Tuesday, 26 March 2013

The REAL issue behind Cyprus

While the news around Cyprus has mostly died down here in favor of the many many media stories on the S&P 500 hitting an all time high, there's a very long lasting impact from the "bailout" deal.  It has to do with the very public realization that your bank deposits are NOT safe.

People talk about "risk free" rate of return and generally that is very short term US government bonds.  However, that is not really risk free as there is always the small chance of US default (see all the budget hooplas over the last couple years).  As well there is the real chance of US bonds dropping in value.  With the interest rate as low as it is, any rise of rate will cause a drop in bond prices and thus a potential loss.  So that's not really risk free in my opinion, especially for small investors.

So for small investors, real risk free is bank accounts, CDs and savings account.  Yeah they have crappy interest rates but most people see that as zero risk.  This was not always the case, its only this way because of FDIC Insurance.  People don't remember the days before FDIC insured deposits were around but bank runs and losing your money because someone else had withdrawn it already was a very big and prevalent problem.

The Euro bailouts has always protected the depositors at the expense of shareholders and bondholders...until Cyprus.  The Cyprus deal essentially cuts deposits above the insured 100k Euro, likely everyone will lose almost all of their deposits above that.  Now the key point is that this is NOT some third world country or some unreliable tax haven country like Bermuda.  No this is a country with the full backing of the EU and the EU with all their money is willing to do this.

With this precedent, I expect a mild bank run situation to occur in vulnerable banks in other problem countries like Spain and Greece and also tax haven countries like Luxembourg where people realize there isn't that much safety.  Luxembourg banks has somewhere around 22x more financial assets than it has GDP, a big drop in their value will never be recoverable via taxes.

Naked Capitalism had a good summary of other aspects of the Cyprus deal, a few excepts here:

As we’ve indicated before, the threat is that bank runs start in other periphery countries, based on a recognition that their bank is at risk plus a concern that they will be made to take losses, as large depositors were in Cyprus. We never thought the odds of a “hot” run, as in people lining up at banks to withdraw money, was all that high, and it’s been reduced even further by the fact that depositors under €100,000 were spared. However, we think the slow-motion departure of depositors from periphery banks is likely to resume. It was arrested by the introduction last September of the OMT, which was peculiar since the OMT was merely a clever PR exercise that simply repackaged existing ECB powers. But the ham-handed ambush of the Cypriot president Anastasiades and the initial rejection by Parliament of the ultimatum elevated international interest in the negotiations. Commentators generally disapproved of the plan to whack all depositors, particularly small ones. Even though they are likely to be less critical of the final plan, which haircuts only big depositors at the two biggest banks, the imposition of capital controls has produced, if anything, an even more negative reaction.

It isn’t hard to see why an business owner or a wealthy individual in the periphery countries who hasn’t moved his money out of banks in his country might think twice. Before, the worry was that some country might exit the Eurozone, and if that happened to be your country, your deposits would be redenominated in New Currency which would plunge in value relative to the euro, leave you poorer. While that risk may continue to be seen as de minimus, we now have two new reasons to wonder about the wisdom of standing pat with home-grown banks.

Second, capital controls in Cyprus mean that there are now two Euros in effect: The Euro that you can use only in Cyprus, and the Euro you can use elsewhere in the so-called “monetary union.” So from the perspective of people in Cyprus, the results are in some ways worst that a breakup: rather than having depreciated dough, you have dough that has been impounded, particularly in terms of using it outside Cyprus.

In each case, why wouldn’t every business owner or wealthy Euro-holder in the periphery go into “First, they came for the Cypriots” mode, take economist Krämer at his word, and move their money to where they had some reason to believe it was safe?

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