Cyprus crisis: eurozone collapse vs. chill the hell out
Macro-conjecture-on-a-fast-moving-story alert: no one knows how the Cyprus bailout will play out. However, dismissing its impact, citing the small size of the economy, misses the point: the damage to market psychology and the EU's institutional architecture is very real.
What are EU policymakers smoking? And can Cypriots have a toke?
As we have reported, the Cyprus crisis exposes the fundamental holes in the heart of the EU's institutional architecture, which undermines cross-border sovereign guarantees and heightens the prospect of bank runs.
And another dose of virtual reality, from Credit Suisse's Asian Investment Conference:
|“Jean-Claude Trichet, former ECB president, also speaking at the AIC Wednesday, said he believes there’s little chance of contagion from the Cypriot crisis but warned of the need for European politicians to continue making the economic reforms necessary to avoid future financial crisis."|
Seizing on the Cyprus saga to argue structural reforms will act as a crisis circuit-breaker by boosting medium-term economic competitiveness and confidence surely misses the point in an economic recession and bank-solvency crisis. And the proposition that Cyprus, representing just 0.2% of the EU's GDP, can be firewalled belies the longer-term impact of the botched bailout attempt. After all, the troika-backed bailout proposal violated creditor-hierarchy norms and the sanctity of insured deposits, triggering market fears now that depositors are seen as just another class of creditors to banks that face losses when there are no bondholders to haircut. The mooted use of capital controls has broken another taboo.
Speaking at the same conference, Lorenzo Bini Smaghi, a former ECB board member, was more bearish, according to Credit Suisse:
|“The former central banker said he is concerned about the psychological impact of the Cypriot bail-out delays which have required the country’s banks to close, leaving depositors unable to access cash. He said this could spread anxiety across the region."
“We should not forget the psychological element,” Bini Smaghi told delegates at the conference in a panel session on the euro crisis. “This may, at a certain point, create some contagion to other parts of Europe and this will have to be managed very, very carefully."
Quite. Here's the all-too familiar Berlin backlash, highlighting the weakness of the pro-EU consensus in yet-another country and the lack of fiscal solidarity:
|Protesters in Cyprus.
|Photo from Spanish satirical weekly magazine rightly or wrongly nails the populist view on Germany's role in Cyprus. Source: El Jueves|| More protesters.
Source: We are all Greeks
Graham Bishop, a eurozone analyst, sticks his neck out with the following calls:
|"The key now is the willingness of the ECB to continue to provide liquidity to the major banks. However, it is difficult to see how the ECB can provide that continuing liquidity support via the 'ELA' when the country’s Parliament has voted down a key component of the Eurogroup’s offer of support. That offer was actually only a political agreement on the 'cornerstones’ of a programme. Eurogroup expects a 'strict implementation of the agreed conditionality’ and this seems to include an independent anti-money laundering analysis that would eventually include a loan by loan review.
"Without a satisfactory review, it is inconceivable that the German Parliament for one would approve the disbursement of ESM funds and thus any chance of recapitalising Cypriot banks from EU resources. In any case, the ECB can only lend to solvent banks and re-opening the Cypriot banks would expose them to a deposit run that would demonstrate their inability to meet their obligations – a classic test for insolvency.
"Accordingly, the window for continued ECB support for banks that are likely to become insolvent in the very near future seems likely to close swiftly. Once the banking eggs are scrambled, they cannot be unscrambled!
"The decision by the new government to turn to Russia for support is extraordinary and fateful. Under the circumstances of a Russian-dominated bailout, it is inconceivable that the anti-money laundering analysis would be pursued with sufficient vigour to enable the Eurogroup to proceed with any part of its financing. So Russia would have to be willing to provide all the funding that Eurogroup would have done, as well as funds instead of the bank deposit levy.
"Would the ECB be willing/empowered to provide any special liquidity arrangements until it could assume its new supervisory functions under the SSM system agreed today between Parliament and Council? That would be at least a year away. In the meantime Russia would have to meet all liquidity needs to maintain the banks’ solvency as deposits flow out. Accordingly, Russian support might have to be 10 times the €2.5 billion loan advanced so far. What could they get for this money?
• Protection for Russian depositors against a 15% levy on perhaps €20 billion of deposits. Their countrymen’s deposits would have to be much larger than thought to make it worth paying out such sums.
• Political influence over Cyprus gas. This is exactly what Cyprus has refused to give to the EU so why would they give it to Russia instead? Russia would have to finance the investment to bring it to market in say 2018. But which market? The EU – just at a time it is trying to reduce dependency on Russian gas?
• Access to the British military bases at Akrotiri and Dhekelia to exert additional influence in the Middle East. But the bases are formally known as Sovereign Base Areas for good reason: they are British sovereign territory that was explicitly retained when Cyprus became independent in 1960. So Russia would have to seize them by military force – an unlikely event.
"These possible benefits seem quite modest in comparison with the sums that Russia would have to advance in the near future. Given the Troika analysis that adding such debts to Cyprus would make the overall debt burden unsustainable, it does not seem an attractive economic proposition to convert Cyprus into a colony. In a statement on Saturday, President Anastasiades described the deal as a choice between the 'catastrophic scenario of disorderly bankruptcy or the scenario of a painful but controlled management of the crisis'.
"The hiatus in the Cypriot banking market that now looks inevitable for at least a few more days has already done great damage to the economy. If the worst happens, then catastrophe will be the right description."
And the medium-term impact for Cyprus's economy in Bishop's words:
|“In recent years, the Cypriot national business model seems to have been based on a low corporate tax rate to attract international financial business that the Eurogroup now seems to feel included a lax application of the EU’s money laundering laws. If the Cypriot authorities decline to permit the agreed audit by Moneyval and a private international audit firm, then the EU will presumably regard the money-laundering case as proven. Some form of sanctions must surely follow that would have the practical effect of negating the benefits to the money launderers of holding assets in Cypriot banks. The business model would be at an end.
"An alternative scenario is that anti money laundering laws are rigorously enforced – also putting an end to the former business model. At that stage, the inability of some depositors to get their money back would probably induce them not to repay the back-to-back loans associated with the deposits. Major loan losses would then be recorded by the banks, perhaps requiring further recapitalisation.
"Publication of the PIMCO report will enable outsiders to gauge to what extent this scenario has already been taken into account. Financial services now account for around 18% of GDP so the destruction of this business model is likely to hit the overall economy very hard. Has this been taken into account in the Troika’s economic forecasts?"
Well at least the failure of the insolvent Cypriot banks won’t hit other eurozone financial institutions because no one was lending to them in the first place, explain Deutsche Bank analysts:
|“Cypriot banks [relying on deposits rather than on security issuance, and already shunned in the markets] probably owe very little money on the interbank market. That is a difference with Greece, and this limits the contagion risks. Their main liability [outside deposits] is to the Eurosystem via Target2 [deficit of €6.5 billion when looking at the net claims vis a vis the Eurosystem, to compare with €109 billion at the peak in November 2011 for Greece]."|
Reflecting the largely sanguine sell-side consensus, here's UniCredit's conclusion:
|“Hence, we think Cyprus will see the logic and agree to haircut big depositors - but if not, the prospect of a collapse of the Cypriot banking system becomes a possibility, unfortunately. While this would be an economic disaster for Cyprus, we are convinced that markets – and depositors elsewhere in Europe – will appreciate the exceptional case of Cyprus, so contagion would be limited. And if needed, the pan-European response would be 'enough', as they say.|
On a side-note, enter this parallel universe: the Latvian finance minister has just touted the virtues of eurozone accession in a wide-ranging interview with Euromoney.