It was a week of high-stakes drama for the euro zone. Last weekend saw Cyprus leaders and European officials agree to a “bail in” whereby bank depositors would be “taxed” to help pay for the cost of bailing out Cyprus’ troubled banking sector. Apparently, outflows from Cypriot banks had recently accelerated and the available supply of emergency ECB liquidity had about been exhausted. The EU would contribute 10bn euros to the bailout, with Cypriot depositors on the hook for 5.8bn euros. The levy (“haircuts”) on deposits below the 100,000 threshold unleashed a firestorm of condemnation heard around the globe.
There actually seemed a bit of histrionics on the prospect of small depositors taking a 6.75% hit. Yes, these deposits were insured. But, as German Finance Minister Schaeuble noted, deposit insurance is only as good as the solvency of the sovereign. Are the Germans expected to back all euro zone deposit insurance? Still, with Draghi’s ECB market backstop in place, the worry that depositors (and investors/speculators) around Europe would suddenly fear for the safety of their deposits (or bonds) was farfetched.
At the same time, the Cyprus situation is as intriguing as it is potentially troubling. This Eastern Mediterranean Sea island has a population of only about a million and a tiny little economy. It didn’t become part of the euro until 2008. It’s a nice tourist spot, but mainly it’s distinguished by its bloated banking sector. Regrettably, bank assets doubled over the past five years, ballooning to a precarious eight times GDP. Its low corporate tax rate, loose banking regulations and euro zone membership propelled Cyprus into a major hub for tax evasion and money laundering. As money came flooding in, much of it from Russia, too much of it found its way to high-yield Greek corporate lending and government bonds.
I wonder if European officials appreciated at the time that euro membership would greatly increase the allure of Cyprus’ questionable “banking” arrangements. Here Cyprus, you and your friends enjoy your new euro printing press! We’ll count on you to regulate yourself, as we don’t even want to contemplate what we know you all are up to.
On Tuesday, the Cypriot parliament brazenly rejected the bailout agreement negotiated over the weekend between Cyprus’s new President and the “troika” (European Commission, ECB and IMF). To cheers from Cypriot citizens and others (notably left-wing Greek politicians), the Cyprus’ parliament became the first governmental body to spurn EU bailout terms. After the vote, Cyprus’ finance minister jumped on a flight to Russia, while street protesters pointed blame directly at Angela Merkel and the German government. In a Mediterranean region where “austerity” and German political influence have become such hot-button issues, there was palpable enthusiasm that someone was finally going to call Germany’s bluff.
At least the Cypriots acted as if they had a strong hand to play, as they fought to safeguard their little financial empire. They appeared confident in their close ties with Russia, and the Russians did lend Cyprus $2.5bn a year ago. Cyprus does have a strategically important location (and naval port), along with supposedly large untapped natural gas deposits. Protesters drew Hitler mustaches on Merkel photos, while politicians were determined to publicly snub euro zone officials. They were surely emboldened by tough talk from the likes of Putin and Medvedev.
By week’s end, however, the Cypriots were left empty-handed by the Russians. With tails between legs, the Cyprus Parliament was desperately passing legislation hoping to avert financial and economic collapse while remaining in the euro zone. Tuesday’s deposit levy legislation had been supplanted with bills providing the Central Bank of Cyprus authority to wind down at least one of its major banks. Instead of a 9.9% tax, many large depositors now face major losses and even the loss of access to their funds for an extended period. Capital controls will be necessary, as well as strict limitations on bank accounts and fund transfers. Cyprus may very well do enough to remain a euro member on Tuesday (banks are to reopen). But their banking and business model has been destroyed, with unknown consequences for Cyprus and their financial relationships. Thursday’s Russian tough talk had turned strangely quiet by Friday.
It has been part of my thesis that the Germans would over time adopt a harder line. Market participants never seem to tire repeating the mantra that the Merkel government will talk tough and predictably cave when market turmoil puts a gun to its head. Emboldened markets have been confident that, at the end of the day, Germany will have no option but to use their wealth to backstop the entire euro zone. This week’s Cyprus eruption may have market players rethinking a few things.
I’ve assumed that the further along the “European” crisis evolves the more the German point of view shifts from backstopping the euro project to protecting German interests. It is worth noting that while the Cyprus bailout structure was being lambasted (“stupid” and “incompetent”) Merkel and Schaeuble were winning plaudits at home. German public opinion against bailouts has notably hardened over recent months. The days of railroading big euro member bailouts through the Bundestag appear over.
