Cyprus: Move Along Now, Nothing To See Here

Please note: The following is a reprint from a new segment of BCA’s recently (beta) launched Daily Insights service. Originally published March 22, 2013.

In our recent research, we have highlighted why Cyprus is different from other European nations in crisis. But in this Inside BCA, Peter Berezin, Chief Strategist – The Bank Credit Analyst, provides the counterargument and presents why the story in Cyprus is depressingly similar to other bailout situations. You will note Peter takes a much less sanguine view about the implications for the euro area.

Preserve the Narrative at all costs. That, in a nutshell, is Europe’s strategy for dealing with the crisis in Cyprus. The Narrative, of course, is that Cyprus has nothing to do with anything. The events there, so the story goes, are an anomaly, a one-of-a-kind situation, with absolutely no relevance for the euro area as a whole.

Needless to say, the Narrative is wrong. Yes, the reliance of Cyprus’ banking system on deposits from people of, shall we say, dubious moral character, introduces a new twist to the saga. No one can fault the Germans for refusing to underwrite this noxious bailout. But take away the Russian angle, and the macro picture looks depressingly familiar. Massive property bubble? Check. Huge current account deficit? Check. Bloated financial sector? Check.

The only thing Cyprus didn’t have going into the crisis – much to the annoyance of those who insist on seeing the euro crisis as a morality play about profligate fiscal policy – are large budget deficits. However, just as was the case in Spain and Ireland, that too has changed. Having been forced to socialize private-sector debts, the government’s debt-to-GDP ratio has ballooned to 90% of GDP – up from 49% of GDP in 2008 – and would be closer to 150% of GDP if one includes the full cost of the bank bailout. In short, we have seen this movie before.

European policymakers will be quick to point out that Cyprus’s banking system is not a template for the rest of the euro area. That is true to the extent that attracting oligarch money and using it to buy Greek bonds is not exactly a recipe for prudent banking. But Cyprus’ banking system was a template in one important respect: ever since the euro crisis began, policymakers have been arguing that banks should become less reliant on short-term debt and more reliant on “sticky” deposits. Well, Cyprus was reliant on deposits, although they turned out not to be so sticky.

It is true that no other euro area country has contemplated imposing a haircut on depositors. Then again, such an action is not completely without precedence. Italy instituted a one-off 0.6% deposit tax in 1992, just months before the country devalued the lira and withdrew from the ERM. Might that happen again? Probably not, but we won’t know that for sure until the next flare up in Europe. Cyprus may not be the catalyst for another round of euro angst, but it could turn out to be an accelerant.

How will the crisis in Cyprus end? Ironically, at this point, the best hope for restoring confidence in the local banking system is to impose a massive haircut on deposits over €100,000 – probably in the range of 50%. That way, the banks can be returned to solvency, which might mitigate the risk of an out-of-control bank run.

Russia may not like that, but there is something Cyprus can offer in return. Russia is in jeopardy of losing its naval base in Tartus, Syria, if the Assad regime were to fall. A new base in Cyprus would preserve Russian naval access to the Mediterranean and undermine NATO influence.

The geopolitics in the region are about to become even more interesting.

Source: BCA Research

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