This note was originally published March 20, 2013 at 14:51 in Macro
Below is an update on how we see the developments in Cyprus playing out after the Cypriot parliament yesterday firmly rejected the levy on bank deposits with 36 votes against, zero in favor and 19 abstentions.
In short, we see Cyprus turning to Russia for a larger loan to support both its current government budget obligations and to fulfill the Eurozone’s demand that the country contributes €5.8B to the bailout. Should Russia not play ball, there’s no clear fallback plan, yet we expect some form of compromise from the Eurocrats (Eurozone heads and the ECB) due to the group’s biggest fear, contagion. Given today’s market action we think participants have already priced in some form of a deal getting done.
Here’s how we think these two scenarios may develop in finer detail.
1. Russia Offers Additional Loan Guarantees:
- Cypriot Finance Minister Michael Sarris was in Moscow today meeting with his Russian counterpart.
- This is a critical meeting given that beyond the leverage Cypriot banks have with Greece, Russia has the most skin in the game (an estimated total exposure of €60B, €20B of which in deposits, a sum roughly equal to the size of Cyprus’ annual GDP).
- It’s appears likely (in hindsight) that the Eurocrats did not work at all with Russians (which is saying something about geopolitical relations) to limit the failed step it made in issuing a deposit levy.
- It’s clear that Eurocrats (especially German Chancellor Merkel who is preparing for an election in September) chose this deposit levy option to pander to their constituents by throwing “less” in total bailout funds. However, their game theory in issuing a bank levy and in not consulting with the Russians was squarely wrong.
- No outcome was reached with the Russians today but press reports have indicated that Cyprus asked Russia for a five-year extension of an existing €2.5B loan (maturing in 2016), along with a reduction in the 4.5% interest rate. We believe this loan will be primarily used to fund the government operations which could not be paid for otherwise.
- We suspect that Cyprus will also ask for funding to cover the €5.8B that the Eurozone has asked it to contribute in order to receive a €10B loan.
- Given Russian interests in having a location outside of Russia to bank (be it to launder money, obfuscate assets, remove assets from Russian territory, etc.) and its potential interest in exchanging more favorable loan terms for physical Cypriot assets (in banks and energy), we think there’s a high likelihood that Russians write the checks the Cypriots request.
2. Cyprus Calls the Eurocrats' Bluff on Bailout Terms:
- However, should Russia not write the check, and the Cypriots balk on contributing to the bailout, the Eurocrats will quickly be on their heels with the threat of capital flight and with it bank failure.
- Just today ECB Executive Board member Joerg Asmussen stoked the fire by saying that banks in Cyprus are not solvent without them being quickly recapitalized via a bailout program. Current ECB rules do not allow national central banks to lend to insolvent banks. So the pillars supporting the banks could give way if deposits walk.
- Remember, Eurocrats thought they had the upper hand in issuing these deposit levies. While the Eurocrats may ultimately still have the upper hand, as both the Cypriot government and its people do not wish to live in a failed state (much like the Greeks), they too may be testing the waters to call the Eurocrats’ bluff in just how serious they are about the terms of the bailout loan.
- To buy time and prevent assets from fleeing, it appears that the banks in Cyprus are unlikely to open until next Tuesday (Monday is another official bank holiday), and could be closed all next week depending on the developments.
- Should the Eurocrats’ bluff be called there could be renewed discussion around imposing haircuts on debt holders of the major Cypriot banks, however given the Eurocrats initial misstep, this option may too be off the table.
If Russia doesn’t step up to aid Cyprus, look for the Eurocrats to be forced to compromise on the loan terms as their biggest fear remains contagion. The optimal outcome for both the Russians and the Eurocrats is for this issue to be resolved so that both sides can largely “get back to business.” A longer impasse may result if Russia doesn’t play ball in writing a larger loan in which case we think only time will tell just how the Eurocrats come to a concession.
We continue to think that this "crisis" in Cyprus will be short lived; today’s market action is also supporting this view. However, taken together with Italian election uncertainty, we believe the events will continue to put downward pressure on the EUR/USD. We’re signaling an immediate term lid on the EUR/USD of $1.30.