A casual review of the financial press on Monday would lead one to conclude that the Euro crisis is back with a vengeance:
"State-sponsored theft" reports CNBC, describing reactions to the Cypriot bail-out, which involves a one-off 'tax' of between 6.75% and 9.9% on all depositors in Cypriot banks.
"Welcome to another Great Depression" thundered the headline in Forbes magazine, accusing the ECB of setting the scene for a catastrophic collapse of the global economy, by triggering a giant bank run on a world-wide scale.
Lars Seier Christensen, CEO of Saxo Bank, was apoplectic: "Shocking!" he wrote in an article on Saxo's web site, "this is full-blown socialism and I still cannot believe this really happened."
Critics of the Cypriot bail-out maintain that by forcing all depositors to bear some of the cost of the bailout, the Rubicon has now been crossed. It will now be clear to everyone that bank deposits are no longer safe, not just in Cyprus, but in all of the troubled nations of the euro zone periphery. If the ECB can seize the funds of a Cypriot depositor, why can they not do the same thing in Greece or Spain?
To an extent, these critics do have a point. Seizing cash from depositors does indeed represent a new addition to the ECB's toolkit, and it certainly won't increase confidence in the stability of the euro zone's banking system. Bank runs are, in effect, a psychological phenomenon, and it is probably unwise to test the psychological stamina of beleaguered European depositors at the current time.
However, in our view, the risks of broader financial contagion, and the risks to the EUR in particular, are not materially increased by the Cypriot bail-out. There are three main reasons for this view:
1. Cyprus is a unique case:
The biggest risk created by the Cypriot bail-out is that it leads to panic throughout the euro area, particularly southern Europe, leading to bank runs and capital flight. We believe this scenario is unlikely, mainly because Cyprus is clearly an exceptional case. The Cypriot banking system is disproportionately large, at eight times the size of the domestic economy. (This is comparable with Iceland, whose banking system was about ten times the size the domestic economy, and is much greater than the euro zone average of about 3.5 times).
In addition, Cyprus is a well-known tax haven, and between a third and a half of the Cypriot banking system's deposit base is composed of foreign depositors (mainly wealthy Russians). It is one thing to bail out domestic depositors, and quite another to bail out Russian oligarchs, and this distinction will not be lost on the man in the street in Barcelona or Naples. In addition, the Euro Group has made it very clear that structure of the bail out (and the requirement for depositor participation) is the direct result of the unique circumstances in Cyprus, and is not a blueprint that will be repeated in other euro zone countries.
2. The bail-out is actually a good deal for Cypriot depositors:
Despite the media hysteria, the bail-out can actually be construed as a positive outcome for Cypriot depositors. First of all, consider the possible outcome for depositors if the Euro Group did not support the bail-out. It is likely that either the entire banking system would have collapsed and / or the Cypriot government would have had to exit the Euro and monetize its debts. In Iceland, for example, the banking crisis led to inflation rates in excess of 20%, whilst the currency dropped by 80%. A 6.75% one-off stability tax does not seem quite as bad in comparison!
Also, Cypriot depositors have been relatively well compensated for their deposits in recent years (deposit rates in excess of 7% were not uncommon, especially for foreign depositors). In addition, Cypriot depositors will receive some sort of bank equity compensation in return for their 6.75%. And perhaps the best benefit for Cypriot depositors is that their banks remain eligible for ECB liquidity support. As such, the remaining 93.25% of their deposits are clearly much safer than they would have been in the absence of a bail-out.
3. The ECB are strengthening the link between solvency and sovereignty:
The Euro Group / ECB could have done things a lot differently and arguably given themselves less of a headache, had they just quietly bailed out Cyprus without the need for private sector participation. Given the size of the Cypriot economy, at less than 0.25% of the total euro zone economy, this would have been easy to do by simply printing a few more euro's, and using them to recapitalize the Cypriot banking system.
However, the ECB has not chosen to take this easy path. Rather, they have chosen to strengthen the link between solvency and sovereignty - if a country lives beyond its means, it will be required to make sacrifices to repair its own balance sheet. The EUR will not be made to bear the brunt of financial profligacy of individual nation states; this can only be good for the currency in the long term. In fact, this can be contrasted neatly with the UK, for example; instead of making taxpayers pay for bank bail-outs directly, savers have paid indirectly as the Bank of England has essentially monetized the debt issued to fund these bailouts. As such, UK depositors will just pay via a higher inflation rate, and negative real returns ( the 6.75% tax expected to be paid by Cypriot depositors is not much more than the inflation impact experienced by the average UK depositor over the last two or three years).
Whilst the Cypriot bail-out has resulted in some marginal EUR weakness, we would expect this to be a short-term phenomenon. Over the long-term, the European approach of addressing the issue of excessive debt directly (whether it be via fiscal austerity, haircuts on sovereign bondholders, or taxes on depositors of insolvent banks) will benefit the single currency. The reality is that in virtually every Western economy, there is simply too much debt. This will have to be addressed either directly (via defaults and / or fiscal tightening) or indirectly (via monetary policy and currency debasement). For now, at least, it is clear the ECB is anxious to avoid the latter.