Monday, March 18, 2013

Don't get too excited about Cyprus

The financial markets sold off early Monday on the news of the weekend bailout of Cyprus, but while the risks of a financial meltdown, while real, they are overly exaggerated. As I write these words, US equities have recovered most of their losses and shrugged off the Cyprus news.

What happened?
To explain what happened, Cypriot banks got in over the heads with too much Greek debt and had to be rescued. The EU stepped in with a €10 billion rescue package, but with the conditionality that the government impose a 6.75% one-time levy on bank deposits under €100,000 and 10% for deposits over €100,000. The deal has yet to be ratified by the Cypriot parliament. If it isn’t, banks in Cyprus are certain to collapse and there are reports about how the deal is going to get modified.

The knee-jerk reaction was instantly negative. The fear is that if this can happen in Cyprus, it could happen elsewhere. What if Portugal, Spain or Ireland had to get bailed out, would depositor funds be at risk there too? What’s to stop the Portuguese, Spanish and Irish from pulling their euros out of their banks and putting into Deutschebank in Frankfurt, thus sparking an enormous bank run and threatening the health of the European banking system?

Bank run fears are overblown
I believe that any panic over a possible bank run in the eurozone is exaggerated. Wolfgang Münchau (see Europe is risking a bank run in the FT) highlighted the risks of a bank run but admitted that there are institutional barriers to a bank run on retail deposits:

There are some institutional impediments against bank runs within the eurozone. Some countries impose daily withdrawal limits, ostensibly as a measure against money laundering. Nor is it easy to open a bank account in a foreign country. In many cases, you need to have residency. You may need to travel there in person, and you need to speak the local language – or at least English.
While it is possible to get around these rules, the risks of a bank run that threatens the health of the banking system are low.

In addition, ECB head Mario Draghi has said in the past that he would do “whatever it takes” to save the eurozone. However, he has also made it clear that rescues come at a price. The Cypriot rescue conforms with the EU and ECB principle of the imposition of “conditionality” on rescues. In the case of Cyprus, the banks had insufficient equity to withstand the shock of a write-down of Greek debt and it didn’t have enough senior bond holders to cushion the pain without rendering the banking system insolvent. The only ones left to take the hit were the depositors. It didn’t hurt politically that Cyprus was known as an offshore banking haven, mainly for Russian oligarchs. So it was easy for Angela Merkel to sell a bailout involving shared pain to the German people.

I believe that bailouts of other eurozone countries, should they be necessary, will conform to a different template of conditionality other than the imposition of a tax on bank deposits. For example, the ECB has made it clear that it will backstop Spain, but on condition that the government undertake structural reforms and austerity. In the case of Spain, Rajoy has yet to swallow the bitter pill that comes with an OMT bailout.

Based on my analysis, the worst fear of the pessimists, which is a bank run in the eurozone, will not materialize.

Key risks
However, there are two key risks to this forecast. First, I am assuming that the Cypriot parliament will approve the rescue package and approval isn’t fully assured. If the deal were not to be ratified, it would likely introduce a new element of risk to the eurozone banking system and possible contagion into the global banking system. In that case, all bets are all.

The second is the French elephant in the room. The French economy is negatively diverging from Germany and France needs to take steps to align itself with Germany and the core eurozone economies. While the EU can rescue Greek and Cyprus, France is at the heart of the EU and much too big to save.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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