Those predicting the break-up of the euro probably did not imagine it would happen in Cyprus, given the focus on the debt problems in Greece and Italy in recent years. However, the capital controls imposed as part of the rescue package for Cyprus have in effect created a two-tier euro, putting the validity of currency union into question, with a deposit in Cyprus not being seen as good as a deposit in the rest of the eurozone.
Under the deal announced in the early hours of March 25, the terms of the bailout changed from a deposits levy across the banking sector, which was proposed the previous week and would have imposed a tax on all deposit Cypriot deposit holders – including those with deposits of less than €100,000, who had believed their funds were insured.
The terms of the deal changed to involve the restructuring of Cyprus Popular Bank and Bank of Cyprus, the two largest Cypriot banks. Deposits of under €100,000 were protected, and instead larger uninsured depositors and bondholders will bear the cost of the deal.
That allowed Cypriot banks to re-open on March 28, albeit with capital controls imposed, including a limit of €300 on cash withdrawals and a limit of €1,000 on cash taken abroad.
However, the main casualty in the financial markets so far has not been the euro but senior banks bonds.
The cost of insuring against default by those institutions in the credit default market has risen to its highest level since Mario Draghi, president of the ECB, announced the central bank’s OMT government bond-buying plans in September.
Indeed, while EURUSD dropped to a five-month low of $1.2750 on March 27, it has since rebounded above $1.28 and has not shown the weakness it displayed during the first Greek crisis in May 2010 or during the Greek elections of 2012.
The reaction has been similar in the FX options market, with the premium for three-month implied volatility versus realized volatility standing at just 1% – far less than the 5% premium witnessed during previous crises.
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| Thanos Papasavvas, of Investec Asset Management |
Thanos Papasavvas, strategist at Investec Asset Management, believes the relatively muted reaction of the euro reflects the fact that the situation in Cyprus is an isolated event and that the eurozone is better prepared than it was to handle a crisis in one of its member states. “Two years ago, policymakers in Europe were way behind the curve,” he says. “The [eurozone sovereign debt] crisis has made policymakers realize that for the eurozone to continue existing, they need to make some structural changes and they are in the middle of making those, which will take years to come through.”
Papasavvas says the commitment from eurozone policymakers to stick together will mean the region makes the moves towards closer fiscal integration and closer banking union that will ensure the survival of the euro.
“Isolated events such as Cyprus are not sufficient enough to raise the risk of an implosion in the eurozone,” he says.
Still, despite the muted reaction from the euro, for some the Cyprus deal raises a number of issues as far as potential contagion to the rest of the eurozone is concerned, and therefore the future prospects of the single currency.
Most obviously, the Cypriot crisis has now set a new precedent for the use of capital controls in the eurozone, which under the European Treaty are only allowed in times of national emergency and on the grounds of “public security”. The relatively benign public protests in Cyprus would suggest that threshold had not been crossed.
Second, despite the revised agreement protecting smaller deposit holders, it will be tough for European authorities to convince the public their insured deposits really are safe, given that they were willing to contemplate a tax on them in the first place.
Perhaps most significantly, with European authorities having to openly consider the potential exit of a country from monetary union, the region’s commitment to the “irreversibility of the euro” has been put into question.
Furthermore, the impact on banks of a shift from bailouts being funded by taxpayers to them being funded by bank creditors could renew worries over the supply of credit. That could exacerbate divergence in eurozone debt markets, reversing the convergence that has been seen since Draghi unveiled the ECB’s OMT programme and he promised to do “whatever it takes” to ensure the survival of the euro.
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| Maurice Pomery, of Strategic Alpha |
Maurice Pomery, chief executive at research firm Strategic Alpha, believes the actions taken by the European authorities in Cyprus have undermined their credibility, making their reaction to future crises – perhaps in Italy or Spain – hard to predict. Indeed, Pomery believes that without the support of central banks, EURUSD would be trading closer to $1.10 than its current levels and that fund managers should be wary of holding the single currency in their portfolios.
“There is a growing feeling that Europe could do anything in a crisis, and thus investors and savers need to ignore promises and assurances on savings and commitments to bond holders,” he says.
“I am amazed we have not seen more forced divestment from the eurozone as it is irresponsible to be highly committed. On this basis, I cannot be long of the euro.”
The ramifications of the deal to rescue Cyprus could be larger than some believe.