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Is Cyprus the New Bailout Blueprint? 

Neil Dwane 

 

3/28/2013 

Forcing bank depositors to chip in to pay sovereign debt could be the new template for the euro zone. If seizing assets is fair game, it will disrupt markets and prompt a flight from troubled banks, says Neil Dwane, CIO Equity Europe.

Key Takeaways

Cyprus’ bondholders and uninsured depositors with more than €100,000 are being forced to subsidize a sizable portion of the bailout
Dealings with debt-laden countries now consider a new blueprint, one marked by greater fiscal accountability and a direct payment from citizens
Weak banks in weak countries may see additional deposit flight—possibly to gold and the Swiss franc—in the coming weeks. Any new signs of stress will force faster bank runs and bank collapses. Fund flows could potentially be enormous and disrupt markets
Ahead of its national elections, Germany is taking a tougher stance on picking up the tab for troubled countries in the euro zone but remains pro-Europe
With political ineffectiveness an dysfunction so rampant, the European Central Bank (ECB) is the only entity offering relief from the challenges plaguing the euro zone


The euro zone

Following a marathon weekend of talks, an eleventh-hour bailout deal between international lenders and Cyprus has been reached. The deal capped a week of uncertainty that rattled markets, reminded spectators that the euro-zone crisis is far from solved and revealed Germany’s new toughness as euro-zone paymaster. The €10 billion bailout for Cyprus and decision to shut its second largest bank, Cyprus Popular Bank (also known as Laiki Bank) sets a harsher tone and has been referred to as a "blueprint" for future euro-zone bailouts by EU finance ministers. The new precedent set by the deal struck with the European Central Bank (ECB) and International Monetary Fund (IMF) includes, for the first time, hitting bondholders and uninsured depositors with more than €100,000; all part of the new strategy to shift the cost of bailing out failed European banks from taxpayers to investors in the future.

The ECB responded to the rejection of the initial bailout deal by Cypriot parliamentarians last week by threatening to suspend Emergency Liquidity Assistance (ELA) to Cypriot banks beginning March 25 if an alternative bailout plan failed to be approved by the troika1; in my view an extraordinary move, with the ECB potentially putting itself in the position where it could have blown up the euro. If the ECB stopped supporting the Bank of Cyprus, it would trigger the collapse of the Cypriot banking system and take the Greek banking system with it, with blame resting entirely on the ECB. Rationally, this was not a sensible position for the ECB to put itself in—although it was prepared to threaten this tactic. The agreement was reached just before the deadline between Cypriot President Nicos Anastasiades and troika leaders without the controversial levy. The deal spares deposits under €100,000, part of the original proposal, but instead “bails in” larger deposits only.

A morphing EU strategy for managing the debt crisis

The strategy adopted by the EU for containing and managing the euro-zone crisis has morphed as the individual issues of each “problem country” have unravelled and presented new challenges. To date we have seen the following measures implemented in different crisis-hit countries:
Greece forcing a sovereign default on all domestic bondholders—among them Cypriot banks that invested heavily in Greek government bonds—except the ECB and internationally listed bonds
Ireland punishing senior bank bondholders in the rescue of Anglo Irish Bank
Holland punishing subordinated bondholders in the rescue of the Dutch bank, SNS Reaal
Cyprus now being forced to “bail in” bank depositors above the guaranteed level, whether domestic or international (perceived to be ill-gotten) investors.
Despite bouts of acute angst and anxiety, the longer-term chronic issues continue in the euro zone.

Badly implemented austerity

The entire euro zone has been forced to adopt austerity which, where badly implemented, has created disasters like Greece; it’s proven to have serious negative economic feedback loops and to undermine governments and their policies, increasingly misaligning them from the EU and Germany especially. One thinks particularly of last month’s inconclusive elections in Italy, where a second election may now occur, with the growing likelihood of a weak and unstable result. Moreover, as part of the euro-zone core, France should be setting an example on the implementation of austerity. But, after only a year, it is finding it too tough and l’austerite is already over. I find it interesting that, when it’s painful for somebody else, people are happy to advocate austerity; but when it is implemented at home and found to be painful, it’s either not implemented or abandoned quite quickly in practice.

A change of tone from paymaster Germany?

Following the disappointing outcome of the Italian elections, German Chancellor Angela Merkel’s room for manoeuvre for tolerating a lack of progress on fundamental structural issues in Europe, as she has done for the last two to three years, is beginning to diminish as Germany’s elections approach. Moreover, she probably feels let down by the fact that French President François Hollande and others are back-sliding so quickly on austerity. While, in general, German politicians are pro-Europe, they are arguably facing the dichotomy of wanting to support Europe, but having to respond to a growing sense of voters’ incredulity that euro-zone members, like Cyprus, are in such a mess. There is no sign of a serious anti-European party ahead of September’s elections but there is a growing level of bailout fatigue being felt at the individual level in Germany, to which politicians will have to react. The balance for German politicians is, therefore, being pro-Europe, while not seeming to be bailing out any weaker euro-zone members. There is also clearly a desire to shift the bailout burden from German taxpayers to other parties, for example investors, going forward.

A blueprint for future bailouts in the euro zone and the implications:

The Cypriot solution suggests that all euro-zone citizens should now review both where and how much cash they have on deposit. This may potentially have three fatal implications:
1. Weak banks in weak countries may see additional deposit flight in coming weeks
2. New signs of stress will force faster bank runs and bank collapses
3. With €34 trillion of deposits, fund flows could potentially be enormous and disrupt markets

While a banking union is desirable, the problem is it requires similar standards of behaviour to be guaranteed across the whole of Europe. If that means guaranteeing bank deposits or other similar types of structure, Europe does not have enough money to do so. That is the challenge and, therefore, a banking union will proceed slowly. The euro zone will not underwrite international investors in Cyprus, nor has it enough capital to underwrite €34 trillion of deposits (equivalent to over twice Europe’s GDP).

The race to safety—the reaction of investors to what is happening

If European citizens are worried about their deposits being taxed or seized, they will rationally seek to move them to safer places. Historically, the Swiss franc and sterling have been regarded as “safe havens”—although sterling looks more vulnerable now following the UK’s own failed austerity policies. Gold, the other traditional safe haven, is now rising toward an all-time high in euro terms, which might suggest that people in Europe are buying gold. Should euro-zone investors start to worry about the safety of their money, it will show up in the coming weeks and months in the amount of money central banks are borrowing through the ECB Target2 system. If, therefore, there is a run on the weaker peripheral banking system, Target2 (Trans-European Automated Real-time Gross settlement Express Transfer system) would highlight the run as it appears. By watching the Target2 balances, therefore, it will be possible to track where this is happening—at both a corporate and an individual level.

ECB to the rescue—by default

Politicians make up policy on a case-by-case basis—or, even worse, on the hoof—in order to get into power or to retain it. Standing back from what has happened in Cyprus recently, it’s very clear that politicians are quite capable of making a bad situation worse and, therefore, the only real help can come from the ECB supporting the financial system. Politicians, both EU and national, are currently not aiming to solve this challenge and, therefore, it is left to the ECB to do it for them, insofar as it can. Once again, it all comes down to the ECB.




Source of all data: Allianz Global Investors, as at March 2013
1 Troika: EU, IMF and ECB
2 Target2 is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union

Gross domestic product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance.

The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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