For me, the near-term significance of this week’s developments rests not with deposits and potential runs. And it’s not even about the serious issues of capital flight and capital controls. I’m trying to discern if the Cyprus fiasco takes a little strength away from powerful “risk on” and perhaps even pushes some momentum in the direction of “risk off.” Do these developments spur players to consider taking a few chips off the table? On the margin, is the leveraged speculating community apt to see the world somewhat less supportive of market risk and leverage? Does Cyprus increase the odds we’re in the midst of a topping process and important inflection point for global risk markets?
The big macro hedge funds have placed major bearish bets against the yen. And the yen rallied more than 1% on Thursday’s more “risk off” trading session – and ended the week up 90 bps against the dollar and 1.5% versus the euro. Some funds have scored big returns from Greek bonds, and we see that Greek yields spiked 100 bps this week. And while there was certainly no panic in their bond markets, Spain’s and Italy’s Credit default swap (CDS) prices were modestly higher this week. More notably, European bank CDS prices jumped. Over the past few years, Europe’s bank CDS market has provided a decent early indicator of both market risk aversion and embracement.
From my perspective, the Cyprus crisis arrives with global markets in a somewhat vulnerable position. In particular, the emerging equity and debt markets have begun to struggle. India’s stocks were hit for 3.6% this week – and are down 3.6% y-t-d. South Korea’s Kospi declined 1.9%, pushing 2013 losses to 2.4%. Eastern European stocks and currencies have been under pressure. This week saw equities fall in Russia (down 2.2% y-t-d), Poland (down 5.1% y-t-d) and the Czech Republic (down 5.6% y-t-d). Latin America stocks also remained on the defensive, with Brazil’s 2.9% drop this week pushing y-t-d losses to 9.4%. And while U.S. investment grade and junk bond CDS have been grinding to multiple-year lows, emerging market CDS have curiously diverged and moved higher. On the more bullish side, Chinese stocks did muster a 2.2% recovery this week.
U.S. stocks ended the week having sustained only minimal damage. Bernanke confirmed that the Fed’s printing press will be running 24/7 for the foreseeable future. Between the Fed, Draghi’s backstop, the Bank of Japan and basically concerted global central bank printing, most market participants see no end to the bullish backdrop. The Financial Times ran a story Friday, “Hedge Funds Storm Back into Form.” Like most, the hedge funds have rediscovered the secret to success: throw caution to the wind and jump aboard the raging global bull. It’s late-night and the raucous crowd has gathered contently on one side of the party boat.
Inflated and highly speculative global risk markets remain enamored by central banker resolve – and perhaps not all that focused on fundamental developments. And, ironically, Bubbling risk markets were this week conducive to resolve elsewhere. Strong markets provided the Germans, Finns, Dutch and the EU more generally a favorable backdrop for demonstrating some backbone. For one, they didn’t appreciate little Cyprus copping a big attitude. The Germans were incensed – and they weren’t going to let Cypriot politicians get away with any nonsense. You either want to remain in the euro zone or you don’t. If so, we dictate the terms. If not, we’re confident we can manage the consequences. Cyprus follies must not set a precedent. EU and “troika” credibility was on the line, credibility that’s been taking some hits of late.
Actually, it was probably time for a new approach in dealing with the troubled debtors. I think the Germans and the “northern” countries come out of this experience with new resolve. And this could set the stage for trying times in the markets when bailouts are required for Spain and Italy - Draghi, Bernanke, Kuroda and friends, notwithstanding.
I also wouldn’t be surprised if history looks back at this week’s developments and finds some significance. There was some real money lost this week. And I mean “money” as in perceived safe and liquid nominal stores of value – like euro-denominated bank deposits (in contrast to non-money-like Greek sovereign bonds or subordinated bank debt). Cypriot deposits (small and large) had retained their “moneyness” based on what is now clearly a misperception that Germany and the EU would backstop their value. And there’s literally Trillions of suspect Credit and “money” throughout Europe whose value is today inflated based upon similar (mis)perceptions.
While we’re on the subject, there are tens of Trillions of securities and “money” that retain full and inflated market values based on the perception of the wealth-creating capacity of the Fed’s printing press. And there are as well monetary partners in crime in Japan, China, the developing economies and the rest-of-world. For going on five years now, since the 2008 Credit crisis, the global “system” has been grossly over-issuing “money.” I have referred to the Greek collapse and “European” crisis as the initial crack in the “global government finance Bubble.” It is tempting to see Cyprus as the first crack in “money.”