|Summary: With today’s announced Cyprus bailout plan grabbing global headlines, the big fear is that a bailout like this will lead to a broader bank run across the European continent – or contagion more broadly. The good news is there is very limited scope.|
|Key take-out: Instead of Cypriot banks collapsing and causing a market slump, it is more likely the European Central Bank will grant an extension.|
Key beneficiaries: General investors. Category: Economics and strategy.
As of this afternoon, there was a tentative deal between the European Union, the European Central Bank, the International Monetary Fund and the Cypriot government to bail out Cyprus.
There are some significant details missing and any deal still has to be passed by the Cypriot government. More to the point, ratings agency Moody’s came out immediately after and said that even with a bailout, Cyprus could still be insolvent and be at risk of default. It is, of course, quite possible that by the time you read this the Cypriot parliament will have passed through all the necessary legislation. If so, then the bailout will look something like this:
The Cyprus Popular Bank (also known as Laiki, which is the second largest) will be wound down. Good assets will be merged with the island’s largest bank, the Bank of Cyprus. Deposits below €100,000 will be transferred to the Bank of Cyprus and those over this amount, which are not insured, will participate in winding down the bank (no detail here). Uninsured deposits in the Bank of Cyprus will be frozen and used to resolve debt through a deposit equity conversion. Toxic assets will be liquidated.
Now we don’t have details but there had been reports that deposit holders with accounts over €100,000 in the Bank of Cyprus will also have 20% to 40% of their deposits converted into shares. All insured deposits – i.e. those under €100,000, are protected. So there will be no taxes or levies on them.
“Administrative measures” are to be taken in opening Cypriot banks – I read this as capital controls, which are to be temporary. It may not end up being exactly that, but I don’t think it will vary too much without Russian assistance. It’s not like the €6 billion can be raised through austerity or some domestic tax levy.
Why? Well, because while government debt to GDP is around 70% – i.e. not too bad – the problem is that bank loans are about 550% of GDP. One-third of those loans are non-performing, which means that the potential government liability, if they don’t want their banks to collapse, is about 170% of GDP. Throw in existing government debt of 70% and you can see the size of the problem.
Now consider that Cyprus has a working population of 440,000, about 10% of whom are unemployed. So you’ve got about 400,000 persons to service debt of around €42 billion, which leaves a debt of €105,000 for each citizen. Even getting debt-to-GDP down to 100% of GDP would cost citizens €50,000. If the government just wanted to raise the €6 billion needed, that still equates to €15,000 per person, which is substantial for an economy where the average wage is between €20,000 and €30,000. It can’t be done, and indeed to try would be to overlook the fact that, by and large, Cypriot public finances were comparatively pristine prior to the GFC. Debt-to-GDP was about 50%, and the budget was pretty much in balance. The problem is the banks. And these banks lost a lot of money or capital during the Greek crisis as the price on Greek bonds plummeted and were written down etc. This is why Cypriot banks needed to recapitalise – a deposit levy of some form is really a very sensible option. Having said that, small increases in corporate and withholding tax are expected and the Eurogroup holds out for a financial contribution from Russian banks.
Now the big fear is that a bailout like this will lead to a broader bank run across the European continent – or contagion more broadly. Especially, of course, through the European periphery. So far the market reaction is cautious – the All Ords and most Asian markets are higher as I write, and most of the alarm is being expressed by analysts and some media commentators. So, for instance, the Financial Times’ Wolfgang Munchau reckons not only will there be a bank run in Cyprus, but that there is every reason there should be a bank run around the periphery. Throw in warnings from Moody’s and the World Bank and, well, the scope for severe financial market disruptions looks high.
Now bank runs are funny things. They can occur for no reason and can be quite irrational events – so you can’t rule it out. Capital controls can’t last forever. Having said that, there are very rational reasons why there wouldn’t be. Indeed there may not even be a bank run in Cyprus – or only a limited withdrawal. And as for contagion through equities or bonds? I think there is very limited scope.
- You need somewhere to run to. It’s not that easy just to set up another tax-haven account, and repatriating money to you home country carries its own risks – official questions, taxes etc.
- Then, remember that there is a punitive element to the Cyprus deal. Cyprus is a special case, the EU wants Cyprus to shrink its banks – and to shrink its deposit base. The banking system is widely regarded as far too large and a haven for criminal activities – money laundering, arms dealing etc.
- The EU doesn’t have the same concerns in Italy or Spain. Unlike Cypriot banks, Italian and Spanish banks are not insolvent, are now well capitalised and have the full support of the ECB. More to the point, both Italy and Spain have full access to capital markets and alternative sources of funds to tap, without resorting to bank deposits. Cyprus didn’t have this option – and this is why there has been no bank run elsewhere to date.
- Next consider that even with a 20% or 40% deposit/equity conversion in Cyprus, the island is still a very attractive location for tax minimisation, avoidance and a great place for those who require ‘discretion’. Wealthy individuals who run businesses out of Cyprus may just stay there for that reason alone.
- Cyprus has other tax advantages anyway. It has a very low income and corporate tax rates – even with proposed increases. No wealth tax etc. Before packing up and running, wealthy deposit holders will weigh up the deposit/equity conversion against these other benefits and their other business interests. I think when they do, it’s unlikely that foreign money will just up and leave.
Therefore, there is very little chance that I see of a sustained market rout. Cyprus is too small and I don’t think anyone really buys some of the more alarming commentary that bank deposits everywhere are now unsafe. Market action tonight will be very interesting and a key test. Of course, it is quite possible nothing will be sorted in the Cypriot parliament, but instead of Cypriot banks collapsing and causing a market slump, I think it is more likely the ECB will grant an extension. Deadlines like the one imposed are arbitrary.
There is a sense of urgency though. Cypriot banks have been closed thus far, but this isn’t a situation that can last indefinitely. They must open and a deal must be found before they do.
What happens if there isn’t a deal? Well the banks are insolvent, that is the bottom line. By now you know the drill: banks will collapse, the central bank recapitalises them by printing new currency, which leads to massive depreciation, and massive inflation, followed by a national impoverishment.
Yet, even in this unlikely scenario, I don’t see any broader trouble, especially for Spain or Italy. Don’t forget the ECB stands ready to buy their bonds in the secondary market and we also have the bailout funds (the European Stability Mechanism etc), which stand ready to recapitalise banks and/or buy bonds. Truth is, European firewalls are more than sufficient to protect against any Cypriot contagion.