A Rubicon crossed

March 18, 2013

What a weekend. The euro zone crossed a dangerous Rubicon by whacking Cypriot bank depositors as part of a bailout – a dramatic departure from previous aid programmes. The finance ministers insist it is a one-off (as they did for Greece) but if investors and bank customers fear a precedent has been set, there could yet be a serious backwash for the euro zone. And all this for six billion euros? It seems perplexing to say the least although our trawl of the streets of the euro zone periphery has detected little alarm so far.

Markets are voting with their feet. The euro has dropped well over one percent, European stock futures are pointing to losses of two to three percent and the safe haven Bund future has leapt a full point at the open. Italian bond futures have done the reverse, suggesting that in the bond market at least, there is more than a little concern about contagion from Cyprus. “The crisis is back,” one bond trader told us. “Precedent” is the word on everybody’s lips. I’ve used it before but Bank of England Governor Mervyn King produced the definitive line on bank runs – it’s never logical to start one but it sure could be logical to join one.

To muddy the waters further, the Cypriots are trying to renegotiate the deal to ease the 6.5 percent burden on smaller depositors and raise it on the richer (from 9.9 percent). This suggests that the president fears that today’s parliamentary vote may be lost without changes. If it is lost – no party has a majority and three of them said yesterday they wouldn’t support the programme – we’re in for a real rollercoaster as everyone scrambles to avoid a default, with all the reputational damage that will do to the euro zone. At that point, we could probably kiss goodbye to the five months of calm imposed by the European Central Bank and its “do whatever it takes” pledge.

On the other hand, if it is passed, this could blow over. Cyprus is a special case with a banking sector – home to money laundering – dwarfing the size of the economy, and the size of the bailout had to be trimmed to something plausible somehow. That may have been the price of keeping the IMF on board, something which the Bundestag probably requires to support this. So better communication by the eurocrats could get that across. Either way, the IMF’s call on Friday for the currency area to press ahead with a common deposit guarantee – a red line for Germany – looks startlingly prescient.

A source close to the consultations told Reuters Nicosia is hoping to cut the tax band to 3.0 percent for deposits under 100,000 euros. Brussels said last night that would be fine as long as the net savings were the same. President Anastasiades is also trying to sugar the pill by offering savers who lost money shares in commercial banks, with equity returns guaranteed by future revenues expected from natural gas discoveries. Another potential spanner in the works has come from Russia (a lot of the deposits in Cyprus are Russian-owned) which says it still hasn’t decided whether to roll over its existing $2.5 billion loan to Cyprus at more favourable rates – something the euro zone is counting on.

All this is intriguing because we know from our sources, confirmed by German finance minister Schaeuble last night, that a deal to protect small savers was on the table in Brussels on Friday/Saturday but the Cypriots, the European Commission and ECB knocked it back. Why? As Schaueble said, it is up to those three to explain to the Cypriot people.

We’ve got opportunities to put all this to the top people today. Francois Hollande and Angela Merkel meet in Berlin along with European Commission President Jose Manuel Barroso. In fact, a host of policymakers are speaking in Germany – Schaeuble, Bundesbank head Weidmann, ECB policymaker Asmussen (a key player in the Brussels talks) and euro zone rescue fund chief Regling among them. The Bundesbank also publishes its monthly report.

Remarkably, Italy is completely overshadowed although the president is about to start trying to form a government on Wednesday. He appealed for unity on Sunday but got no change out of the parties. Centre-left leader Bersani will get first crack but needs the support of populist Beppe Grillo’s acolytes in the Senate and it is far from certain that will be forthcoming.

That leaves a distinct chink in the euro zone armour which Cyprus could prise open. The ECB has stated it will only buy the bonds of a country on certain policy conditions encompassing economic reform and austerity. An unwilling or unstable Italian government may be unable to meet those conditions so in theory the ECB should stand back. But what if the euro zone’s third biggest economy comes under serious market attack? Without ECB support the whole bloc would be thrown back into crisis and yet if it does intervene, some ECB policymakers and German lawmakers will throw their hands up in horror, potentially calling the whole programme in to question.

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