Europe got it right on Cyprus

By:
Published on:

Europe’s leaders should be praised, not berated for their hard-nosed approach to Cyprus. The immediate outlook for the island’s economy and banking sector appears bleak but for the wider eurozone this episode will eventually be seen as an important milestone on the road to stability.

Richard Barwell, senior European economist and Lee Tyrrell-Hendry, macro credit analyst, RBS
The subtext of Europe’s tough line on Cyprus is, of course, the situation in Italy and Spain. Europe has enough money to bail out a small country like Cyprus ten times over. The question is, and always has been, whether Europe has the firepower to bail out a much larger country, as well as the courage to stick to its principles if and when those countries get into serious trouble. The specifics of the Cypriot bail-out package are clearly tailored to the unique situation of its banks – it does not represent a template for future bail outs. Undeniably, domestic politics has played their part too: European politicians will rightly ask why their taxpayers should prop up an offshore banking sector and the wealthy individuals who have money invested in it earning a tidy return. There is no doubt that the original proposal to involve those with relatively small sums in the Cypriot banks would have been problematic. That would have broken the taboo that insured depositors can lose money when a bank fails. Cypriot policymakers seem to have pulled back from that idea just in time and avoided serious contagion to the rest of peripheral Europe’s banking sector. The new proposal to only ‘bail in’ deposits above EUR100,000 makes much more sense, since the wealthy creditors of the banks are better able to shoulder the burden than the average Cypriot and those deposits were not covered by a guarantee. Elsewhere in Europe, we may still see savers switching their deposits from weaker banks to their stronger peers. However, we are unlikely to see a return to the scale of deposit flight seen in late 2011 and early 2012, when depositors – particularly international companies and other financial institutions – were withdrawing their funds from the periphery as a whole. In fact, retail and commercial deposits in peripheral Eurozone banks have slowly started to come back over the past six months. Protecting deposits below EUR100,000 will support this trend. The impact on bank bond markets has also been fairly contained judging by the modest widening in yields. The bailout has reinforced the principle that ‘who fails pays’ and highlighted the collective will of eurozone finance ministers to impose losses on senior – as well as junior – bondholders. For now, the market has accepted the argument that Cyprus is a unique case. As for Cyprus, its aspirations to remain a centre of offshore finance have been dealt a heavy blow. It won’t ease the pain for thousands facing unemployment to know that this was always on the cards once confidence in their banks evaporated. Balancing large banking sectors on top of small economies (in the case of Cyprus, seven times larger) looks a risky proposition at the best of times. When those banks are fragile, it becomes a recipe for disaster. There are broader lessons to be learned here, with Italy and Spain waiting in the wings. European finance ministers and the IMF have taken a stand: they will not lend money that countries have little prospect of repaying. Perhaps more importantly, the ECB has taken a stand on emergency support: it will not lend money indefinitely to failed banks. It is much easier to lay down the law to Cyprus than Italy or Spain. But by passing this small test, the ECB has enhanced its reputation. Its threat to stick to its guns and its remit – to not buy bonds without conditions, to not bail out insolvent banks – has gained added credibility. By standing its ground today, the ECB increases the chance that its resolve is not tested in the future. Countries which expect to receive tough love may be more likely to do their homework and save themselves. Despite some short-term pain – rising unemployment, economic contraction and outflows from the periphery – the tough love approach represents the best chance of keeping the euro intact and successfully resolving the debt crisis. The broad message is clear. There will be no ‘money for nothing’ solution. Europe is willing to help – but it will only help those countries who are willing to help themselves. 

For more RBS Insight content, click here
Disclaimer The contents of this document are indicative and are subject to change without notice. This document is intended for your sole use on the basis that before entering into this, and/or any related transaction, you will ensure that you fully understand the potential risks and return of this, and/or any related transaction and determine it is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. You should consult with such advisers as you deem necessary to assist you in making these determinations. The Royal Bank of Scotland plc (“RBS”) will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser or owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on RBS for investment advice or recommendations of any sort. RBS makes no representations or warranties with respect to the information and disclaims all liability for any use you or your advisers make of the contents of this document. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not lawfully be disclaimed. Where the document is connected to Over The Counter (“OTC”) financial instruments you should be aware that OTC derivatives (“OTC Derivatives”) can provide significant benefits but may also involve a variety of significant risks. All OTC Derivatives involve risks which include (inter-alia) the risk of adverse or unanticipated market, financial or political developments, risks relating to the counterparty, liquidity risk and other risks of a complex character. In the event that such risks arise, substantial costs and/or losses may be incurred and operational risks may arise in the event that appropriate internal systems and controls are not in place to manage such risks. Therefore you should also determine whether the OTC transaction is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. RBS and its affiliates, connected companies, employees or clients may have an interest in financial instruments of the type described in this document and/or in related financial instruments. Such interest may include dealing in, trading, holding, or acting as market-makers in such instruments and may include providing banking, credit and other financial services to any company or issuer of securities or financial instruments referred to herein. RBS is authorised and regulated in the UK by the Financial Services Authority, in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US, by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in this document are made in compliance with an applicable exemption from the registration requirements of the United States Securities Act of 1933, as amended. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC (www.sipc.org) member and subsidiary of The Royal Bank of Scotland Group plc. Dubai International Financial Centre: This material has been prepared by The Royal Bank of Scotland plc and is directed at “Professional Clients” as defined by the Dubai Financial Services Authority (DFSA). No other person should act upon it. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Professional Client”. This document has not been reviewed or approved by the DFSA. Qatar Financial Centre: This material has been prepared by The Royal Bank of Scotland N.V. and is directed solely at persons who are not “Retail Customer” as defined by the Qatar Financial Centre Regulatory Authority. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Business Customer” or “Market Counterparty”. The Royal Bank of Scotland plc acts in certain jurisdictions as the authorised agent of The Royal Bank of Scotland N.V. The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB