Against the tide: Cyprus – They think it’s all over

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The Cyprus solution is inadequate as well as sending the wrong messages on depositors’ risks and free capital flows. Then there’s Slovenia... and Italy.

Last month I argued that optimism in financial markets must be balanced against the risk of pessimism on growth from a fiscal squeeze in the US and the return of the euro debt crisis. The jury is still out on the first risk but the second risk has come back with a vengeance. The debacle of the bailout deal negotiations over Cyprus revealed yet again that the continued recession in Europe is putting the single-currency area under pressure. Contagion from Cyprus to Italy and Spain has been avoided, partly because Cyprus is a small player in the eurozone, partly because the taxpayer (both local and eurozone) has taken less of the burden of any bailout with the bail-in of Cypriot bank depositors. And it’s partly because Mario Draghi and the European Central Bank have continued to talk about being ready to support the sovereign debt of distressed eurozone states. But bailing in depositors has raised the risk of deposit flight every time there is a whisper of a crisis anywhere in the eurozone. And the introduction of capital controls threatens the principle of the single currency, the longer they last. Furthermore, the package is probably way too small to cover the funding needs of Cyprus over the next three years. A further bailout for the banks and the sovereign might well be necessary – Greek-style – and before 2016, renewing the crisis. Cyprus’s public debt to GDP ratio will reach 126% before turning south. But it will still be 104% in 2020, way above the eurozone fiscal compact target of 60%, and well above what most studies show would be considered the threshold of vulnerability to a further funding crisis. At end-2020 it will be a minimum of 17 percentage points higher than at end-2012 (and 2012 was a record for Cyprus). In the worst-case outcome, it could be 44 percentage points higher in 2020. On more realistic real GDP growth assumptions, where real GDP falls 17% to 20% through to 2016, similar to Greece, the bailout funding is inadequate by about €4 billion. So the Cyprus mess is likely to come back to haunt the EU leaders. Crisis rumblin’ But even before then, there is another crisis rumbling down the track. Slovenia is experiencing a serious banking crisis. Banking assets are not particularly high at about 140% of GDP, compared with 700% in Cyprus, but the Slovenian banks’ nonperforming loan ratio is already at 15%. The banks, mainly state-owned, got into trouble because they lent heavily to developers in Slovenia during a commercial real estate and infrastructure boom that eventually turned sour. The IMF estimates the cost of restructuring Slovenia’s banks at €3 billion (depending on the haircut imposed on loans taken over) plus €1 billion for the recap costs. However, this cost is almost certainly going to be larger, especially as there has been a delay in implementing the restructuring when the previous centre-right coalition fell. The new centre-left coalition is dithering about what to do and is in denial that a bailout is necessary (at least a European Stability Mechanism bailout). And there is a serious hidden issue on top. Much of the bank lending for big transport and infrastructure projects during the construction boom was made with government guarantees. These contingent liabilities add up to €7.5 billion (21% of current GDP). So Slovenia’s gross funding needs over the next three years could be as much as €12 billion, equivalent to 33% of current GDP. Some of this could be financed by Slovenia but it is likely that ESM funding of about €7 billion to €10 billion will be required. The question of a bailout will soon arise. And then there is Italy. The country has looked increasingly ungovernable after the inconclusive February election that left the unpredictable Five-Star party with the balance of power. However, it seems that the main parties have managed to persuade 87-year-old president Giorgio Napolitano to continue for another term and Enrico Letta of the centre-left Democratic Party was installed as prime minister at the end of April. But this government will not be implementing any badly needed reforms to raise Italy’s growth. And while that is lacking, Italy remains in the firing line for the next crisis.

So the euro debt crisis is not over. And all this slows the process of reducing financial fragmentation in the eurozone. Markets are far too sanguine about the outcomes.