Drama in Europe

After a period of relative calm, drama has returned to Europe, first in the inconclusive Italian elections where Beppe Grillo’s anti-corruption Five Star Movement party went from nowhere to take 25% of the vote, and secondly, around the conditions of the proposed bailout for Cyprus.

While Cyprus is a tiny country in the scheme of Europe, the precedent it has set with the restructuring of its banking system will have much wider ramifications.  No further tax payer money will be used to recapitalise Cyprus’s two largest banks and instead shareholders, large depositors and senior bondholders will take the loss.  In the case of Cyprus’s second largest bank Laiki, it is reported that losses for senior bondholders and large depositors with balances over €100,000 will likely be well-over 60% of their money.  Only small depositors, with amounts below €100,000 will be protected.

The mathematics of why this has occurred is not complex.  With a population of 1.1 million, the size of the Cypriot economy is a mere €18 billion.  The government takes in €7.5 billion in tax revenue annually, but is currently spending roughly €8.7 billion pa, giving them a budget deficit of €1.2 billion.  The government already has a high debt load of €15 billion or 83% of GDP, international bond investors will no longer lend the government money and it is relying on the European Central Bank (ECB) and European Union (EU) as a lender of last resort.

The finances of the Cypriot government are clearly shaky and they are in no shape to provide further assistance to the banks.  This is more obvious when you consider the size of the Cypriot banking system, which at €150 billion is a full eight times larger than the economy (if we only look at loans outstanding, the size of the banking system is still €92 billion, five times larger).  The size of the banking system is heavily influenced by foreign capital (there are €34 billion of foreign deposits in Cyprus), in particular money belonging to Russian individuals and corporates taking advantage of tax loopholes generated by Cyprus’s double tax treaty with Russia.

In essence, a large swathe of the €92 billion in loans (which included large exposures to Greek borrowers and Greek government debt) has gone into default with limited chance of recovery.  An injection of at least €6 billion was required to stabilise the banking system.  The government doesn’t have the money and the EU, already providing €10 billion in aid to the government, was reluctant to be seen giving further taxpayer money to bailout Russian depositors.  In the end the only choice was to hit large depositors and bondholders.

Unfortunately, the final decision of who should take the losses in the banking system was clumsily handled.  The Cypriot governments first announced plan around the bank restructuring was to tax all depositors (including small deposits below €100,000) a minimum of 6.5% of their balance.  While this was later revoked in favour of taxing large depositors, you can imagine that for most Cypriots having the government nearly confiscate 6.5% of your deposits is enough lose confidence in the banking system and many are very keen to get their money out of the country.

The wider implications of this move is the effect it will may have on confidence in lending to the banks of the other weaker peripheral nations.  Depositors and lenders to banks in Portugal, Spain, Italy and Ireland seeing the losses and subsequent capital controls in Cyprus will surely ask themselves whether its ‘worth the risk’ to keep their funds there.  At the least, in the short-term, these banks will need to pay up with higher rates to convince people to stay (with funding rates in the likes of Italy and Ireland spiking over the last week).  The other knock-on effect is if people are trying to stash their money into ‘safe havens’ (offshore bank accounts etc), by definition this is money they are not spending, which throws a wet blanket on any economic recovery as savings rates increase.

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