EU lets genie out of the bottle in Cyprus bailout

March 18, 2013

Breaking with previous EU practice that depositors’ savings are sacrosanct, Cyprus and international lenders agreed at the weekend that savers would take a hit in return for the offer of 10 billion euros in aid.

Cypriot ministers are now scrambling to revise a plan to seize money from bank deposits before a parliamentary vote on Tuesday that will either secure the island’s financial rescue or threaten its default.

Whatever the final result, analysts say the genie is out of the bottle and the mere consideration of making savers pay for bailouts sets a dangerous precedent for the euro zone.

Toby Nangle, head of multi-asset allocation at Threadneedle Investments says the terms of the Cypriot bailout have introduced a levy on deposits as part of the euro zone crisis response toolkit:

The iniquity of exempting large and sophisticated government bond holders and senior bank bondholders from the bail-in, and instead designing it as a tax on depositors in such a way that deposit guarantees would not be triggered will lead to further erosion of trust between governments and their people. This is likely to contribute to the rise of anti-European politics across the European south. And the only thing that can defeat the European project is electoral anti-Europeanism.

Second, and of greater importance to financial markets in the short-term, is the question as to whether small depositor taxation will bring contagion and depositor flight to other peripheral countries.

The news unsettled financial markets, with Spanish and Italian bond yields jumping higher, but many were surprised at how relatively muted the market’s reaction was. For some analysts, the risk of contagion remains at large.

Michael Michaelides, rates strategist at RBS, says:

On the contagion side, this heightens the risk quite substantially but we need to wait to see what will happen if there are banking runs or not. Clearly it makes the risk a lot higher than it was on Friday. At the moment, it’s a big gamble from the European side. It shows the limit of the solidarity (in the euro zone). You have to do stuff like this to make sure (a bailout) gets passed and to minimize the cost to the core countries.

If I were a depositor in Spain I would be much more inclined to put my money somewhere else.

I doesn’t need to be an immediate reaction. What you can see is that if any of the sovereigns were to get in trouble, then the chances of there being a deposit flight at that time would be much higher. So if you were ever to see a scenario where Spanish yields were looking like they were going to go into OMT, that’s when people would cast their eyes towards this.

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