Cyprus: Disaster Averted, Problems Persist

By Dr Jerry Webman, PhD, CFA, chief economist, OppenheimerFunds

Cyprus struck an 11th hour deal with its European partners and the International Monetary Fund to shrink its banking system in exchange for €10bn ($13bn) in emergency funding.

The deal allows Cyprus, the tiny Mediterranean island with a population on par with Rhode Island and economic output similar to Vermont, to avoid an imminent default and an unprecedented exit from the Eurozone.

The rescue package will include an additional €4.2 billion to be funded by a yet to be determined, but likely very sizeable levy (perhaps as high as 40%), on uninsured bank deposits of over €100,000. In a meaningful reversal from the conditions imposed by the highly contentious bailout plan released last week, deposits of up to €100,000 will be left untouched.

By not imposing levies on small deposits, European policymakers hope to reduce the risk of bank runs in other eurozone countries. The agreement appears to be structured in a way that will be executed under legislation that has already passed and will therefore not require the approval of the Cypriot parliament.

Cyprus, in exchange for the bailout funds, has agreed to the resolution of its second-largest bank, Bank Laiki and the restructuring of Bank of Cyprus, the nation’s largest bank. The plan calls for Bank Laiki to be separated into a good bank and a bad bank, with the bad bank to be run down over time, and the good bank to be folded into the Bank of Cyprus. The restructuring will involve losses for both junior and senior bondholders.

Cyprus has agreed to accelerate fiscal austerity and structural reforms as has been the case in each of the preceding bailouts of European countries. The country will impose “temporary” capital controls (some reports suggest that controls could be in place for as long as six months) including restrictions in daily withdrawals and transfers, to prevent a massive flight of money out of the country.

Disaster averted, but problems persist

The rescue package averts imminent disaster and European markets responded favorably in the morning trading session. However, the incident will have destructive effects on the Cyprus economy and has once again called into question the efficacy of the European common currency.

Cyprus will now enter a deep recession amid a severe deleveraging of the banking sector, which is roughly 8x the size of the total economy, and a massive flight of foreign investment out of the country.

Debt sustainability will remain an issue as the €10bn loan (equal to 56% of Cyprus’ Gross Domestic Product) will raise the country’s debt levels from 86.5% to over 140% of the country’s total output. The ratio will only get worse as economic activity collapses. There is a very high probability that, as has been the case with Greece, this will not be the country’s last bailout.

The episode has once again exposed the political dysfunction in the eurozone. Policymakers continue to allow small problems to potentially push the currency union to the brink of disaster. The ongoing willingness of Germany and other core European economies to continue to support their southern neighbors will be questioned.

The incident did revive talk of the possibility of a country leaving the Eurozone and the imposition of capital controls does essentially make the value of the euro in a bank in Cyprus worth less than the value of the euro elsewhere. However, the episode did also demonstrate Europe’s commitment to improvise and avoid imminent disaster. It is unlikely that this latest chapter in the European debt crisis will lead to contagion to other European countries at this time.

Conditions have stabilised in larger European countries like Spain and Italy since Mario Draghi announced the European Cetnral Bank’s (ECB) commitment to do whatever it takes to preserve the common currency. Currently, neither Spain nor Italy currently require external assistance nor have banking sectors as a percentage of their total economies anywhere near that of Cyprus.  

Moderate Growth Continues In US

So far, US investors have reacted to events in Cyprus the same way they responded to the sequester – by largely shrugging it off. This is reflective of the fact that the U.S. is on firmer ground these days. Consumer spending has been resilient.

Housing data continue to be broadly positive – housing starts and existing homes sales rose in February. The jobs picture is improving gradually; the four-week moving average of initial jobless claims reached a recovery low last week. Leading economic indicators, up 0.5% in February, also point to continued moderate economic growth.

Federal Reserve chairman Ben Bernanke took note of this improvement in his press conference following the release of the latest Federal Open Market Committee (FOMC) statement and forecasts. As expected, the Fed kept the federal funds rate unchanged at 0-0.25% and maintained the current level of asset purchases.

Citing concerns over the still high unemployment rate and the impact of restrictive fiscal policies on growth, Bernanke reiterated his commitment to accommodative monetary policy. Sifting through the “Fed speak,” I took note of a few things. Bernanke kept reiterating that the Fed’s next move, once economic conditions warrant policy normalisation, would be to taper off asset purchases. The bond market responded by rallying, which tells you 1) it’s not 1994, at least not yet if the hint of the Fed tightening can spur a bond rally, and 2) the economy, though improving, is still vulnerable.

Though I believe the Fed has reached the limits of what monetary policy can do, it is unlikely that the Fed will be taking away the punchbowl anytime soon, although I would expect the pace of asset purchases to slow in the months ahead.

What Does This Mean For Investors?

Cyprus is a reminder that there will be negative events in the markets, but investors are better served focusing on the long term. Looking forward, we continue to believe stocks appear attractive especially relative to bonds. Any near-term correction, Cyprus-related or otherwise, could pose an even better buying opportunity.