One-off or precedent?

March 26, 2013

Cypriot banks were supposed to reopen today but they won’t and when they do capital controls will be slapped on to prevent money fleeing its borders (was that how the single currency zone and single market was supposed to work?) The controls are supposed to be temporary but the Icelandic experience showed that once imposed they can be devilishly hard to remove. It seems pretty certain that there will be a bank run when the doors are reopened, which is now slated for Thursday.

Dutch Eurogroup chief Jeroen Dijsselbloem gave markets a jolt yesterday. In an interview with Reuters he said in future, the onus would be put on banks to recapitalize and if they couldn’t “then we’ll talk to the shareholders and the bondholders, we’ll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders”. He added that he wanted to get to a situation where the euro zone never needed to use its ESM rescue fund to recapitalize banks directly – a plan that was created last year at the height of the crisis. That all seemed crystal clear but after some adverse market reaction a later statement was put out on his behalf reverting to the earlier line that Cyprus was a one-off case.

So which is it? One-off or precedent? With a banking system eight times the size of its economy and awash with foreign money Cyprus clearly is unlike any of its euro zone peers. But it’s been also clear for some time now that Germany and other northern Europeans don’t want taxpayers to be on the hook for future bailouts and are not keen on using the ESM to recapitalize banks (that was supposed to break the doom loop between weak banks and sovereigns but maybe not any more). German Finance Minister Wolfgang Schaeuble was explicit after the bailout was agreed in the early hours of Monday morning, saying with the bail-in “we got what we always wanted”. As such, the Bundestag is almost certain to vote for it.

The main threat to the wider euro zone in the short-term is that people elsewhere see images of Cypriots battering down the doors of their banks and conclude it would be sensible to get their money out too. The European Central Bank and Brussels are already making strong statements explaining why Cyprus is a one-off so there is no chance of this being replicated elsewhere. It has to be said that there is zero sign of that happening so far but if investors and depositors feel Cyprus is really not a one-off those risks are enhanced. It was worth noting what happened to Italian bank shares yesterday. They dived.

However, the ECB backstop is still there and, if called upon, it could quickly flood the euro zone banking system with money. It will almost certainly have to do that for Cyprus.

The other big question is whether this bailout will work for Cyprus. EU officials have admitted that the economic projections they built into the programme are probably shot to pieces by an economy in lockdown for the past week and more so do the debt numbers still add up? And can the government deliver its bailout terms given a parliament that so firmly rejected a plan last week and the president himself threatened to resign over? Either way, with its banking model now ruined, Cyprus is in for a grim time for the foreseeable future, which might also fuel the anti-austerity backlash in southern Europe, most recently seen in Italian elections. That maybe the biggest long-term threat to euro zone cohesion.

After yesterday’s wobble, safe haven German Bund futures have edged down at the open and European stock futures are pointing modestly higher. But the above questions will limit any upside.

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