Orlando's Outlook: Pimple on an elephant's rear
Bottom Line: Just when we thought it was safe to wade back into European investment waters, the recent emergence of a Cypriot banking crisis has global financial markets concerned. To be sure, Cyprus represents a miniscule portion of the European Union (EU) economy, such that its possible expulsion from the EU over this mess should result in barely an economic ripple. The much bigger question, in our view, is how the Cypriot government and the troika—the European Central Bank, the International Monetary Fund, and the European Commission—address and resolve the problem from a process standpoint. What’s caught the market’s attention was the since-rejected proposal to seize assets from “insured” bank accounts to cover the shortfall, which represents a clear violation of the rule of law. But if the troika can force this solution on Cyprus, the thinking goes, what’s to prevent them from doing the same thing in Spain and Italy? And if the EU can successfully implement a policy like this, might government asset confiscation serve as a helpful fiscal policy tool in the U.S., to help pay down our self-inflicted $16 trillion federal debt? While we don’t believe that this can or will happen here in the U.S., that doesn’t mean that hyperactive investor imaginations can’t create a temporary 3-5% air pocket for stocks—in response to some Cypriot “noise”—which we would use as a tactical buying opportunity.
Does Cyprus matter? Cyprus is the third-smallest of 17 countries in the EU economy (ahead of only Malta and Estonia), and the size of the entire Cypriot economy is 18 billion euros, which is only 0.2% of the total EU gross domestic product (GDP). To put this in perspective, troubled Greece—with a GDP that is 2.5% of the total eurozone—is 13 times larger than Cyprus. Germany, by comparison, is the world’s fourth-largest economy (behind the U.S., China and Japan), and the EU’s clear monolith, with an economy that is 27% of the total eurozone. That’s more than 10 times the size of Greece, and 142 times the size of Cyprus.
What’s the broader scope of Cyprus’ banking crisis? According to French economist Eric Dor, the EU’s total credit exposure through its central banking system and national banks to Cyprus is an estimated 27 billion euros, which is less than 0.3% of the EU’s 9.4 trillion euro GDP. So if Cyprus’ banks disappeared, it probably wouldn’t register as a blip on the EU’s economic radar, let alone the U.S. But it would certainly decimate the Cypriot economy, whose outsized banking industry is thought to be some eight times larger than its economy as a whole.
Will there be a Cypriot bank run? The Cypriot banks have been closed since Saturday, March 16, and they will not reopen before next Tuesday, March 26, at the earliest, pending the results of crisis meetings this coming weekend, to forestall a likely run on the banks. So the banking industry—and the Cypriot economy—is currently frozen. International corporate transactions involving Cyprus cannot occur, ATM’s are limited to doling out a few hundred euros at a time—if they have any cash at all—to retail customers, and local merchants are demanding payment in euros for routine transactions, as they will not accept credit or debit cards or checks.
What’s the problem? Cyprus is a relatively tiny nation with 800,000 people, an 18 billion euro economy, and 70 billion euros on deposit in their banking system. About 30 billion euros are held in accounts smaller than 100,000 euros each, which is the level under which they are fully insured, according to EU law. (In the U.S., by comparison, the Federal Deposit Insurance Corporation insures bank accounts up to $250,000.) The remaining 40 billion euros are domiciled in bank accounts larger than 100,000 euros—and are therefore not insured—with one-third of those larger accounts held by non-Cypriots. Some two-thirds of the foreign accounts are thought to be held by Russian depositors—many of whom live in Cyprus—with widespread industry speculation that the Russians use the Cypriot banking system for money-laundering purposes.
A banking industry review in Cyprus at the end of January revealed a shortfall of 17.5 billion euros (about a quarter of total deposits), largely due to bad business loans and investments in government debt in neighboring Greece, with 10 billion of that euro shortfall in Cyprus’ two largest banks: Laiki Bank (also known as Cyprus Popular) and the Bank of Cyprus.
Cyprus parliament rejects Plan A Last weekend, the troika and the Cypriot government negotiated and proposed a comprehensive bailout package, in which the troika would provide 10 billion euros in funding, and they demanded that Cyprus contribute 9.7 billion euros, with 5.8 billion euros coming from a one-time tax on depositors: a 6.75% tax on all insured accounts of less than 100,000 euros, and a 9.9% tax on the larger uninsured accounts. Customers would get shares in their banks as compensation for the asset seizures.
The broader thinking was that without a bailout, Cyprus’ two largest banks would certainly face insolvency, which would likely take down the entire Cypriot banking system, leaving depositors with nothing, and forcing Cyprus out of the eurozone. So given that prospect, depositors would be relieved to lose less than 10% of their deposits instead of everything. The Cyprus parliament voted unanimously against this measure, with 36 against and 19 abstaining, believing that it set a bad precedent to violate the rule of law and seize assets from insured savings accounts.
Russian-centric Plan B Speculation exists that after Plan A failed, Cyprus government officials turned their attention to Russia. Cyprus hoped to sell exploration rights to their offshore gas deposits in the Mediterranean Sea to Russian-based Gazprom, the world’s largest natural-gas company, which accounts for about 10% of Russia’s GDP. But they were unable to consummate a deal. In addition, Cyprus approached Russia about renegotiating the terms of a 2.5 billion euro loan that it had extended to Cyprus in 2011, and perhaps offering more aid, but those talks went nowhere. Cyprus was also unsuccessful in its discussions with Russia about selling Laiki Bank to them.
Plan C discussions this weekend There are a range of other options likely to be under discussion this weekend. These include the Cyprus government taking over the pension funds of state-run companies and issuing additional government bonds (presumably at very high interest rates) to raise immediate cash. With regard to bank deposits, the current thinking is that insured deposits under 100,000 euros must be left untouched, but the larger uninsured deposits—particularly those held by foreigners—would be subject to a sizable haircut, perhaps 40% or so. Finally, Cyprus could merge their two large banks, and split them into a good bank with the healthy assets and a so-called bad bank with the troubled assets. Equity and bondholders of Laiki Bank and Bank of Cyprus would be wiped out.