under current plans hashed out by euro-zone finance minister late last year, that is unlikely to happen until 2014 at the earliest. Mr. Rehn said under plans now being worked on governments would have to contribute something to such bailouts to retain some "skin in the game."
—Laurence Norman in Davos contributed to this article.
Write to Stephen Fidler at stephen.fidler@wsj.com, Gabriele Steinhauser atgabriele.steinhauser@wsj.com and Matina Stevis at matina.stevis@dowjones.com
A version of this article appeared January 25, 2013, on page A14 in the U.S. edition of The Wall Street Journal, with the headline: Rifts Over Cyprus Bailout Feed Broader Fears.
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