Cyprus – who next?

Investment Notes

The starkest lesson that should be taken from the Cyprus crisis from all in the eurozone is that no bank deposit is guaranteed. It is always ultimately a loan from the depositor to the bank with the possibility that your government may mitigate any loss. Depositors with more than €100,000 in local Greek, Portugese, Spanish and Italian banks should now be giving serious consideration to moving their money to stronger banks in safer countries, as also might those with less than €100,000.

Cyprus represents 0.2% of the eurozone economy, so the amount of bailout money required for it to avoid defaulting on its debts was never a major economic problem. However, it has posed significant political problems, not least because many Northern European nations saw the Cypriot banking system as profiting from black money from Russia and elsewhere, and therefore less deserving of rescue. The crisis has underlined that, though the euro is the currency of one of the two largest economies in the world, its economic policies are driven by politicians of what are, in global terms, rather small economies, who do not appreciate the wider implications of the decisions that they make.

Until last summer, the euro crisis was spiralling out of control as banks with poor asset bases required government bailouts from governments, which themselves were struggling to raise money to fund their deficits. The capital that was injected into the banks was then invested in government debt of the home country because (i) it was the patriotic thing to do and (ii) the yields on offer were very attractive. Thus weak bank finances created weak government finances which further weakened the banks. At the July EU summit last year, a major breakthrough seemed to have been achieved when it was agreed to try and stop this vicious circle by using the ESM to directly recapitalise weak banks, in a way that this would not be a liability of the national government. In addition, it was agreed that the eurozone needed a full banking union in order for the monetary union to work.

This analysis was sound. However, by September Germany was backtracking on this agreement, and now does not support using ESM money to recapitalise banks, insisting that this is a matter for the individual country to sort out. Further, one of the fundamental elements of a banking union is a Europe-wide deposit guarantee insurance programme, and here again Germany has insisted that this is the responsibility of the individual country. The political will in Germany to provide money for more bailouts has declined markedly since last summer. It should also be noted that Cyprus did admit at the height of the crisis, that it did not have the money to honour its deposit guarantee scheme – this is also likely to be true in several other weaker economies.

A crisis in the next few months, ahead of the German elections would bring together the “austerity fatigue” that is evident in many Southern European countries like Greece, Spain and Portugal with the “bailout fatigue” that is evident in Northern European countries like Germany, Finland and the Netherlands. It could thus be that the tiny Cyprus bailout debacle is the first in a chain of events that leads to the end of the euro. The withdrawal of deposits from weaker banks in the weaker countries could lead to bank failures which require their governments to recapitalise them with money that has to be borrowed, pushing up their bond yields and creating another sovereign debt crisis. A similar tough approach from the Northern European countries, to that they adopted with Cyprus, could set the terms of a bailout so high that the debtor countries will not accept them and instead choose to exit the Euro. It will be the peoples of these countries, rather than the politicians, who make this happen.

The investment conclusion is to remain very wary of most euro-denominated investments until a more sustainable monetary system is in place in Europe.