Cyprus Averts Disaster, But The Price Is High

Includes: EU, EUFN, FXE
by: AllianceBernstein (AB)

By Darren Williams

The European Union’s last-minute deal with Cyprus has headed off bankruptcy for now, but comes at a heavy price for uninsured bank depositors. Meanwhile, the move to impose losses on private creditors and growing complacency among policymakers could be storing up trouble for the future.

After a week of frantic negotiations, Cyprus and the Eurogroup have reached agreement on the basic structure of a €10 billion bailout package. Laiki, Cyprus’s second-largest bank, will be liquidated by splitting it into a “bad” bank and a “good” bank. The bad bank will be run down over time and the good bank will be folded into the Bank of Cyprus. The latter will then be recapitalized by wiping out equity and bondholders and by bailing-in uninsured depositors. What this means is big losses for uninsured depositors at Laiki and Bank of Cyprus, but full protection for insured depositors both there and at Cyprus’s other banks.

The Cypriot government and the troika will now begin work on a formal memorandum of understanding, which is likely to include budget cuts totalling 4.5% of GDP. It is hoped that this will be approved in the third week of April so that the first support payments can be made at the beginning of May. The memorandum of understating will need to be approved by the Cypriot parliament, which may not be easy in the current environment.

So where does this leave us? For Cyprus, it means that it has avoided the worst-case scenario of a total bankruptcy and euro-area exit (at least for now). But the outlook is bleak and the economy is likely to experience a very deep recession or even depression—perhaps worse even than that seen in Greece. This, in turn, is likely to push its adjustment programme off track, raising the risk that the current bailout might not be big enough. It is unlikely that we have heard the last of Cyprus.

For the rest of the euro area, it is all about the precedent this sets. Not surprisingly, much of the focus has been on the proposed and actual treatment of bank deposits in Cyprus. The risk is that the settlement could trigger bank runs in other countries, should they run into financial difficulties and be forced to ask for assistance from the rest of the euro area. But we also regard the likely imposition of capital controls in Cyprus—required to prevent a complete economic/financial implosion and ring-fence the island’s economy from the rest of the region—as a backward step that could have unforeseen consequences.

For investors, there are two main messages. First, the core euro-area countries seem to be increasingly in favour of private-sector burden sharing when they are advancing loans to troubled sovereigns and debt-sustainability cannot be guaranteed. This does not have any immediate implications for the other peripheral states, but needs to be borne in mind should adjustment programmes elsewhere fail to stabilize public-sector debt dynamics.

Second, the lack of a significant market response to events in Cyprus may be misinterpreted by governments as a sign that they have now got the measure of financial markets. This, in turn, may encourage them to take steps that have so far been rejected for fear of destabilizing markets. In our view, forcing a country to select from two unpalatable choices, one of which is leaving the euro, is a very high-risk strategy.

Disclaimer: The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Darren Williams is Senior European Economist at AllianceBernstein