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Why the market is underestimating Cyprus

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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