| Richard Barwell, senior European economist and Lee Tyrrell-Hendry, macro credit analyst, RBS |
The subtext of Europe’s tough line on Cyprus is, of course, the situation in Italy and Spain. Europe has enough money to bail out a small country like Cyprus ten times over. The question is, and always has been, whether Europe has the firepower to bail out a much larger country, as well as the courage to stick to its principles if and when those countries get into serious trouble. The specifics of the Cypriot bail-out package are clearly tailored to the unique situation of its banks – it does not represent a template for future bail outs. Undeniably, domestic politics has played their part too: European politicians will rightly ask why their taxpayers should prop up an offshore banking sector and the wealthy individuals who have money invested in it earning a tidy return.
There is no doubt that the original proposal to involve those with relatively small sums in the Cypriot banks would have been problematic. That would have broken the taboo that insured depositors can lose money when a bank fails. Cypriot policymakers seem to have pulled back from that idea just in time and avoided serious contagion to the rest of peripheral Europe’s banking sector. The new proposal to only ‘bail in’ deposits above EUR100,000 makes much more sense, since the wealthy creditors of the banks are better able to shoulder the burden than the average Cypriot and those deposits were not covered by a guarantee.
Elsewhere in Europe, we may still see savers switching their deposits from weaker banks to their stronger peers. However, we are unlikely to see a return to the scale of deposit flight seen in late 2011 and early 2012, when depositors – particularly international companies and other financial institutions – were withdrawing their funds from the periphery as a whole. In fact, retail and commercial deposits in peripheral Eurozone banks have slowly started to come back over the past six months. Protecting deposits below EUR100,000 will support this trend.
The impact on bank bond markets has also been fairly contained judging by the modest widening in yields. The bailout has reinforced the principle that ‘who fails pays’ and highlighted the collective will of eurozone finance ministers to impose losses on senior – as well as junior – bondholders. For now, the market has accepted the argument that Cyprus is a unique case.
As for Cyprus, its aspirations to remain a centre of offshore finance have been dealt a heavy blow. It won’t ease the pain for thousands facing unemployment to know that this was always on the cards once confidence in their banks evaporated. Balancing large banking sectors on top of small economies (in the case of Cyprus, seven times larger) looks a risky proposition at the best of times. When those banks are fragile, it becomes a recipe for disaster.
There are broader lessons to be learned here, with Italy and Spain waiting in the wings. European finance ministers and the IMF have taken a stand: they will not lend money that countries have little prospect of repaying. Perhaps more importantly, the ECB has taken a stand on emergency support: it will not lend money indefinitely to failed banks.
It is much easier to lay down the law to Cyprus than Italy or Spain. But by passing this small test, the ECB has enhanced its reputation. Its threat to stick to its guns and its remit – to not buy bonds without conditions, to not bail out insolvent banks – has gained added credibility. By standing its ground today, the ECB increases the chance that its resolve is not tested in the future. Countries which expect to receive tough love may be more likely to do their homework and save themselves.
Despite some short-term pain – rising unemployment, economic contraction and outflows from the periphery – the tough love approach represents the best chance of keeping the euro intact and successfully resolving the debt crisis. The broad message is clear. There will be no ‘money for nothing’ solution. Europe is willing to help – but it will only help those countries who are willing to help themselves.
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