By Mandeep Bhandal, on 28 March 2013
ISRS Senior Research Fellow, Chris Cook discusses how the Cyprus National Debt may be resolved into a Cyprus National Equity.
The article was posted on the Financial Times, Alphaville on March 25, 2013.
The case for Cypriot National Equity
The second attempt to resolve the unsustainable debt burden of Cyprus’s over-leveraged banks spreads the pain differently to the disastrous initial attempt, but looks likely to leave Cyprus as an economic wasteland for generations. Frances Coppola outlined brilliantly yesterday the sort of financial disaster zone which Cypriots can expect.
Cyprus, in common with many other countries, but far more urgently, requires resolution and transition: Resolution of existing debt; and transition to a sustainable and low carbon economy. Surely there must be a better way of achieving this? Well, my research leads me to conclude that there was; there is; and there will be again; if Cyprus ceases to attempt to resolve 21st century problems with 20th century solutions and instead uses an updated version of a financial instrument which pre-dates modern debt and equity finance capital.
In this post I will suggest how the Cyprus National Debt may be resolved into a Cyprus National Equity… but not equity as we know it.
The first step is for the Cyprus Treasury to create a new class of undated – by which I do not mean permanent – ‘Stock’.
This instrument consists of a non interest-bearing promissory note or unit which is returnable at any time (i.e. undated) in payment of €1.00 par value of Cyprus tax. The second step in the process is the nationalisation of the key banks, Bank of Cyprus and Laiki Bank, with shareholders receiving one €1.00 unit of Cyprus Treasury stock at par – i.e. they will receive a zero discount – in exchange for each existing €1.00 share.
The third step will be for all demand deposits, term deposits, and all classes of bonds to be exchanged for Cyprus Treasury €1.00 stock at graduated discounts reflecting the seniority, term and interest rate which applies.
The fourth step is that all existing Cyprus Treasury dated interest-bearing Stock – the Cyprus National Debt — will also be exchanged for and consolidated into €1.00 units of undated stock, again with a discount reflecting the term and interest rate.
The result will be a Cyprus National Equity: a single consolidated fund of Cyprus undated Treasury Stock returnable in payment for Cyprus taxes.
This will be supplemented by the flow of debt repayments (after operating costs) to the Cyprus Treasury from the borrowers of nationalised banks.
Rate of Return
The phrase ‘tax return’ comes from the way in which the ‘stock’ portion of a ‘loan tally’ record of prepaid tax would be returned to the Exchequer for cancellation by a tax-payer who had chosen to prepay tax. The phrase ‘rate of return’ was literally the rate at which such loan tally stock could be returned to the Exchequer.
Naturally, no creditor who prepaid tax by advancing money or money’s worth of goods and services to the sovereign would do so other than at a discount, and the rate at which the stock could be returned was literally the rate over time at which the profit derived from the discount could be realised.
By way of example, £10 of stock exchanged for £8 of value from the tax-payer and would give rise to a profit of £2, but the rate of return depended – literally – on the rate over time at which the stock could be returned to the Exchequer for cancellation. So a £10 annual tax obligation would mean the discount was realised in one year and would give rise to a £2 profit on the £8 advanced – i.e. a 25 per cent rate of return.
A £5 p.a. tax obligation would give a 12.5 per cent rate of return and so on.
Return on National Equity
The rate of return applying to this Cyprus National Equity will therefore literally be the rate over time at which the units of prepaid Cyprus taxes may be returned to the issuer at €1.00 par value, and the profit arising from any initial discount may be realised.
This is where it gets interesting.
Firstly, Cyprus taxpayers will always be in the market for stock at the best price below €1.00 so they may pay their taxes at €1.00 and make a profit. Secondly bank borrowers will also be in the market for stock, at the best price below €1.00, to pay their debt with it.
There is no possibility of a default since there is no dated debt obligation.
However, the rate of return will be determined by the levels of tax levied by Cyprus, and will be supplemented by demand for stock returnable against the flow of payments made to the nationalised banks by borrowers. Such Cyprus Treasury €1.00 stock units will not actually be euros or even (not quite) generally acceptable retail Cyprus currency, but will rather be investments priced in and exchangeable for euros at a level which reflects likely future demand from taxpayers and bank borrowers.
Through the creation of a Cyprus National Equity – not permanent equity as we know it, but an ancient form of undated equity – the Cyprus crisis may be resolved to create an interim breathing space as Cyprus funding costs are drastically reduced.
It will be seen that the debt has been resolved by a conversion or consolidation into a form of undated, rather than permanent, equity.
There’s nothing new about such a consolidation: in 1888, the UK Chancellor, George Goschen enacted “Goschen’s Conversion” which consolidated the existing disparate classes of undated ‘gilt-edged’ stock into a single class of undated ‘Consols’ which remain to this day.
In the medium and long term, however, there must be a transition to a low carbon and fiscally sustainable Cyprus economy.
Firstly, Cyprus must address resource resilience: in other words, how energy infrastructure and energy reserves, in respect of which Turkey explicitly and unequivocally staked out a claim over the weekend, may be equitably shared and optimally developed.
Secondly, Cyprus must become financially resilient, and while attention is currently away from the isolated and friendless North Cyprus it is clearly the case that some kind of economic co-operation, if not integration, is long overdue.
In that context, there was an interesting post by Nick Dunbar recently as to how the use of structured products could perhaps lead to a re-unification of Cyprus. How such resource resilience and financial resilience might be achieved simply, consensually and without the need for either power-seeking or rent-seeking intermediaries, is for another post.