Cyprus: Out Of Frying Pan, Into The Fire

Whew! Cyprus parliament began the week rejecting the tax on depositors. It has been scrambling to find an alternative source of funds. As a percentage of GDP, the 10 bln euro EU package that has been offered to Cyprus is larger than the initial package for Greece, Ireland and Portugal. Still, the 5.8 bln euros that Cypriots are being told to pony up is incredibly difficult. There are no easy answers.

Same Tax, Different Name
The solution proposed to raiding the pension funds, giving them government bonds, which all three rating agencies rate well below investment grade, seems to likely target many of the same people who would have been hurt by the tax on small depositors. Moreover, that would not stabilize the debt/GDP ratios, making it more likely that the government debt is restructured.

Given the bank holdings of government bonds, a restructuring of government debt would also spur a banking crisis and likely trigger the deposit insurance, which Cyprus cannot make good on. The two largest Cyprus banks had a combined 50 bln euros of deposits at the end of 2011. This is more than twice the country's GDP. In addition, another obstacle to a sovereign restructuring is that much of the country's debt is under the governance of UK law, which make it easier for the creditors to block it.

Cyprus initially requested assistance last summer. However, the president at the time refused to consider privatization and that creditors wanted to do their own analysis of Cyprus' banking system even though the OECD had previously said that Cyprus has met the 40 EU directives against money laundering. In November, a German study found that more than 21 bln euros of Russian and Middle East funds had found a home in the Cyprus haven.

Huge Bond Investment
Cyprus banks have not been good guardians of those foreign or domestic deposits. With roughly 50% of their deposits they bought Greek bonds. That was a huge leveraged carry trade that collapsed. The loan book has also soured. In Q3 last year, the top two banks tripled (Bank Popular/ Laiki) and quadrupled (Bank of Cyprus) their loan loss reserves.

Cyprus banks have long run out of collateral that is acceptable to the ECB. They have relied on Emergency Lending Assistance (ELA), which is provided by the national central bank, at its own risk, but with the ECB's approval. In January, the ECB warned Cyprus banks that they had two months to recapitalize or it would no longer sanction ELA funding. Those two months are up and the ECB now says officials have until Monday to reach an agreement.

There was a conference call yesterday, according to wire accounts, among euro area officials to discuss views and potential solutions. Cyprus officials reportedly did not take part, leaving European officials dumbfounded.

Exit Fears
Clearly, the risk of an exit from the euro area has increased. Many of the critics of EMU, who think it is better to be out, may be able to test their hypothesis. We think Cypriots' lives will be made significantly worse on an exit. Small depositors will not simply seen 6 3/4% of their savings taken, but will lose much of savings. The banking system will collapse and the means to recapitalizing it are not obvious. The economy will collapse and unemployment will soar. The social fabric will be torn asunder.

The increase in miser in Cyprus, however, will likely have minimal impact on the euro area. If anything the misery of Cyprus, if our analysis of what an exit would mean, may be sufficient to scare other weak members of the euro area and convince them that it is better in, with all the yielding of sovereignty that it entails, than outside, where the degrees of freedom are limited, although in different ways.

Vulnerable Greece
Because of the economic and financial integration, Greece appears to be the most vulnerable to a Cyprus exit. A bankrupt Cyprus, cut off from the EMU and EU, may vulnerable, from a geopolitical vantage point, which also needs to be considered.

Although our medium term outlook is for a weaker euro ($1.20 for year end), we suspect that once there is closure on Cyprus, one way or the other, the euro may bounce. We continue to place technical significance in the gap on the bar charts created by Monday's sharply lower opening, The gap now extends from last Friday's low of $1.30 to yesterday's high near $1.2980. A move above the gap would be constructive and suggest another 1-2 cent advance. Until that gap is closed though, the risk is on the downside, where our next target is in the $1.2680-$1.2700 area.