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Cyprus tests the limits of currency union

The agonizing process of agreeing a bailout in Cyprus has set troubling precedents for creditors, laid bare fractures within the European currency union and reminded investors of the ad hoc, inconsistent and arbitrary nature of its institutions’ response to sovereign crises.

Outwardly the currency, bond and equity markets remained surprisingly calm. That might show the tranquillizing affect of close to €1 trillion of cheap central bank liquidity, or that sophisticated investors are unwilling to bet against the authorities as they target designated systemic assets, such as peripheral government bonds, to repress. Less-sophisticated investors might simply have been shocked into inactivity. Behind the scenes the mood was anything but calm. The head of markets at one large eurozone bank had his traders, risk managers and lawyers assembled at 8.30am on the Monday when the Cypriot parliament rejected the first Troika deal to haircut depositors above €100,000 at 9.9% and those below at 6.75%.

It was immediately obvious that capital controls were coming, driving a wedge into the supposed currency union. The bank was working out the legal validity and technical processes for delivering and receiving payments to and from nostro accounts outside the country of Cypriot counterparties.

It was only because his teams had planned for and war-gamed eurozone break-up scenarios several times in the previous two years that there was no panic. This was the storyline for Greece in 2011 and 2012 now being played out in miniature but for real.

The fiction that the eurozone had got past the most dangerous moment following European Central Bank president Mario Draghi’s whatever-it-takes speech was so comforting and so seductive that both the buy side and the sell side are reluctant to give it up. But that doesn’t mean markets will remain calm for long. We are into a new world.

It’s not simply that the Troika initially blessed a tax on supposedly insured depositors. That insurance, of course, was useless, coming from a provider, the government of Cyprus, that couldn’t possibly deliver it across the entire banking system. Even taxing uninsured depositors, the cornerstone of the eventual deal, breaks a core banking taboo.

Remember that amid all the holier-than-thou castigation of the Cypriot business model of an offshore financial centre, its banks had done what regulators told all banks to do: attract funding from depositors rather than the unreliable debt capital markets. It was not that liability structure that wilted them but losses on the asset side from PSI imposed on Greek government bonds.

The idea that depositors are somehow exempt from taking losses on bank failures has been shattered. Whereas at the start of the mess, the troika insisted that Cyprus was a unique and exceptional case with no read across to other struggling eurozone economies, Dutch Finance Minister Jeroen Dijsselbloem, head of the eurogroup, has since confirmed that it represents a new model for resolving failing banks through a bail-in of creditors including depositors as a first resort, rather than recapitalizing them through the ESM. This shift imposes an urgent requirement for much greater discernment on all lenders to banks. Only over time will the consequences play out for weak banks in countries with weak government finances. It remains to be seen if worries over possible redenomination will compound heightened concerns over banks’ creditworthiness. It is a fair guess that deposits, especially large corporate deposits, will now become as prone to sudden evaporation as access to wholesale debt market funding.

The Cyprus botch destabilizes the very funding foundations of European banks. Depositors and bondholders must first reassess which banks now look safe and then reprice funding even for those that still do. A rising cost of borrowing is likely to impede banks’ appetite to lend, threatening the already weak eurozone economy.

The unconventional and arbitrary nature of the demands on Cyprus, in which the Troika initially subverted the creditor hierarchy, show that the play book for dealing with sovereign crises changes if a country is small, judged to be of less systemic relevance, or has an economic model unpalatable to northern European voters.

The ECB sees fit to give a deadline for withdrawing emergency liquidity assistance funding support based on politicians signing up to its deal. Does it expect markets to believe that all the other peripheral banks it is propping up in more systemic countries would still be solvent in the absence of its support? This looks like rule by man not rule by law.

Now, with capital controls, is this really a currency union? The head of markets at the large eurozone bank, reflecting after a first day of crisis planning at the outset of the Cyprus mess, reflects: “It’s becoming increasingly plain that Europe has one over-riding problem... and that is the single currency.”

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