3/28/13 – Europe Post-Cyprus

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 28, 2013 9:44:31 AM

and tagged Europe, Politics and the Economy

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With all of the focus on Cyprus over the past couple of days, the refrain has gone something like this: what really matters isn’t Cyprus itself but the bigger picture and what that might mean for Europe. No one has really gotten into what happens and how, so I thought I’d give that a shot.

Cyprus is an even smaller piece of Europe than Greece was. The banking system, which was seven times the size of the economy, is also small in the larger scheme of things. The amount of money required to bail out the system was a rounding error; there was no financial reason not to simply write a check.

The fact that depositors were put on the hook instead was driven by politics—specifically, German politics. The idea of bailing out what were seen as corrupt Russian deposits was a step too far given a pending German election that’s looking increasingly uncertain. German domestic politics drove a decision to abrogate a deposit insurance policy that has been in place in all developed nations since the 1930s, and for good reason. This is a very big change.

Just as with Greece, what matters are not the consequences to Cyprus’s depositors—although those aren’t small—but the wider implications. Many countries have a banking system larger than the domestic economy. In Europe, there is Luxembourg, at 21x; Malta, at almost 8x; Ireland, at more than 7x; Great Britain, at 5x; Switzerland, at almost 5x; and even Germany, at 3x. The U.S., by contrast, is at less than 1x.

We have already seen what happened in Ireland and Cyprus. It’s clear that key financial centers and major economies in Europe are large enough that governments would have a very difficult time actually backing up their banking systems—the more so since they’re generally loaded with debt. Arguably, given a deeper look, none of these economies is really at risk, but that’s not the point.

The point is that very few people, pre-Cyprus, really took any kind of look at all. To question whether the governments can back up the banking system is the beginning of the end of confidence—and that’s just what Cyprus has started.

The follow-up comments from eurozone officials, doubling down and again explicitly bringing depositor risk into play, have only made the situation worse. While we haven’t seen capital movement start yet, depositors would have to be fools not to at least be thinking about it.

Not that long ago, the euro crisis was brought to a pause—two weeks ago, I would have said “a halt”—by Mario Draghi’s claim that the European Central Bank would do “whatever it takes” to preserve the euro. With Cyprus, we have found out for certain that, while the ECB may still be willing, the governments with the money have hit a limit and are about done.

I’ve been relatively optimistic about the eurozone for some time, figuring that its economic foundations were sound enough that, even given economic trouble, the political support would carry it through. By relatively optimistic, I mean that I thought the euro would survive, although it was only a 51/49 conviction.

After Cyprus, I find myself seriously doubting that the political will is there after all. The economic troubles aren’t even close to done, and if the northern countries are politically vulnerable enough to sacrifice the idea of deposit insurance over what, in context, is short money, then my assumption of political support is looking quite weak.

I’d like to say I still think the euro is going to make it—and it might. But I’m now on the other side. My 51/49 for has become more like 45/55 against. A small shift, but a big change.

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