Saving Cyprus means nobody is safe as Europe breaks a taboo

The devil lies in the detail of Cyprus’s salvation.

The island nation’s rescue sets precedents for the euro zone that may stick in the memory of depositors and bondholders alike as investors debate who will next fall victim to the debt crisis. Under the terms of the agreement struck Monday in Brussels, senior Cypriot bank bond holders will take losses and uninsured depositors will be largely wiped out.

The message that stakeholders of all stripes can be coerced into helping a cash-strapped nation may make investors more skittish they’ll be targeted if Slovenia, Italy, Spain or even Greece again is next in line to need help. The risk is that bank runs and bond market selloffs become more likely the moment a country applies for a new rescue, said economists and academics from Nicosia to New York.

“We now have a new type of rule and everyone within the euro zone has to sit down and see what that implies for their own finances,” Nobel laureate Christopher Pissarides, an adviser to the Cypriot government, told “The Pulse” on Bloomberg Television.

The Stoxx Europe 600 Index (SXXP) Monday erased a gain of as much as 1 percent after Dutch Finance Minister Jeroen Dijsselbloem indicated the model used for recapitalizing Cypriot banks could be replicated elsewhere. The euro, which fell as much as 1.2 percent Monday, was little changed at $1.2862 Tuesday.

Until now, euro region officials had left bank depositors and senior bondholders untouched as they tried to rescue the bloc’s struggling economies in a series of all-night summits over the past three years.

The Irish banking system collapsed partly because its government refused to renege on a guarantee to deposit holders made after Lehman Brothers Holdings Inc. collapsed. In Spain, senior bank bondholders have been safeguarded, unlike investors in the subordinated debt and preferred shares of Bankia Group (BKIA). And in Greece, a restructuring of government debt was set up in a way that avoided default.

With Cyprus, that tradition has been broken. The original pact, announced March 16, shocked Cypriots by imposing a levy on all deposit holders before opposition led to it being watered down in the final deal to protect holdings of less than 100,000 euros. It also marks the first time that senior bondholders in a euro-region bank have taken losses. In the case of Cyprus Popular Bank (CPB), also known as Laiki Bank, those bond holders will get wiped out.

“The Cyprus crisis has opened up some precedents that will make investors more worried about how future euro zone crises will evolve,” said Steven Englander, head of Group of 10 currency strategy at Citigroup Inc. in New York.

Europe’s crisis fighters are spreading the net wider as taxpayers across northern Europe balk at the cost of rescuing their cash-strapped neighbors. That shows there may be few taboos left, said Charles Goodhart, emeritus professor at the London School of Economics.

“They will swear black and blue that Cyprus is a unique case but so was Greece,” he said in a telephone interview. “You can talk about the inviolability of insured deposits but the problem now is would anyone believe you.”

The first use of capital controls by a euro-area member may also pose a challenge to countries such as Malta, Luxembourg and Estonia whose banks also boast large foreign deposits, said Jacques Cailloux and Dimitris Drakopoulos, economists at Nomura International Plc.

“Fearing a similar fate as those with deposits in Cyprus, there is a serious risk that these depositors decide to reduce their exposure, putting other countries under stress,” they said in a report to clients.

Some spotted silver-linings. Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics in Washington, told Bloomberg Television the Cypriot deal marked a “step forward” for Europe by better detailing the order of who loses out in a rescue.

“It provides a lot of clarity for investors and depositors,” he said, drawing a parallel with the Federal Deposit Insurance Corp., which serves to protect depositors in the U.S.

At Berenberg Bank in London, Chief Economist Holger Schmieding said the lesson is that “countries will take a lot of pain to stay in the euro zone. The glue that holds the euro zone together remains strong.”

One potential spillover from Monday’s agreement is the knock-on effects for bank funding, analysts said. Banks typically fund themselves with some combination of deposits, equity, senior and subordinate notes and covered bonds, which are backed by a pool of high-quality assets that stay on the lender’s balance sheet.

The consequences of the Cyprus bailout could be that banks will be more likely to use contingent convertible bonds — known as CoCos — to raise money as their ability to encumber assets by issuing covered bonds reaches regulatory limits, said Chris Bowie at Ignis Asset Management Ltd. in London.

“We’d expect to see some deposit flight and a shift in funding towards a combination of covered bonds, real equity and quasi-equity,” said Bowie, who is head of credit portfolio management at Ignis, which oversees about $110 billion.

By threatening to skew the management of finances, the Cypriot package risks undermining confidence in an economy already suffering its second recession since 2008. Euro-area services and manufacturing output contracted more than economists estimated in March and economists from Deutsche Bank AG to Morgan Stanley are predicting a sharper economic contraction this year.

“Banks will be more cautious, consumers more timid, bank depositors a little more wary and growth across Europe a little weaker even than it was before,” said Kit Juckes, head of foreign exchange research at Societe Generale SA in London.

The Cypriot saga may also give more ammunition to populist leaders across southern Europe, who say the political elites running crisis management don’t care about ordinary savers. Italy’s political system is gridlocked and Greek voters are signalling mounting support for the opposition Syriza party, which wants to renegotiate Greece’s bailout program.

“Cyprus was led to a painful compromise in the eurogroup meeting late Monday under the weight of blackmail and threats,” the party, led by Alexis Tsipras, said in an e-mailed statement Monday.

The true test may only come if the rot spreads from Nicosia and starts to infect larger economies, said Carsten Brzeski, senior economist at ING Group in Brussels. Italy is still struggling to put a government together and Spain’s unemployment rate is making it harder to get the country’s finances in order. In Slovenia, lawmakers are scrambling to avoid becoming the sixth country needing a bailout as they curb investor angst about bad loans equalling a fifth of economic output.

“Germany won the bet as Cyprus eventually bended,” said Brzeski, a former European Commission economist. “However, this strategy is not risk-free and will hardly work with bigger countries with a broader economic business model than Cyprus.”

[Bloomberg]