How could financially-stricken nations withdraw from the eurozone? Roger Bootle submits his Wolfson Economics Prize-winning theory in: What would happen if member states left the euro?
Cyprus bail-out: a note of optimism for investors?
By Elsa Buchanan | Mon, 25th March 2013 - 16:43
Eurozone finance ministers, the International Monetary Fund (IMF), European Central Bank (ECB) and representatives of the Cypriot government have struck an 11th-hour agreement on a €10 billion (£8.5 billion) bail-out for Cyprus which will save the island from financial meltdown and keep its ECB lifeline open.
Analysts list the biggest losers from the deal, say they expect the euro to bounce and explain why they prefer equities over bonds now European markets seem to have regained confidence.
Key points of the deal
- Cyprus Popular Bank (Bank Laiki) will be closed indefinitely and split into a "bad bank" (run down over time) and a "good bank" (folded into Bank of Cyprus (BoC) along with small deposit holders' accounts).
- Laiki's €4.2 billion in deposits over €100,000 which are uninsured will be placed in the "bad bank", meaning the deposits will be wiped out entirely. The extent of the losses on those deposits is unknown, and will depend on the value of the bad assets that will be transferred from Laika's balance sheet.
- Laiki's €9 billion Emergency Liquidity Assistance (ELA) debt will be transferred to BoC, which will also be restructured.
- BoC's shareholders and bondholders will be hit: depositors with over €100,000 at the bank will also be involved in the recapitalisation and could face losses of up to 40%, while deposits up to €100,000 will be left untouched.
- The Cypriot government has committed to fiscal consolidation, structural reforms and privatisation; and withholding tax on capital income. Corporate income taxes will be hiked
The Eurogroup stresses "the programme money will not be used to recapitalise Laiki and BoC."
What it means
Reinhard Cluse, EMEA economist at UBS, explains the agreement should "prevent a further escalation of the eurozone crisis and much more dramatic damage that would have followed from a Cypriot eurozone exit".
Separately Darren Gibbs, chief economist at Deutsche Bank, says: "This will leave scars, in particular on the perceived stability of deposits."
According to Willem Sels, UK head of investment strategy at HSBC Private Bank, the biggest losers under the agreement are "equity holders, junior and senior bank holders, as well as uninsured depositors". Sels explains that in Cyprus, where most of the funding comes from deposits, the senior bank bond market was small, and was not deemed "worth taking the risk of destabilising the bond market by applying a haircut for small local gain".
How the markets reacted
"Markets re-opened a little nervously [on Monday] as the deadline to agree a rescue package neared," says Gibbs. He explains earlier key European policymakers had made clear that there was little appetite within the Eurogroup for offering Cyprus a more generous package than the €10 billion already on offer.
But, as news emerged that the Eurogroup had approved the deal, European markets rallied, strengthening by almost 0.4% according to Prashant Pande, fixed income strategist at Nomura.
By midday, European markets had all picked up, with the FTSE 100 growing 0.89%, the Russian MICEX following suit up 0.71% and the German DAX soaring 1.19%.
"Markets are reacting favourably, as tail risks have been reduced," explains HSBC's Sels. He says the deal allows the ECB to avoid the collapse of the entire banking sector in Cyprus.
"The prospect of a eurozone exit, which some commentators were worried about but seemed remote to us, has faded again," he says. However, "markets may be more worried about the precedent of a restructuring of Bank of Cyprus' bank bonds outside of liquidation".
Despite this, Sels remains cautiously optimistic: "We think markets will be willing to consider this as a special situation. We expect some limited capital and deposit flight from the periphery, but contagion should remain limited."
The euro weakened 0.2% to $1.2964 following the news, after reaching $1.3048, the strongest level since March 15, but Sels says: "We continue to expect it to trade in its recent range in coming months.
"In the short term, it may bounce as a result of the agreement."
Sels concludes: "The handling of the deal has been messier than expected, but one more potential stumbling block for markets is now behind us. This, in our view, should support riskier assets and our overweight of equities."
Where should investors be looking?
Sels remains underweight on safe haven bonds "due to record-low yields", saying "a recovery of risk appetite should push up safe haven bond yields after the recent bond rally".
"Credit spreads have widened and eurozone peripheral debt spreads have widened more significantly," he adds.
"We think that the last-minute deal will bring down sovereign spreads, with bank bonds likely outperforming in the short run. We continue to see good opportunities in short-dated bonds in the financial and non-financial sector in the periphery."
Within financials, the Cyprus episode supports Sels's preference for senior bank paper over subordinated bank paper, "as losses on the latter will be much larger than on the former".
Sels states: "We remain optimistic on the outlook for equities, as we believe that investor sentiment will remain strong over the coming months as the strength of the global economy is confirmed, especially in the second half of the year.
"In our view," he says, "valuations remain appealing for eurozone equities (Eurostoxx index forward price/earnings (P/E) ratio just below 11) and much bad news is already priced in. However, we remain cautious about the timing of increased exposure to the region."
Alan Higgins, chief investment officer UK at Coutts, agrees: "Equities have been treading water waiting to see if the storm in Cyprus will worsen. Now that a deal has been agreed we hope markets can get back to concentrating on what has been generally good news flow in recent weeks."
He adds the world may not be firing on all cylinders, "but a combination of good US growth and an increasingly confident Japan should provide a solid backdrop for higher-risk securities to move higher. We reiterate our preference for equities over bonds."
While markets welcomed the news, UBS's Cluse says the deal does not come without further issues. "We see a risk that Cyprus's sovereign debt burden post-bail-out might not be sustainable, as the country is likely to enter a deep recession caused by the shrinkage of the banking sector and severe deleveraging."
While David Folkerts-Landau, managing director and global head of research at Deutsche Bank, expects to see Cyprus' bank sector shrink to the EU average by 2018, UBS's Cluse says Cypriot gross domestic product will probably face a sharp drop in 2013/2014 - and most certainly much worse than the European Commission's latest forecast of -3.5% in 2013 and -1.3% in 2014.
Cluse says: "The crisis might well lead to follow-up costs that will end up on the sovereign balance sheet. In our view, it is therefore very likely that the sovereign debt stock will rise substantially further in 2013-15. That the debt stock can then be brought down to 100% of GDP again by 2020 - as the Eurogroup statement from 16 March explicitly stated - must be doubted, in our view."
"Consequently, we believe that Cyprus's sovereign debt problems will remain an issue of concern - for European policymakers and for the markets.
"But there is no easy way out," he concludes.
- The Eurogroup expects an agreement between Cyprus and the Russian Federation on "a financial contribution".
- The group urges "the immediate implementation of the agreement between Cyprus and Greece on the Greek branches of the Cypriot banks, which protects the stability of both the Greek and Cypriot banking systems." This refers to the hope or expectation that Russia would be willing to lower the interest rate and lengthen the maturity on its $2.5 billion (£1.6 billion) loan to Cyprus (currently 4.5% interest, with a 2016 maturity), explains UBS' Cluse.
- The group requests the Cypriot authorities and the Commission, in liaison with the ECB and the IMF, to agree a memorandum of understanding with Cyprus in early April.
- The first quarterly instalment of the Cyprus programme is expected to be made in early May, according to the European Stability Mechanism's managing director Klaus Regling.