The bail-in/bail-out package raises more questions
The crisis in Cyprus is, at least temporarily, over, the euro is trading over 1.30 to the US dollar and sovereign bond yields of the European periphery have climbed down. But this could well be the calm before another storm comes the way of the battered continent. The "Cyprus crisis" (CC from now) has raised a number of uncomfortable questions that need comprehensive answers before investors can feel comfortable about the region's economies and markets.
The first and perhaps relatively minor question relates to why the size of the bailout needed for the tiny island (accounting for 0.2 per cent of euro zone GDP) was miscalculated. Just two weeks after CC broke and plans were being put together for a Euro 17 billion rescue package, EU documents revealed that the amount of funds needed was actually Euro 23 billion. The combined contribution of the rest of the euro zone (through the European Stability Mechanism) and the International Monetary Fund (IMF) would remain unchanged at Euro 10 billion and, thus, the burden on Cyprus (the so-called bail-in) would move up sharply from Euro 7 billion to Euro 13 billion. The bulk of this burden would fall on big-ticket depositors and bond-holders.
The more fundamental question that bothers investors is whether the solution to CC represents a template for future bailouts. While European policy makers have insisted that Cyprus is a "unique" case, there are many who argue that this would be the model for resolving banking crises in other parts of the region. Thus, bank depositors and bond-holders could well have to participate more in rescuing collapsing banks. Should this be the case, the risk of bank runs in the region at the faintest whiff of trouble could increase exponentially. There is the associated risk of contagion that has now become all so familiar to crisis-watchers. News of, say, a couple of Spanish banks teetering on the brink of insolvency could see depositors queuing up at ATMs, not just in Madrid or Barcelona but also in Milan, Lisbon or Dublin, fearing that that their banks would be next in line for a bail-in
The immediate impact of the likely "replication" of the Cyprus model has, of course, been felt in the gold market. The final bailout/bail-in package for the country involves a sale of Euro 400 million of gold reserves of the central bank. This might be a paltry amount. If, however, larger economies like Italy or Spain were to face fiscal stress (both quite likely) later this year, the amount of gold that their central banks might be forced to dump on the markets could be substantially higher.
The other thing that bothers economists about the CC resolution is the imposition of capital controls in Cyprus to prevent Cypriot depositors from pulling their deposits out and seeking safe havens offshore. Again, EU officials have pointed out that this is merely a stop-gap measure. However, once in place, capital controls are difficult to lift as the experience in Argentina (2001-02) or Iceland (2008) has shown. It is highly unlikely that Cypriot depositors will regain their faith in their banks within a couple of months and make the need for capital controls redundant.
The problem with capital controls is that they go against the spirit of a currency union. A euro deposited in a Cyprus bank is worth less than in a German bank. An extreme situation in which there is depositor participation in crisis resolutions across peripheral nations could necessitate different degrees of capital control, leading effectively to many different "euros" in the region all worth differently (depending on the degree of capital control). The currency "union" would then reduce to a sham
The final question that economies like Cyprus need to answer is whether it makes sense for them to remain in the union. Cyprus, among other smaller economies like Slovenia, depended disproportionately on their financial sector that attracted offshore funds, particularly from Russia, that Cypriot banks lent to other countries like Greece. Whether this model should have been followed in the first place or whether it was laundering dodgy Russian money is somewhat beside the point.
The fact is that the resolution has left their financial system and their economy in tatters. Cyprus' GDP is likely to contract by 9 per cent this year and 4 per cent in 2014 and these numbers could actually turn worse. A comparison with Iceland, which is not part of the euro zone, is imperative at this stage. Iceland had a hyper-extended financial system and the 2008 crisis knocked the wind out of the sails of both its financial sector and the economy. With capital controls and a massive depreciation of its currency, however, Iceland has managed to revive its economy. Economies like Cyprus have to make a choice now - whether it makes sense to remain in the union or to exit and bet on currency devaluation to crawl back to some degree of normalcy.
Slovenia is next in line for a handout to sort out a banking crisis that is brewing. The size of the problem, however, seems to be much smaller. Some estimates suggest that it might need just Euro 2-3 billion. It is also possible that its "rescue" involves just line of cheap funding from the EU and IMF and a draft on depositors can be avoided. But then, there is Malta and Luxembourg, which also have banking problems. Europe's troubles never seem to end, do they?
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