Thoughts On Cypro-Toxins

- The EU group is suffering from the weak leadership of the Dutch Finance Minister. The pasting he received in the EU Parliament yesterday was fully justified. He even apologised for not getting it right and said it was for us to decide if they were incompetent! TMM answer with a firm "YES!".

- This lack of leadership within EU policymaking has led to an impasse: The recent Eurogroup statements barely disguise the complete lack of agreement as "German Economics" espoused by an election driven Schaeuble, with its determination to force internal devaluations on the periphery, going unopposed.

- German Pressure is compromising ECB freedoms to do its job. The ECB has announced that it will not provide ELA to insolvent banks and will turn off the tap on Monday without a bailout. First, the ECB/ELA *can* lend to insolvent banks and has done so in the past (Anglo Irish). Second, and more importantly, the ECB is shirking its core responsibility of lender of last resort.

- Is Draghi happy with having his mandate hamstrung? TMM severely doubt it and wonder if his silence hides deeper ire that is too dangerous to publicise.

- Precedent-setting, no matter what they claim - calls into question whether the OMT can be employed in large enough scale to prevent EUR exit risk premia arising in peripheral market.

- Imposing depositor haircuts across the board (again, let's not kid ourselves: Barclays Nicosia is hardly a bankrupt bank) has de facto devalued the Euro in Nicosia. It is now worth just 0.92 Berlin Euros. This, in TMM's view, is a catastrophic policy error for Europe.

- Cyprus solution has broken THE MOST IMPORTANT FUNDAMENTAL PILLAR that supports EMU: A Euro in Berlin is both worth the *SAME* as a Euro in Nicosia, and entirely fungible. This reminds us of the similar breakdown the Federal Reserve System in the 1930s where Bills of the NY Fed were discounted elsewhere.

- Similarly, the ECB's attempt to force Cyprus to adopt capital controls is a hugely misguided endeavour, for it *too* violates this fundamental premise

- The Target 2 system was designed to prevent Balance of Payments crises between member states, not for the purpose of economic war. ECB threats to cut the Cypriot Central Bank off from its window (don't buy the ECB/German rhetoric: it's the Cypriot Central Bank that is being cut off here, not the domestic banks, given it intermediates the Target 2 balance and ELA facility to the domestic banks), and similarly the possibility of Cyprus defaulting on its Target 2 balances have turned a payments system designed to prevent crisis into the economic equivalent of a Nuclear strike. Political interference (and TMM would include the German contingent of the ECB here) should never have been allowed to interfere with this system.

- By just announcing that deposits could be haircut, the Troika have unleashed very powerful forces that will inevitably result in the deposit base of Cyprus' banks evaporating via capital flight. This, by definition, will cause a collapse in the money supply & a deep recession.

- TMM's men on the ground in Cyprus report that today, the economy has, unsurprisingly, primarily become a "cash only" economy.

- Imposing limits on cash withdrawals, online payments etc simply results in *a collapse of the velocity of money." The economic effect is likely to be the same as if the money supply collapsed via deposit flight. MV = PQ = GDP. Cyprus's economy is being hit by an unforced policy error of the type usually seen in chaotic EM crises.

- The policy of limiting cash withdrawals was tried in December 2001 in Argentina - known as the Corralito. It failed spectacularly - within a couple of weeks. Riots eventually forced the President to flee as economic transactions became virtually impossible. Default & devaluation quickly followed.

- Cyprus is thus in the early stages of experiencing what it would do were it to leave the Euro: (i) a household liquidity crisis, (ii) a paralysed financial system, (iii) a collapse in monetary velocity, (iv) a large loss of national wealth, (v) capital controls, (vi) shortages of imported basic goods [trade credit for Cyprus now non-existent], and (vii) an exceptionally deep recession.

- The "Alternative" that the Cypriot government (with the encouragement of the ECB) is to impose Capital Controls & deposit withdrawal limits. Under Article 63 of the Treaty, these are illegal. There is, of course, a clause that allows governments to do this with a "macro prudential" remit. However, TMM totally call "horse sh1t" on the idea that such measures are "prudential", and given that they have been made up in a very short amount of time before properly thinking them through, imagine that a Court may well agree that an injunction be imposed until policy has been properly considered, instead of rushing into potentially damaging actions.

- TMM are opinion that imposing capital controls drastically increases the probability of Cyprus exiting the Euro.

- This state of affairs, TMM believe, is entirely unsustainable. Given the drastic recession that is about to occur, government debt will blow out again, requiring a further bailout in 6months. Germany has declared that there will be no more money. Cyprus would then have to leave the Euro *anyway*.

- TMM used to have a German boss many years ago who once described German foreign policy as such : "You throw in a hand grenade, wait for the dust to settle and walk straight through. Don't even bother counting the bodies". They appear to be sticking to their rule book. But then, what else would you expect from Germany?

- TMM think that the Rest of World is numbed to Euroblx and is happy using the "just muddle through" model to trade on, having been severely roasted last year expecting the opposite.

- TMM think this creates a more dangerous environment for markets as complacency levels with respect to Europe are at levels not seen since for some time.