In my view, Cyprus will be a one-month wonder.

The share market fell in March, for just the second month since last June. The ASX200 declined by 2.7% but remains up 6.8% for the year to date. Including dividends, share investors are 8.1% ahead so far this year.

It's made a lot of difference what sector investors have been in. So far this year, consumer discretionary stocks have risen by 16.4% and the banks by 15.5%, while the resources sector has declined by 7.5% and materials stocks by 9.3%. The US share market had a far better month, with the S&P500 index rising by 3.6%, to be up by 10% so far this year. Remarkably, the S&P rose in 11 of the 13 weeks of the March quarter. This index finished the month at an all-time record high.

Once again, a European country was the cause of the Australian market's blues. In this case, for the first time ever, the market was depressed by the tiny Mediterranean island of Cyprus.

Cyprus is the third smallest nation in the Eurozone. Its banking system is in a lot of trouble, in part because it has made a lot of loans in Greece. It thus asked for aid from the troika (the European Central bank, the International Monetary fund and the European Commission) to bail out its banking system. It thus followed Greece, Ireland, Portugal and Spain, each of which has previously been "bailed out". As a condition of supplying aid, the Troika asked that the Cypriot banks make a significant contribution themselves, and a plan (plan A) was hatched to impose a tax on all Cypriot bank deposits, including those of less than 100,000 euros.

The issue with this is that deposits of less than 100,000 euros are guaranteed throughout the euro zone, and any tax on such deposits violates this system-wide guarantee. If this can be done for Cyprus then, many would argue, it may be tried again at a later date in a more significant country. If it were thought that this could be applied as a remedy elsewhere, then the merest hint of trouble in the future could lead to a bank run, and that's what has to be avoided at all cost if the Eurozone is to survive.

Within a week, Plan A was replaced by Plan B, which dealt only with the two largest banks in Cyprus, and taxed only those deposits above 100,000 euros. The size of the "haircut" has not been officially announced, but it is believed it will be in excess of 20%. Plan B is a long way from perfect. Many of those deposits are owned by foreigners, particularly Russians, for whom Cyprus is a tax haven. Such a tax is not likely to encourage growth in the "tax haven" industry! Russians are estimated to hold about one-third of all bank deposits (by value) in Cyprus.

To prevent money from leaving other Cypriot banks, capital controls have been imposed. This means that a euro inside Cyprus is no longer equivalent to one elsewhere, which violates a fundamental tenet of the currency union.

There is no happy ending in this for Cyprus. By the time it has worked through its problems, its economy is likely to have shrunk by about 20%. Apart from its status as a tax haven, Cyprus, which joined the Eurozone as recently as 2008, relies on tourism and some offshore energy to survive. It is used to shrinkage the Cyprus economy is estimated to have contracted by close to a third when Turkey annexed a large part of the island in the mid-1970s. But whatever happens to Cyprus really doesn't matter in a direct sense.

The economy of Cyprus is smaller than that of the Scranton area in Pennsylvania. Most readers will never have heard of Scranton, and there's a good reason for that. It's very unlikely that anything that happens there would have a great direct effect in Australia. Scranton is the sixth-largest city in Pennsylvania. For those who want to know more, it's the hometown of Joseph Biden, and a sister city to Ballina, but the one in County Mayo rather than the one in New South Wales. Perhaps most importantly, it is the home of the famous Dunder Mifflin paper supplies company. The point of this digression is to highlight just how small Cyprus is its GDP is about 0.03% of global GDP!

In my view, Cyprus will be a one-month wonder, but what this episode has done is raise the tail risk of a catastrophic ending to the entire European debt issue. This risk is still very small, however.

Other international issues remained in the background. In the United States, mandatory government spending cuts began in early March, but the US economy seems to have been little affected to date. Congress even passed a further continuing Budget resolution, thus avoiding a Federal government shutdown. Early forecasts suggest that the US economy will record GDP growth of close to 3% (annual rate) in Q1, and the housing recovery is clearly continuing.

The uncertainty continues in Italy, with very little likelihood now of a second election before September or October. An earlier election, say in June, would have required that the current President resign before the end of his term on 15 May. He can't dissolve Parliament and thus bring on a new election in the last six months of his term, and he has shown no inclination to resign early so that his successor could do so, with the obligatory 45 days notice, before the country effectively shuts down for the summer. It is thus possible that the current Monti government will remain in place for some time yet, or that it will be succeeded by an institutional government committee of "wise men" (some sexism there!) agreeable to the major political parties. If the latter were to occur, this would obviate the need for a second election.

The Australian Economy

In the month, we learned that the economy grew at only a moderate rate in the second half of 2012. The news about the labour market was decidedly mixed, with the employment growth reported for February clearly too good to be true and the vacancy data for the same month unbelievably bad. Slow credit growth suggested that Australian businesses are still very cautious, but the January retail trade report was much better than those of recent months.

The Reserve Bank opted not to cut rates in early March, and also stood pat on 2 April. It still has at least a soft bias to ease, being cognisant of the need to cushion the economy when the mining capital spending boom peaks, as it surely will.

Chris Caton
Chief Economist

The views expressed in this article are the author's alone. They should not be otherwise attributed.

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