MacroScope

It’s May Day and most of Europe, barring Britain, is taking a holiday so maybe it’s a day to take stock.

But first, a nervous glance at little Slovenia. Last night Moody’s cut its debt rating to junk, forcing Ljubljana to abandon a planned bond issue which looked set to raise several billion dollars and making a fifth euro zone sovereign bailout much more likely. Given the ham-fisted effort to rescue Cyprus didn’t put markets into a spin, it’s unlikely Slovenia will upset the euro zone applecart but it’s a reminder that this crisis isn’t over and won’t be until the currency bloc gets serious about creating a banking union. Slovenia’s problems, like Cyprus’s, are rooted in the banking sector, which is stifled by about 7 billion euros in bad loans.

One bullet was dodged when the Cypriot parliament narrowly approved its bailout late yesterday, which will avert bankruptcy but at a painful cost.

Looking at the wider picture, Item One on the agenda is that after euro zone inflation plunged to 1.2 percent yesterday – way below the European Central Bank’s target of close to but below two percent – it now has the greenest of green lights to act at Thursday’s policy meeting.

We already had it on very good authority that a quarter-point interest rate cut is on the cards, which will take rates to a record low 0.5 percent. However, nobody is under any illusion that that alone is going to lift the currency bloc out of recession, one reason perhaps that a debate is now raging over the benefits of cutting debt versus going for growth at a governmental level.

The European Central Bank takes centre stage. While others in the euro zone are saying the way Cyprus was bailed out – with bank bondholders and big depositors hit – could be repeated, the ECB insists it was a one-off.

Fearful of any signs of contagion it will continue to talk that talk and there’s no sign of it having to do more so far, with no bank run even in Cyprus let alone further afield. But the last two weeks has reignited debate about what the ECB might have to do in extremis. It’s no nearer deploying its bond-buying programme but it could flood the currency area’s financial system with long-term liquidity again if called upon.

Interest rates are expected to be held at a record low 0.75 percent. Hints of policy easing further out are not out of the question. As ever, Mario Draghi’s hour long press conference will be minutely parsed but there will be nothing to match the Bank of Japan which earlier announced a stunning revamp of its policymaking rules – setting a balance sheet target which will involve printing money faster and pledging to double its government bond holdings over two years.

The problem of a “democratic deficit” that might arise from the process of European integration has always been high on policymakers’ minds. The term even has its own Wikipedia entry.

As Cypriots waited patiently in line for banks to reopen after being shuttered for two weeks, the issue was brought to light with particular clarity, since the country’s bailout is widely seen as being imposed on it by richer, more powerful states, particularly Germany.

Luxembourg has accused the Germans of trying to impose “hegemony” on the euro zone.  The country, whose banking system, like Cyprus’, is very large relative to the economy’s tiny size, fears that similarly harsh treatment could be imposed on its depositors.

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.

They’ve only been looking for it for a day but Cyprus’s Plan B has already taken on mythical status. A myth it might remain.

Ideas being floated include nationalizing the pension fund (back of the envelope calculations suggest that will raise less than a billion euros) and issuing bonds underpinned by future natural gas revenues (but no one is really sure how much they are worth). So to avoid default it still looks like the Cypriots may have to return to the bank levy they rejected so decisively in parliament on Tuesday, to raise the 5.8 billion euros the euro zone is demanding in return for a bailout.

Finance minister Sarris is still in Moscow hoping for some change out of the Russians and is out this morning saying discussions are ongoing about banks and natural gas.

The slow motion Cypriot car crash of the past five days reached impact point last night when not a single lawmaker voted for the bailout with bank levy attached – the first time a euro zone legislature has simply said no.

So what next? The finance minister is in Russia, ostensibly to seek an extension on an existing 2.5 billion euros loan on better terms, but could there be more on offer besides? The Eurogroup made clear last night that the 10 billion euros bailout was still on the table but that Nicosia had to come up with 5.8 billion euros of its own – the sum that a levy on bank depositors was supposed to raise. Could Moscow fill that gap, maybe in return for a slice of the island’s untapped offshore gas reserves? It looks unlikely but not impossible and there are powerful geopolitics at play. That there will be no more money from the euro zone looks like a given and there seems to be a resolve that it would be better to let Cyprus default then buckle at the last moment.

Finance minister Sarris has just said he hopes for a deal on the existing Russian loan today. In Nicosia, the president is meeting party leaders.

Cypriot lawmakers are supposed to vote today on a bailout that hits at least some of its bank depositors but the president’s spokesman has said any such legislation is unlikely to pass. This could be brinkmanship but it doesn’t sound like it.

Last night, euro zone finance ministers urged Nicosia to spare depositors with less than 100,000 euros in the bank and hit the richer harder, in order to raise 5.8 billion euros to free up a 10 billion euros bailout. Without it, Cyprus will surely go bankrupt but that is a deal that President Anastasiades baulked at in Brussels over the weekend. The government faces a stark choice: hit those who vote for it and rip up the deposit insurance they thought they had, or clobber the richer (many of them Russians), thus threatening the meltdown of its banking model.

Despite their belated support for the little guy, the euro zone will accept pretty much anything that raises the requisite cash. Germany and others insist the days of bailouts funded solely by taxpayers are over and the Bundestag probably wouldn’t sanction any other sort of deal.

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.

We had thought the end-of-week EU summit was going to be a lacklustre affair but things are starting to bubble up.

Ireland announced last night it would issue its first new 10-year bond since it was bailed out in 2010. It sounds like the books on the syndicated issue will open today with dealers predicting strong demand. This is a crucial step in Dublin becoming the success story the euro zone desperately craves. Some European Central Bank policymakers have said the bank’s bond-buying programme could be deployed to help Ireland once it has demonstrated its ability to issue debt in a variety of maturities. Others, notably Bundesbank chief Jens Weidmann, appear less keen on the idea.

With yields below four percent (they peaked above 15 percent in 2011) and needing to raise only a few billion in debt this year, it’s not clear that Ireland even needs ECB help to put the bailout behind it, but bond-buying support would certainly seal its exit and also show the ECB’s intent to markets. Further down the line, it will be worth pondering whether Ireland’s journey demonstrates that austerity was the right medicine. Plenty of euro zone policymakers will say so. The interesting question to address would be whether Dublin could have got there faster with more leeway to boost growth and therefore tax revenues.

Italy will continue to cast a long shadow and has clearly opened a chink in the euro zone’s armour. It looks like the best investors can expect is populist Beppe Grillo supporting some measures put forward by a minority, centre-left government but refusing any sort of formal alliance. That sounds like a recipe for the sort of instability that could have investors running a mile. The markets’ best case was for outgoing technocrat prime minister Monti to support the centre-left in coalition, thereby guaranteeing continuation of economic reforms. But he just didn’t get enough votes. Fresh elections are probably the nightmare scenario given the unpredictability of what could result.

The story of the last five months has been the bond-buying safety net cast by the European Central Bank which took the sting out of the currency bloc’s debt crisis. But now it has an Achilles’ Heel. The ECB has stated it will only buy the bonds of a country on certain policy conditions. 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.

In other words, until or unless a durable government is formed in Italy which can credibly say and do the right things, the euro zone crisis is back although not yet in the way it was a year ago when break-up looked possible.