The Markets Will Not Ignore The Trouble Brewing In Cyprus

by: Dividend Pros

Imagine this. You're a hardworking school teacher living a serene life in one of Europe's smaller economies. You're about to retire, but you have worked hard enough in the earlier part of your life to have made decent savings for your retirement. Instead of investing in equities to avoid any risk, you've parked your savings in the local bank. You go to sleep Friday night, assured that despite getting a very low interest rate on your bank deposit, your savings are safe by virtue of EU's Deposit Guarantee Scheme as well as your government's Deposit Protection Scheme. You wake up the next day. Boom! You learn that up to 10% of your bank deposit is gone. The decision was made on a holiday so that you can't withdraw any cash, and the government has banned any electronic transfers; you can do nothing about it. Now stop imagining, because for Cyprus citizens, this nightmare turned out to be true. In the early hours of Saturday, the eurozone finance ministers agreed to a bailout package worth 10 billion euros which will force Cypriot bank depositors to pay 9.9% on deposits exceeding 100,000 euros and 6.7% on deposits below that figure.

Why Did It Happen?

There are two aspects of this question. The first one is: Why did Cyprus need a bailout?

To answer that, we need to understand that the Cypriot economy is heavily interlinked with the Greek economy. During the years of the global credit bubble of the last decade, Cypriot economy, especially the banking sector, was doing very well. However, Cypriot banks had taken an excessive exposure to Greece by financing a large portion of Greece's property market bubble; Cyprus had made loans to Greece worth 1.6 times its own GDP whereas the overall banking system in Cyprus had grown to become more than 8 times the country's GDP. After the Greek economy collapsed, Cypriot banks had to take a big hit as most of the debt owed to Cyprus went "bad" and Cypriot banks had to take a huge haircut on Greek sovereign debt holdings as part of the Greek bailout program. Thus to save its banks from going bankrupt, the Cypriot government had requested a bailout package from international lenders, most of which would be used to recapitalize the Cypriot banks.

The other question is: Why were bank depositors targeted?

This is an interesting question because despite being the fifth and the smallest nation to request the Eurozone for financial help, Cyprus is the only country in which the painful levy has been imposed on bank depositors. The theoretical capitalist answer to this question is that the Cypriot depositors made an irresponsible decision by lending to banks who continuously made bad investments with their money, therefore the depositors should suffer as well. But there is a more political aspect to this as well: Cypriot banks were notoriously known as safe havens for money laundering, mostly by billionaire Russian oligarchs; almost half of the Cypriot bank depositors are believed to be non-resident Russians. The idea of using the taxpayer's money to bail out banks that have been making bad investments financed by laundered Russian money would not have gone well in countries financing the bailout like Germany and Netherlands, and few German legislators would have voted for a rescue plan without this measure. That is why the bank depositors were forced to bear some of the burden for the banks' troubles.

But what about the EU's depositor guarantee and Cypriot deposit protection scheme, you ask? Well, that turned out to be a sham: to circumvent those regulations, the politicians are calling the levy a one-time "tax," which is perfectly legal under the current regulations.

Impact on The Eurozone Economy

The economic impact of this decision is not hard to imagine as the decision to punish innocent savers would be a huge negative for the already fragile eurozone economy. First and foremost, this decision will completely erode whatever confidence the eurozone citizens have left in the banking system. A loss in the already fragile consumer confidence could have a damaging impact on the troubled economies. Moreover, setting the precedent that even the bank deposits are not safe would create panic in debt stricken eurozone countries and could possibly lead to bank runs especially in Greece and Spain. After all, why would you keep your savings in the bank even if there is a tiny chance that they could be reduced by 10% overnight? Spain had an incredibly hard time in 2012 to prevent deposit flight from the troubled economy. After hearing the Cypriot bailout decision, Spain's economic ministry was quick to issue a statement saying that Spanish citizens would not suffer the same fate. However, Cyprus citizens would advise their fellow eurozone members not to trust what the government says after they trusted the following statement made by their finance minister just two weeks ago regarding the idea of a bank deposit haircut:

"Really and categorically - and this doesn't only apply in the case of Cyprus but for the world over and the eurozone - there really couldn't be a more stupid idea."

Really and categorically, could there be a more blatant lie, I ask?

Impact on Markets

Even a slight hint of a capital flight would send shockwaves across investors whose confidence is already fragile. This could possibly send the peripheral eurozone sovereign yields soaring higher as the risk of contagion from capital flight in Cyprus to other struggling eurozone countries would be very high. From a trading perspective, I expect this decision to put an end to the global risk-on environment witnessed since the start of the year, at least temporarily until things become clearer. For the short term, this decision would certainly shock investor confidence in the eurozone which would take a toll on the Euro (NYSEARCA:FXE), so I would advise traders to cut any longs. I already have a bullish stance on gold and this event would only increase my conviction. The potential "risk-off" environment would be bullish for gold (NYSEARCA:GLD) (NYSEARCA:IAU) as investors fly to safety. Moreover, the fear of future bank deposit haircuts would encourage citizens not only in the Eurozone but also people around the world to convert at least some of their savings to gold. In fact, this could also potentially erode people's trust in paper investments and would give more reason to hold the physical gold ETF (NYSEARCA:PHYS). The potential resurgence of trouble in the eurozone economies would also be a negative for crude oil (NYSEARCA:USO) and could potentially trigger a sell-off. Finally, any shock in Europe would also have its impact on the broader US equity markets (NYSEARCA:SPY) which have been making record highs this year, so now would be a good time to take profits from equity longs until the situation gets clearer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by Dividend Pro's analyst.

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