Cypriot depositor bail-in a ‘game changer’

On Saturday early morning, Euroland Finance Ministers reached a “political agreement” on a bailout for Cyprus with a total package size of €10bn. This was significantly smaller than the originally-requested €17bn and the reduction was achieved through the imposition of rather harsh conditions on Cyprus, including a sizeable upfront one-off tax on all Cypriot depositors. This somewhat controversial approach has not been used in any other troubled Euroland country before and Cyprus is outraged that having contributed to the support of other economies and banking systems in Euroland it is now expected to pass through a haircut.

Whilst the immediate implications for other Euroland ‘peripheral’ economies may be limited, there is a significant risk that depositors begin to shift their funds more aggressively causing strains in the deposit base of Euroland economies seen as ‘at risk’. Meanwhile the deal which will include the IMF is likely to be finalized later in April but needs parliamentary approval in Cyprus (scheduled for Monday) and in a number of Euroland countries, including Germany.

The facts that the size of the bailout has been reduced significantly with extensive burden sharing from Cyprus, and an independent review of anti money laundering measures will be conducted, should help smooth the parliamentary approval process in hawkish Euroland countries.

To put the measures in context, the deal was always going to come with strings and Cyprus will adopt fiscal tightening measures worth 4.5% of GDP and boost privatisation including telecoms, electricity and ports. Corporate income tax and withholding taxes on capital gains will rise. But it’s the decision that depositors in local banks, both resident and non-resident, should pay an “upfront one-off stability levy” that has caused real concern. It’s proposed that tax will be 6.75% on deposits of less than €100,000 and 9.9% for deposits above €100,000. Junior bond holders will be bailed-in, but not senior debt. The domestic banking sector will be re-structured, re-capitalised and downsized.

It was to be expected that Monday would be tricky for the euro, with some investors worried about the re-emergence of tail-risks for Euroland and the peripheral economies in particular. And the proposed “bail-in” of depositors to recapitalise the Cypriot banking system adds to the general uncertainties but from first principles, whilst sentiment may be adverse, contagion to other Euroland economies should be contained. This is because the other peripheral Euroland economies are relatively well placed with stable funding arrangements. Thus, the capital required to re-capitalise the Greek banking system has already been made available and Portugal is fully funded and on track with its austerity programme. Irish banks have also been re-capitalised and Ireland has extended the duration of its debt and has regained access to public markets. The bigger issue is of course Spain, which has further work to do, but there are committed EU funds to re-capitalise the Spanish banking system.

But we should not forget that there has been a significant ‘game change’. It is now apparent that in the event that peripheral economies require additional capital, the EU will consider depositor bail-in rather than letting a country’s debt level, or more precisely its debt to GDP ratio, rise to a level that cannot be sustained. Clearly this risks the onset of a run on banks at the very point when such a move would prove most damaging for the economy involved, which in turn must make resolution more challenging.

The silver lining is that the authorities are now seen to be recognizing that the unwinding of excessive indebtedness has typically in history required central banks to provide liquidity and ease credit conditions, governments to conduct a balancing act between austerity and growth measures, currency to be devalued and debt to be written down. With the currency ‘fixed’, historic indebtedness always risked no resolution to de-leveraging and the entrenchment of depression. Now we can contemplate how the de-leveraging episode can play out – and the likely winners remain quality equities with proven growth credentials, whilst real yields on government bonds of credit worthy borrowers will likely remain significantly negative.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla