Cyprus deal means the cat is well and truly out of the bag

March 27, 2013

By Laurence Copeland. The opinions expressed are his own.

The German insistence that depositors in Cyprus must face a haircut marks a new and dangerous stage in the interminable death throes of the euro zone. Up to this point, the one unshakeable principle underlying all the bailouts on both sides of the Atlantic since 2008 had seemed to be that the value of bank deposits was sacrosanct, whether they were explicitly insured or not. Now, the cat is well and truly out of the bag. It will be clear from now on, even to the most naïve investor, that there are no longer any totally safe assets. The principle of caveat emptor applies to bank deposits as much as to second-hand cars or beef-burgers. If even deposit insurance is now conditional, the difference between insured and uninsured deposits is only one of degree of risk. It is amazing how calmly the markets have reacted to the new reality, but it would be foolish in the extreme to rely on their continued insouciance.

There are a number of lessons we can learn from the events of the last fortnight, most of which relate more to Germany than to Cyprus.

For a start, recall the background to this latest crisis. At the end of last year, Mario Draghi allowed himself a pat on the back, as if he really believed all the nonsense in the financial media about the Man Who Saved The Euro. His policy of standing ready to buy unlimited quantities of short term debt from governments under pressure meant that “the darkest clouds over the euro area subsided in 2012”, he said.

When I want a weather forecast, I’ll go to the Met Office, thank you.

In case there was any doubt before, it is now plain that the ECB policy to save the euro is actually subject to German approval, so that although in principle there was no apparent reason why the Cypriot Government could not have bailed out its banks, using finance raised by borrowing from the ECB, in practice it seems they were never offered this option, which was vetoed ab initio by Angela Merkel and/or finance minister Wolfgang Schäuble. The veto itself must be seen as setting some kind of precedent.

It is far from unexpected. I have long argued in these blogs that the Germans were allowing themselves to be taken for a ride by the Mediterranean euro zone members, and that at some point in the run-up to their general election this autumn, they would put their foot down and say ‘Nein!’ With the benefit of hindsight, Cyprus was the obvious first victim. Although the country is so small that bailing it out will only involve a tiny fraction of the cost of rescuing Greece, Portugal or Ireland, let alone Spain or Italy, it embodies everything the Germans despise. In particular, it has set up shop as an international banking centre, an unforgivable crime in German eyes.

Certainly, the Cypriots are guilty of allowing their banks to behave in an utterly reckless fashion, expanding deposits to seven or eight times GDP, compared to about one-and-a-half times GDP for the UK, which also has a perilously large banking sector. Equally, it is hard to feel much sympathy for large depositors who ought to have asked themselves why they were being paid so much higher interest rates in Cyprus than those on offer elsewhere in Europe. As the old saying goes, when something seems too good to be true, it usually is. After all, investors had ample warning from Iceland, which played the same game with the same disastrous consequences.

Nonetheless, it is hard to see why the Cypriots and their banks should be treated so much worse than the other bailed-out countries, which have been brought down by irresponsible governments, tax evasion and corruption. Cyprus is hardly the only country in the euro zone with a bloated banking sector – Ireland is struggling with the same problem and Luxembourg has a disproportionately large volume of foreign deposits, many reportedly owned by Germans. It is difficult to escape the conclusion that the Germans see Cyprus as small enough to be subjected to exemplary punishment while at the same time sending the tacit message to the markets that – nudge nudge, wink wink – no large country will be treated this way, so deposits in Italy and Spain are still as safe as, er, well… safer than houses.

But is this the message the markets will take from the debacle?

One of the more unpleasant aspects of this episode is that German reluctance to cough up seems to be based on the suspicion that many of the large depositors in Cyprus are Russian criminals laundering their ill-gotten gains. Whether or not this is true, it is at best irrelevant, at worst distasteful.  If there really is evidence to support this charge, then it is a matter for the courts, not for European finance ministers. In any case, much of the suspect money was already in the Cypriot banking system before it joined the euro zone, so if the German authorities had concerns about matters as serious as this, they ought to have stopped Cyprus joining the Euro in 2008 .

In the meantime, where will the Russian money emigrate to?

There are already vast amounts of Russian money in the big Western banks, especially in London and Zurich, both of which are likely to be major beneficiaries of any flight to “safety”, but for an oligarch who needs a euro account, Frankfurt looks the safest bet – and you can be sure that, whatever their politicians may say, German bankers will not actually turn their nose up at Russian money fleeing Cyprus or any other “offshore” banking centre.

Looking forward, it is hard to see anything but more and probably graver crises ahead.  For the next six months at least, EU politics are going to be increasingly dominated by the general election in Germany, which undoubtedly helped to stiffen Frau Merkel’s resolve not to let Cyprus off the hook. The closer we get to September, the tougher she will be in confrontations with the Southern Europeans, and the more she will come under pressure to rein in Signor Draghi and his bailout-by-stealth policy.

The Germans are paying a heavy price for foolishly swallowing their reservations and tamely allowing Chancellor Kohl to sign the Maastricht Treaty. The more they are abused by their welfare clients, the more they will begin to realise that the price is not measured only in euros. For Germany, the euro zone was always a political, not an economic imperative. If, instead of creating gratitude, it is reigniting old hatreds, its underlying logic is destroyed.

Cyprus is going to be forced into introducing capital controls for the foreseeable future, which is a major reverse for the EU’s financial market integration project, and the proposed European banking union, based on joint regulation and deposit insurance, is now as dead as the market for Cypriot bank shares, as is the esprit communautaire, though in reality you could never see much sign of it anywhere outside the windy rhetoric of EU politicians.

A forecast, at least as good as Mario Draghi’s: if the euro zone can survive the German election, it may survive for decades more – but I very much doubt that it can.

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