On Cyprus and the European Crisis

It has been non-stop Cyprus for the past couple of days this weekend. And it has brought back the bad ol’ days when every weekend seemed to be another episode in endless crisis. To wit, this episode in Cyprus demonstrates how misplaced the excessive levels of complacency in markets are. The Cyprus episode also demonstrates that the European crisis is one that is being experienced on multiple levels in numerous locations; trying to call the next crisis is a losing battle. I would also say that the miserable way the Cyprus deal was handled by EU leaders shows yet again that domestic political and ideological considerations  will continue to constrain policy responses, making crisis more volatile. That said, it is not at all clear yet that this has systemic implications. It is when Spain and Italy are affected that we should really worry.

When the Cyprus news ht on Saturday morning, my first impression from the news flow was that it felt similar to the Dubai World shock which began the sovereign debt crisis. Here was an event that was on everyone’s radar screen in which a number of different policy outcomes were being discussed and the options were all known in policy circles and in the financial media. Yet, when the policy choice was made, everyone was shocked at how ill-conceived the choice was and then we all went scurrying through our minds for systemic implications. That’s how the sovereign debt crisis began. And that’s what is similar about this episode.

I have to be honest, I did have a Creditanstalt kind of foreboding when I got the details of what happened. Now this is not something I have said publicly because I think that just adds to the hysteria. But it is something I am willing to admit in this forum here. It has been a long time since I have felt this way, but here we are again. And Cyprus is a tiny country, completely insignificant economically, globally or within the euro zone.

It’s the fact that Cyprus is so insignificant economically within the euro zone that makes this hysteria surrounding its bailout so troubling. It tells you that this is a significant psychological event, as Dubai World was. What it’s telling us is that what has happened in Cyprus represents a paradigm shift in terms of how policy makers are willing to deal with the debt problems they are having in either the banking or public sector. And the vocal outcry about it is due to the fact that this paradigm shift was unexpected, having been executed in an ad-hoc and ill-conceived way.

What the EU is telling us essentially is that it will continue to take these bailouts on a case by case basis and design policies that may or may not be used as a baseline for further action. Basically, we will therefore have no idea what the expected outcome of any crisis situation is going to be because it will depend entirely on the political circumstances at the time and the relative negotiating prowess of the particular decision-makers. To me, this is the real story here – that the EU is going to continue to make unpredictable and ad-hoc decisions on policy.

Now, I have written pretty extensively on this situation so I don’t feel like I need to go into the particulars here. On predictions, I don’t think this is going to cause a bank run EU-wide, at least not yet. However, it does set a bad precedent that makes a bank run a real possibility at a later date. As soon as any peripheral country runs into trouble, the right thing for depositors to do is to start dialling their deposits back – just in case. In fact, if I had deposits anywhere in the periphery, I would be thinking about where I wanted them to go, in which banks, in which countries, and how much I wanted to keep in cash or precious metals.

Spain is the country that comes to mind here first. My first instinct was to think that when you think about Spain, you soon realize that, given its, size, the Cypriot example is not replicable. Sure, many parts of the Spanish banking system are insolvent but there is enough money there and there are enough banks there that many banks are just fine. BBVA and Santander have done well so far. Yet, the reality is that in Cyprus the same is also true to a degree. And so that kernel of doubt creeps in – and that’s where the problem is. What will they do when Spain needs to recap again – as is likely? It is not at all clear. Private sector involvement could mean deposit confiscation. And even if that means taxing funds over the 100,000 euro deposit guarantee threshold, you have a problem because that still invites capital flight.

Apparently, the flight into safe assets is already happening. Bloomberg reports that German two-year yields are below zero percent for first time since 2 Jan and that German bonds in general have caught a good bid. Whether this flight to safety continues is another question. Right now, the banks are closed until Thursday, according to the latest reports. And the ruling government only has 28 out of 56 votes necessary to pass the tax. MPs are afraid of voting in favour of this because it could be political suicide. More importantly, if these delays and the tax itself induce a slow trickle of funds out of Cyprus anyway, the banks could legitimately need another recap down the line – and then you would definitely have a bank run, requiring heavy capital controls.

This whole affair in Cyprus is a disaster, a marvellous cock-up of monumental proportions. Any fool could have seen that taxing guaranteed deposits this way was going to be seen as an outrageous move that violates most basic senses of property law. The right thing to do would have been to only tax deposits over the 100,000 euro threshold or to let the banks default and deal with that outcome. Clearly there aren’t a lot of choices, especially if you can’t print money.

It’s early days yet here. Let’s see how this plays out over the next few days. Irrespective of the immediate effect, the insured deposit grab in Cyprus will leave a nasty legacy which will destabilize the euro zone if and when crisis re-appears elsewhere.