Cyprus bailout raises fears the worst has yet to come

The agreement is the latest example of a fudged Eurozone deal

THE sorry saga of Cyprus’s €10bn (£8.5bn) bailout has followed a familiar Eurozone script of uncertainty and chaos. Even as the ink dries on the deal, ambiguity remains. Plus ca change, as the French would say.

The relief rally was short-lived yesterday. Eurogroup president Jeroen Dijsselbloem spooked the market, saying that this was a “template” for future Eurozone bailouts. And after initially opening higher, most European bourses ended the day in the red. Banks were the losers. In France, Societe Generale and Credit Agricole shed around 6 per cent. In Germany, Deutsche Bank lost 3 per cent.

In previous bailouts, policymakers had been reticent to go after depositors; that taboo has now been broken. Gareth Berry of UBS argues that “confidence in the sanctity of deposits has been shaken”. This has potentially serious implications for weaker banks across the Eurozone.

Dijsselbloem’s comments did little to reassure markets that Cyprus is a one-off, apparently due to the size of its banking sector (over 700 per cent relative to GDP). The euro ominously fell to lows of $1.2827 against the dollar, and looks set to resume its downtrend after its recent rally. Bank of America Merrill Lynch forecast that it may fall to $1.25 by the end of the year. UBS are more pessimistic, forecasting a drop to $1.20.

FUDGED DEAL

Cyprus’s second largest bank Laiki will be wound up. Deposits under €100,000 will be transferred to the Bank of Cyprus, the country’s largest bank, which will be restructured. The target is to shrink the banking sector to the Eurozone average by 2018.

Size of bank assets as a percentage of GDP

Depositors with under €100,000 will be protected, respecting the EU deposit insurance. But exactly how much large depositors will be raided for is still unclear. Given the aim is to tap them for €4.2bn, they will be hit hard. Haircuts of up to 40 per cent are possible.

The deal does ensure that emergency liquidity provisions from the European Central Bank will be maintained (except for Laiki), avoiding a total bank collapse. But it is unlikely to draw a line under this episode.

The squeeze in the banking sector is likely to exacerbate Cypriot unemployment, currently 14 per cent. Chris Scicluna of Daiwa Capital Markets said the deal meant that “the near-term future for the Cypriot economy looks horrific,” and it is likely that we will see “economic contraction and a rise in unemployment to rival that suffered by Greece”. Societe Generale said “Cyprus will, in all likelihood, require additional financial assistance down the road”. It says that real GDP could be 20 per cent lower come 2017, which would make it difficult for Cyprus to reach its target debt-to-GDP ratio of 100 per cent by 2020, as the IMF forecasts.

Moody’s also chimed in, saying that the deal “will have profound long-term negative consequences,” and Cyprus “remains at risk of default and exit from the euro area for a prolonged period,” due to its precarious finances.

CONTAGION FEARS REMAIN

The deal may also accelerate precautionary deposit withdrawals across the Eurozone; if attacks on deposits can happen in Cyprus, why can’t they happen in other peripheral nations? In Cyprus, capital controls have been imposed on Bank of Cyprus and Laiki customers (accounting for half the retail banking sector) to stem this, but it still flies in the face of a key tenet of the Eurozone: the free movement of capital.

Finally, the deal did not require the approval of Cyprus’s parliament, after last week’s vote to restructure its banks. It raises the question whether Cypriot leaders have a defensible democratic mandate for this sort of deal. “If this becomes an issue, it is unclear whether the government could survive the internal strains,” says Berry.

The deal is another example of policymakers kicking the can down the road. Short-term risks have been alleviated, but this crisis is far from over.