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Markets have largely shrugged off
the difficulties around the Cypriot bailout package, with
peripheral spreads holding reasonably steady (Spain up 5bp, Italy
up 3bp). It is notable that the market reaction so far has been
considerably less substantive than in response to the Italian
elections, where intra-day moves were much more significant. This
appears to reflect a view that a resolution of the implementation
issues in Cyprus will be found in the relatively near-term, while
in the longer-term the region’s crisis management framework remains
intact (and substantively unaltered). This view is not necessarily
incorrect, but we think there are reasons to question both
assumptions.
Near-term risks
are material
In the near-term;
implementation will likely remain challenging. While the
probability of an outright failure and default remains low, it is
still possible, in our view; existing as a low probability, high
impact risk. The fundamental problem is that it looks politically
impossible to impose the extent of losses on insured depositors
that the weekend agreement envisaged. These losses, under the
original proposal, total €2bn; and our base case assumption is that
the Cypriot Parliament will refuse to vote to impose them on the
current terms. The Government therefore needs to find a way of
funding the shortfall which has very rapidly emerged in the weekend
package. It faces a Hobbesian choice in doing so, in our
view.
Option
A could be to
recalibrate the pain so that insured depositors do not need to pay
anything, while uninsured depositors pay around 15.4% of their
deposits. The difficulty (and the main reason why this approach was
not tried initially) is that the burden would fall
disproportionately on Russian institutions and individuals. Russian
influence is Cyprus is considerable; and statements from President
Putin indicate that he would be extremely hostile to such an
approach. There is some possibility that Russia would respond to a
larger haircut by refusing to roll its existing €2.5bn loan to
Cyprus; meaning that this option would still leave a significant
shortfall. In such a scenario, either the haircut on uninsured
deposits would need to be around 21.8%, or further Troika funding
would need to be found.
Option
B could be to go
straight to requesting additional support from the Troika. The
Eurogroup is holding a further conference call this evening, which
is likely to investigate the near-term implications of the Cypriot
agreement. In our view, a significant amendment of the terms of the
deals (which calls for €5.8bn to be found from deposit haircuts) is
unlikely. Politically, it could be very difficult for Germany in
particular to make any kind of U-turn (especially since part of the
purpose of the whole exercise has been to demonstrate the
Government’s hard-line to domestic voters). The Eurogroup could
propose looking at different parts of the capital structure, but
this could risk compounding the existing error by creating
additional uncertainties. Finance Ministers may look for other
forms of funding, but their task looks difficult (it is possible
that Cyprus will revisit the idea of securitising future gas
revenues, which we were surprised was not utilised in the initial
proposal).
Option
C could be to
tweak the current pain distribution so that less of the burden
falls on the insureds. The Government has already proposed
staggering the burden so that depositors with less than €100,000
pay 3%, those with less than €500,000 pay 10% and those with more
than €500,000 pay 15%. To our mind, this looks like shifting
deckchairs. Cypriot depositors are angry at what they perceive as a
smash and grab raid, tweaking the quantum is unlikely to change
their prevailing emotions. It is possible however that such an
amendment, alongside further promises, could potentially be enough
to shift the balance within parliament (this is questionable
though, in our opinion).
Our base case is that
the Government, the Eurogroup and the Kremlin prove capable of
coming to some form of accord; especially given the nature of the
downside risks involved. However, there appear to be no good
near-term options; and the market appears too sanguine in its view
that a solution will inevitably be found. It is notable that the
Government has now extended out the bank holiday towards the end of
the week (as we suggested yesterday could occur), and could delay
the parliamentary vote still further. It has a few days at most to
agree on a pain distribution that has eluded policymakers for the
last 9 months (since negotiations began). In our view, the risks
are that a solution is delayed for several days, or cannot be
found.
Longer-term
impacts are meaningful
In the longer-term, we
expect significant ongoing ripple effects from the revealed
preferences and attitudes that have emerged in the Cypriot case.
Firstly, the affair reflects a change of behaviour amongst the
policy making community, which looks more willing to accept risk in
an OMT world. Secondly, it hints at a far more hawkish German
attitude than we expected, which could have implications for the
implied willingness to intervene in extremis elsewhere in the
periphery (we will write more on this shortly). Essentially, we are
seeing the rise of ‘the Germany that can say no’. Thirdly, these
events are likely to lead to gradual change in the behaviour of
depositors around the region.
We do not expect
short-term bank runs or direct contagion, Near-term impacts on bank
equity have been relatively limited so far (mostly in the 4%
range). However depositors will now be aware that they are
effectively taking a significant credit risk when they leave funds
in weak banks backed by weak sovereigns – and there is a good
chance that rates may need to rise in the periphery to reflect this
increased perceived risk (indeed, we believe this action hints at
broad risks for anyone with capital in a fiscally stressed
country). The long-term implication for bank funding in the
periphery is not a positive one, in our opinion, and by
implication, there could be impacts on the supply of credit.
Effectively, this would appear to work directly against the
objectives of Banking Union, which is designed to ensure that a
Euro in a Cypriot bank can ultimately be treated in the same way as
a Euro in a German bank.
In our opinion, there
is a good case to say that the Cyprus crisis may blow over in the
near-term, but the long-term breach of faith between Euro area
policymakers and regional depositors will remain (even if the
insureds are ultimately made whole). Despite the muted reaction so
far, Europe has reminded investors that there are significant
problems behind the curtain.
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