The Cyprus debacle seems to have taken a course towards a resolution of some sort, with the announcement last week of a bailout plan that includes, among other measures, a one-time tax levy on wealthy (supposedly Russian) depositors in Cyprus banks, even when reports are now surfacing that the Cyprus banking system has been experiencing steady capital flight for several months now, with savvy Russian depositors being tipped-off by money managers way in advance of things reaching their dramatic climax over last week. The bailout deal sets a significant precedent, and fires a warning shot towards European jurisdictions who have allowed their banking systems to become offshore parking lots for hot money, to the tune of multiples of national GDPs.
I distill 4 fundamental lessons from this episode:
1) Capital controls are back, clearly embedded in the bailout terms: Capital controls are an extraordinary breach of basic EU rules, which allow freedom of labor and capital movement. Indeed, article 63 of Europe’s internal market rules explicitly states that “all restrictions on the movement of capital between member states and between member states and third countries shall be prohibited” unless there is an issue of “public security”. But there are few signs of the EU enforcing article 63 when it comes to Cyprus, even when the capital controls proposed are currently treated as temporary measures.
2) All deposit accounts are at risk, and some euros are more equal than others: the latest plan, which will see accounts with less than €100,000 protected, has established a new template for future bank bailouts: that depositors’ cash above the “insured” amount can and will be raided.
3) “Too big to fail” still holds: Some will argue that as big savers in the Bank of Cyprus and Laiki, the island’s two biggest banks, are taking such a haircut, the “too big to fail” mantra no longer works. But in truth the banks were minnows within the euro zone. Their near-collapse tells you that the ECB will do all it can to protect banks it regards as “systemic”, but will let the others go hang.
4) EU stress tests are worthless: The European Banking Authority’s annual health check on euro zone banks at the height of the euro crisis in July 2011 revealed significant concerns about just eight banks – five Spanish, one Greek and two Austrian. The Cypriot banks – Bank of Cyprus, Laiki, and Hellenic – passed what was supposedly a grueling assessment. Bank of Cyprus chief executive officer Andreas Eliades said at the time: “The stress test results justify the group’s strategic choices and actions, and illustrate its very strong capital base even under the most extreme, difficult and adverse scenarios.” Make of that what you will.
So who’s next to follow Cyprus’ path in the euro zone? Speculations have been swirling as of late, identifying Slovenia, Malta, Slovakia, or even Luxembourg as potential next domino piece to fall. In essence, Cyprus fell into its mess due to four fundamental factors that converged at a particular point in time, namely: weak fiscal situation, large debt overhang, banking sector size too big (and too weak), and too much reliant on foreign funding. I figured if I plot those 4 dimensions based on latest data observations (2012) for a host of euro zone countries, maybe one can discern possible next targets? Below is my attempt at a visualization in Tableau software. The x and y axis are self explanatory, depicting the debt and fiscal situation respectively, the relative size of the bubbles represents the size of the banking sector relative to national GDP, and finally he bubble color represents the extent of which that banking sector is reliant on foreign deposits (the more red, the “hotter” the funding). The data was sourced from the latest IMF World Economic Outlook edition, and the ECB’s Eurostat. Voila!
Basically, we’re looking for big, red bubbles that are closer to the upper right quadrant of the chart. Cyprus is right there, along with Portugal, France, Spain, Malta, Ireland, Belgium, Slovenia, Slovakia, Austria and Hungary, to name a few culprits. Malta looks particularly worrying, but consider this: Despite the size of Malta’s banking sector, assets held by the more important banks are slightly more than twice the country’s GDP. This is half the EU average. More importantly though is that the vast majority of deposits and loans administered by these banks are domestically derived: Maltese banks have very little exposure to foreign government bonds, have more than enough cash reserves to cover their loan portfolio and adopted over the years a very conservative low-risk approach to investment.
Slovenia has had its share of rumors lately, and the chart above shows it to be on the edge of the danger zone. These fears could be well founded: Slovenian GDP is set for a deeper-than-expected 1.9pc contraction this year, compared with an earlier estimate of 1.4pc, according to official forecasts released on Friday. The revised forecast brings government predictions in line with the IMF’s gloomier verdict that that the economy will shrink 2pc this year, the most in the European Union after Greece and Cyprus. As such, Slovenia’s cost of borrowing soared to a record high on Wednesday, with yields on two-year debt tripling over the past week, jumping from 1.2pc to 4.26pc before falling back slightly on Thursday. Ten-year yields have reached a post-EMU high of 6.25pc. Add to it the Russian connection, and you’ve got yourself a self-fulfilling prophecy.
Personally, I would be nervous about Belgium, particularly after the IMF’s latest assessment, which states: “The economy has entered a second year of near zero growth amid persistent vulnerabilities. While an improvement in external conditions, even if gradual, should support the recovery, the economy’s capacity to rebound and create jobs is constrained by structural rigidities and a loss of competitiveness. The financial sector has been transformed and downsized in the aftermath of the financial crisis, but vulnerabilities remain. Combined with the fragile situation of public finances, these vulnerabilities could, in an adverse environment, undermine macroeconomic stability.” Hum, zero growth, large and weak banks, lousy fiscal, large debt overhang, and an IMF warning to boot? That’s hard numbers. Does the market agree? Belgium bond yields went lower, so maybe the market knows something I don’t, or maybe it’s just a prelude.
By the way, the Tableau visualization above is interactive and dynamic (and Hungary is hiding behind Austria, conveniently), so feel free to click on data points and bubbles and explore around, then write to me or in the comments section below and tell me which euro zone country would be next to fall to the all-new, all-improved punishing bailout treatment.