Monday, March 18, 2013

Why Cyprus Doesn't Matter

Shhhh!!! Don't let them hear your Russian Accent...

So yesterday the Eurozone member states, the ECB and the IMF shocked the world with their demands that depositors in Cypriot banks take a haircut in order to help pay for the rescue of the country's financial system. The shock comes because the nature of what was asked was that uninsured depositors take a 9.9% haircut and, and this is the main point, the INSURED depositors should take a 6.75% haircut. This is unprecedented, the whole point of having deposit insurance is that insured deposits are supposed to be the safest assets there are, you literally cannot lose money because in the event that the bank folds the government is supposed to make you whole.

In a piece of excellent reporting the FT described how this came to pass: it was essentially a coordinated ultimatum from Germany, the power behind the EU since it is the largest contributor to any rescue, the ECB, and the IMF.  The decision produced instant outrage and, to some extent, unreasoning fear in the markets. The Euro dropped a big figure and the Yen rallied 2% as money fled the Eurozone and headed for "safe havens." Pundits in the twitter-sphere high fived each other for beating the Wall Street sell side analysts to the punch in declaring this a terrible precedent that could well push the Euro-zone back into crisis. When the S&P futures opened Sunday night, they were down a percent before Asia even opened. It was a panic.

At the same time as the news was coming out so was a lot of punditry that drove the panic. Various financial journalists were appalled that the Germans, the ECB, and the IMF would collude to destroy the small depositors in Cypriot banks. Not only that, they were demanding that the Cypriot depositors pay up before the bank bondholders and shareholders would have to pay. This seemed like an outrage. What's more, if you imagined that this was going to be the modus opperandi for future rescue packages from the European Stabilization Mechanism then the odds that other countries would choose to apply for them, and thus receive massive speculator destroying ECB bond purchases would decline thus increasing the probability of a reignited speculative attack on the solvency of the Eurozone countries. Pandemonium was on the way and this is why the markets crashed last night and early this morning.

The trouble is, and I pointed this out on twitter yesterday afternoon, Cyprus is a VERY VERY special case and the troika went after the depositors in Cypriot banks for very specific reasons that do not apply to any other country in the Eurozone. Everyone in power knows this but the general reader and the average financial journalist does not. So I will spell it out for you.

The first thing to know about Cyprus is that since the 1990s it has had a very special tax treaty with Russia. The original purpose of this tax treaty was to prevent double taxation of income from investments in Russia which originated in Cyprus, it has had the effect however of making Cyprus an offshore tax haven for Russians both to invest in Russia and to have their money technically outside the Russian legal system. As you might imagine this has had a profound impact on the financial system in Cyprus. Remember that the economy of Cyprus is small. It has a population of 1.1 million, a labor force of about 450,000, and a GDP of about 16 billion EUR. This tiny country has a banking system with 107.8 billion EUR in deposits or 660% of GDP. In the US, bank deposits are about 83% of GDP. So here you have a massive financial system, which actually employs 7% of the working population in Cyprus, funding Russia and providing safe haven for Russian depositors in its banks. What's more E35 billion of the deposits on the Cypriot banking system are in amounts under 100,000 EUR which means they are insured by the Cypriot state.

Now since the financial crisis in 2008 Cyprus has had many of the same problems as Greece with regard to it's solvency and some of the problems of Iceland and Ireland with regard to it's banks. This past weekend those problems came to a head and Cyprus was forced to seek help from other Eurozone members. This presented the IMF, the ECB and the Eurozone member states with a very serious problem. Is the Cypriot state deeply mired in debt? Yes. Will it need to be rescued? Most likely. Is the Cypriot banking system insolvent? Yes, the largest bank in Cyprus is in such bad shape it no longer qualifies for the ECB emergency funding program established in December 2011. Is the Cypriot government capable of making whole the $35 billion of deposits under $100,000 in it's banking system? Not even remotely, Cypriot central government revenues are about $10 billion and it's expenditures are already $11 billion. So what we have here is a collapse in the banking system which, through the deposit insurance scheme will lead to a collapse of the central government finances, which will in turn lead either to a government default or a Eurozone exit either of which may very well result in the reignition of the general Eurozone panic. Time to call in the cavalry: the IMF, the ECB, and the ESM (primarily Germany.)

 It might be tempting to draw a comparison with Greece, which the ESM (nee EFSF) did rescue. There are two differences with that which make Cyprus more complicated. First of all, the main problem in Greece was that the day to day operation of the Greek government was unsustainable. In the case of Cyprus, which does have fiscal issues, there is an acute crisis in the banking system which is forcing the hand of the government early. Second of all, the primary beneficiaries of a rescue of the Cypriot state, and with it the Cypriot banking system aren't even Cypriots, they're not even Eurozone members, hell, they're not even members of the European Union. They're Russians.

According to the ECB, 35EUR billion of the 108EUR billion deposits are from outside the Eurozone, ie Russia. Of the remaining, it's pretty hard to know because Russian money may well be behind an EU incorporated SPV. To come up with an estimate, lets imagine for a moment that the amount on deposit in Cypriot banks by actual Cypriots is similar to that in the Germany which has a 130% bank deposits to GDP ratio, that would mean that something like 80 billion EUR is on deposit in Cypriot banks from Russian account holders much of that is probably decomposed into several accounts below the 100k EUR insurance level to take advantage of the insurance.

I can see the Germans connecting the dots and thinking: "Hold on just one second here. In order for us to defend the Euro and prevent a Cypriot default and potential exit we have to make a bunch of Russians whole on 80billion Euros? What kind of interest rate have they been making on these Cypriot deposits the past few years? 8%? Meanwhile back in Germany depositors in our domestic banks earn next to nothing. And we are going to tax them to rescue these guys? Oh HELL NO! I've got a better idea, why don't we make them pay for their own bailout by confiscating about 10% of their deposits? They'll never miss it, I mean what is that? 5 quarters of interest? To hell with them, let's charge 'em." And that's why they did what they did.

"But wait!" You can hear the financial press exclaim. "What about the retail Cypriot depositor? What about them?" Well, let's look for a second at that. If there are 35 billion EUR in "retail deposits" and 450,000 working age Cypriots that would mean that the average Cypriot has about 78,000 EUR or 5 times the percapita GDP of the country in the bank. Is this likely? Not at all, in fact it's impossible. It is by far more likely that a majority of the accounts under the 100,000 EUR threshold are not retail Cypriot accounts at all but, as mentioned, are Russian accounts purposefully trying to take advantage of Cypriot deposit insurance. So by going after the "small depositors" the Germans are actually going after the more clever Russians.

It is also important to keep in mind that no one can say that this is what is being done. Still less can the implement a policy which specifically targets Russians. There is some effort being made to make the tax 0% on deposits under 20,000 EUR which would probably protect most Cypriots, but the troika had to appear to be addressing everyone equally. Remember, Europe still depends on the goodwill of Russia for it's gas supplies and Russia has many ways of making life difficult for the Eurozone generally.

So what can you take away from this? Well first of all, Cyprus is very much a special case because in its rescue the Germans are being asked to save an EU member state by rescuing depositors in an EU banking system who are themselves based outside the EU and they are saying no. This is not at all an equivalent to what would happen in the event that something similar were to happen in Spain or Italy, both contributors to the ESM, Eurozone members, and EU members. So I don't think anyone should worry about this decision being used as a precedent for other Eurozone states and as people begin to understand that more fully I think the markets will recover. The other lesson is that when the banking system is too large for the government itself to rescue, terrible things happen and as I have written, that is the case in pretty much every state in the Eurozone. So while this will blow over, the larger storm is still coming.

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