Cyprus' troubled banks threaten austerity package

(NICOSIA) - Debt-burdened Cyprus is desperate to enforce a new wave of austerity measures to avoid a European Union bailout, but it could be a lost cause if its banks have to be rescued from outside, experts warn.

The eurozone member is already under pressure from Brussels to slash spending and boost revenues as the government's budget deficit is almost double the European Union's ceiling of 3.0 percent of gross domestic product.

The European Commission predicts it will be near 5.0 percent in 2012 and, unless tough action is taken, the Mediterranean island faces financial sanctions.

Even if the government puts a lid on the deficit, it lacks the financial clout to support the banks, which need an extra 3.6 billion euros in capital as a buffer laid down by the European Banking Authority (EBA) to weather the crisis.

Cypriot banks are badly exposed to toxic debt in Greece, and must face a write-down of Greek bonds, a so-called haircut, of 50 percent.

On Tuesday, the Bank of Cyprus, the country's biggest lender, posted an accumulated net loss of 801 million euros for the first nine-months of 2011.

In the results, the bank announced a write-down of 1.06 billion euros on Greek debt holdings as part of its agreement to take part in the latest bailout of Greece agreed at a eurozone summit in October.

Economist Fiona Mullen said although Bank of Cyprus may be able to survive the write-downs required to cover the voluntary losses on Greek debt, Marfin Popular Bank will struggle to raise the additional cash needed.

"Marfin at the very least will have to beg for money from the government, which doesn't have that kind of spare cash," Mullen told AFP.

"An EU support mechanism is inevitable whatever the government does because the two junk-rated banks will not be able to raise all of the 3.6 billion in capital by June 2012 that has been preliminarily demanded by the European Banking Authority," she added.

As a bank's assets fall in quality, regulations on ratios of risk to shareholders' funds may require a strengthening of shareholder funds, or else the lender concerned has to find ways of reducing the risks it takes on, typically by reducing lending.

Mullen said BoC could use about 890 million euros in contingent convertible bonds (CoCos), which would reduce its capital requirement to an estimated 600 million, of which it is trying to raise 400 million euros in a share issue.

But Marfin has only 65 million in CoCos.

Even after including their convertible bonds, Marfin still has to find two billion euros, according to the preliminary figures.

"So the only option will be to ask the EU for assistance," said Mullen.

Credit agency Moody's came to the same conclusion this month, saying an EU bailout was on the cards owing to the state of the banks.

Moody's downgraded the island's three main banks over exposure to Greek debt amid fears the state would be unable to bail them out if the need arose.

It said the banks' domestically owned asset base was six times the island's GDP.

The agency said Marfin was the most exposed bank and in likely need of a state bailout following a Greek haircut of 50 percent.

BoC and Hellenic Bank, it added, could manage without any external assistance.

Although Cypriot banks have said they can raise the extra capital, others are sceptical.

"Cypriot banks are going to need government money but... how much money the government can provide is a moot point," said retired banker Jonathon Mills.

"The banking system is in huge trouble... because of Greek debt exposure and branch operations in Greece," he told AFP.

The former Barclays man said the banks would now be under pressure to shrink the size of their balance sheets, reducing lending and raising lending rates.

Furthermore, the government's move to establish a support fund for banks and a legal framework for state intervention is opposed by the Association of International Banks, which says the measures could drive its members to leave the island for a more tax-friendly environment such as Malta.

A more pressing issue for the government is slashing the deficit and meeting its EU fiscal obligations.

President Demetris Christofias has called for a consensus for his administration's austerity drive, saying it was of the "highest national importance."

Christofias is to convene a summit on Friday to get the opposition parties -- a majority in parliament -- to back stiffer belt-tightening in line with a European Commission demand for a tougher budget by December 15.

The government is committed to getting the deficit under the EU-approved three percent, but its task was made more difficult after powerful trade unions and business groups rejected the new proposal.

Marginal growth is expected this year after a munitions blast in July knocked out the island's main power plant.

Due to liquidity drying up fast, the growth forecast for 2012 has been revised from an initial 1.5 percent to a mere 0.2 percent. The EU expects zero growth for next year.