In my view, Cyprus will be a one-month wonder.
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.
Frequently Asked Questions about this Article…
Cyprus asked the Troika (ECB, IMF and European Commission) for help because its banks had large exposures to Greek loans. Initial rescue proposals (Plan A) would have taxed all bank deposits, including those under €100,000, which would have breached the euro‑zone deposit guarantee. That prospect and the subsequent change to a more limited plan unnerved investors and depressed markets for a short period.
Plan A proposed a tax on all Cypriot bank deposits (including amounts under €100,000), which would have violated the euro‑zone deposit guarantee. Plan B was scaled back to target only the two largest banks and to tax deposits above €100,000, with a reported “haircut” believed to exceed 20%. Investors worried that breaking deposit guarantees anywhere could raise the risk of bank runs elsewhere and undermine confidence in the banking system.
Yes — across the euro zone deposits under €100,000 are normally guaranteed. The initial Plan A would have overridden that protection for Cyprus, creating fears that the guarantee could be eroded in other cases, which is why Plan A was particularly alarming to markets and depositors.
Capital controls are restrictions on moving money out of a country or bank. Cyprus imposed them to prevent a mass exodus of deposits from other Cypriot banks after the rescue deal targeted the biggest lenders. These controls effectively made a euro inside Cyprus not fully equivalent to a euro elsewhere, which goes against a core principle of the currency union.
Cyprus is very small — the article notes its GDP is about 0.03% of global GDP. The author expects Cyprus’s economy to shrink by around 20% as it works through the crisis. While the direct global economic impact is tiny, the episode raised concerns (tail risk) about a more severe European debt outcome, though that risk was judged still very small.
Sector performance in Australia varied: consumer discretionary stocks rose about 16.4% and banks about 15.5%, while resources fell about 7.5% and materials about 9.3%. The US market had a strong month: the S&P 500 rose 3.6% and was up roughly 10% year‑to‑date, finishing the month at a record high after rising in 11 of the 13 weeks of the March quarter.
The author says Cyprus likely will be a short‑lived (a “one‑month”) market event but that it has slightly increased the tail risk of a catastrophic European debt outcome. Nevertheless, that heightened risk was still considered very small at the time of writing.
For Australian investors, the Cyprus episode was largely a short‑term shock rather than a direct economic threat given Cyprus’s small size. Domestically, Australia showed mixed economic signals — moderate GDP growth in late 2012, mixed labour data, slow credit growth but better retail trade in January — and the Reserve Bank chose not to cut rates in early March or on 2 April, keeping a mild bias toward easing if needed.
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