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Another twist to the Eurozone crisis – what a Cyprus haircut may mean

March 19, 2013

Just when the markets were being lulled into complacency, this weekend’s dramatic news from Cyprus has acted as a timely reminder that at best the problems of the Eurozone have been parked, rather than solved.

Unsurprisingly the markets have taken fright and it is by no means certain that the Cypriot government will be able to force through its plan to sequestrate funds directly from bank depositors’ accounts.

As the Eurozone crisis moves into fresh territory, there are four quick observations I would make on this fast-moving story:

1. Philosophically, not to mention economically, the European Central Bank’s decision to insist that its bailout be conditional upon depositors taking a levy of 9.9% for deposits over €100,000 and 6.75% for those under €100,000 (although there is now talk of a backtrack on taxing small deposit holders, leading to a potential uplift in the 9.9% levy)  is groundbreakingly perverse. Not least as once again, bondholders get off scot-free. The rationale in 2008 to exempt bondholders was made on pragmatic grounds that there was an overwhelming risk of contagion given the interconnectedness within financial markets.

By contrast, bondholders who have lent to Cyprus over the past few years have done so in an environment where the risk of ‘haircuts’ has been ever-present. They have also done so at generous interest rates; presumably as a fulsome reflection of inherently greater risk. Yet once again risk:reward ratio has been utterly ignored by regulators.

2. Whilst the UK Treasury has understandably and swiftly sought to protect the 3,500 UK servicemen and civil servants out in Cyprus from taking losses from the levy, it begs the question whether the other 55,000 or so UK nationals with deposits in Cyprus should not also demand or expect special treatment? This will get messy especially as many account holders live, run businesses and are electors here in the UK. Many reside in key London marginal constituencies and their political influence is likely to outweigh their number. This will also reopen domestic debates about the British government’s lack of involvement and clout in Eurozone governance.

3. I believe the risk of contagion may have been rather overstated. But with confidence still at rock bottom levels, it is not difficult to see that events in Cyprus may yet precipitate bank runs in more sizeable, struggling Eurozone nations such as Italy and Spain. Any suggestion of further bailouts being required anywhere in the Eurozone will almost certainly lead to intense speculation that similar strings will be attached by the ECB. A febrile economic atmosphere risks being brought to a calamitous state in several EU states at some point in the months ahead.

4. As ever we should not discount the role that raw politics has played in the ongoing Eurozone saga. We are now less than six months away from a German Federal Election. Distaste and impatience from German politicians (coupled with the recent upsurge in support for a domestic Eurosceptic party) has led to a demand that ‘Southern Europeans’ should take a hit when financial bailouts are agreed.

The other unspoken issue is that the entire Cypriot banking system has only been saved from collapse over the past few years by the influx of Russian money. Whilst this hot cash has helped underwrite Cyprus’s banks and financial institutions, there have been growing doubts about its provenance. The suggestion that laundered Russian money has been used to prop up an EU economy has troubled Eurozone regulators and politicians alike. Their argument today is that Cypriot banks have for some time been essentially insolvent and the relatively small contribution being demanded by depositors is equitable in the circumstances.