Saturday, 16 March 2013

First memorandum deal makes a second memorandum almost a certainty for Cyprus.

First memorandum deal makes a second memorandum almost a certainty.

It took a while to get around the news this morning. The main issue is the immediate haircutting of all deposits of all Cypriot banks (although oddly Greek depositors are excluded!). What does that mean for the economy of Cyprus:

A) Macroeconomic Instability

The news this morning initiated what looked like a bank run: the Eurogroup must not have known that the Co-op societies are open on Saturday, and people patiently waited in queue to remove their deposits only to be turned away. This made everything worse: we seem to have a bank run, which I think the government promise of this being a “one-off” raid on personal deposits will not stem.

How bad is the bank run? According to government sources, the last two months saw 11 billion euros was removed from the Cypriot deposit system within the last few weeks. This week is not going to be any better. I am assuming that at best there will just be an additional 11 billion loss of deposits for the banking system this following months. This means that banks will need liquidity assistance; as a result the Emergency Liquidity Assistance (ELA) of the ECB is bound to continue.  

What is the effect of this loss of deposits? Let remember the Axiom of economics that links the monetary economy with the real economy:
Ms*V= P*Q
or Money supply times velocity equals price times quantity (P*Q is also called nominal GDP).

The removal of deposits led to a reduction of the money supply. As a result there is a brutal negative shock to the money supply, coupled with reduction of velocity as companies and individuals with loans that are attached to deposits battle it out with the banks. As prices in Cyprus are relatively stable then it means that quantity (output) will decline. This makes the scenario for a recession of -2.4% very unlikely (my prediction is -5% GDP). As the recession will be worse than predicted, then neither the government revenue/expenditure stream we agreed on the troika, nor the PIMCO report on the banks’ capitalisation needs, will be accurate. As a result we need a larger bailout à A second bailout is coming

  1. B)  mortal blow for Cyprus as international financial centre?

If one agrees with my logic of a second bailout then we need to think what that means for Cyprus’ position as an international financial centre.

Some foreign depositors woke up with the news that they have lost money in the unthinkable way. Clever depositors might have thought they were safe by reducing their accounts to several accounts of 100,000 euro tranches, the limit guaranteed by deposit insurance, or by moving them to the better run banks. However these did not help them; they woke up to hear a 6.75% haircut on their deposits under 100,000, which includes all financial institutions, even banks that avoided the mess and were run efficiently.

The confidence to the banking sector is shaken. Quickly as the negative shock ripples through the economy there will be a realisation that a second bailout will be needed. The local and foreign depositor will ask himself “Is this the last time there will be a deposit haircut or will
my deposits be affected in a second bailout?”
No one can answer that question with any credibility anymore. After all, the President of Cyprus had committed while being a presidential candidate to never accept a deposit haircut. No one knows what the Europeans will ask next time. Thinking backwards the depositor will not be lured or committed to stay in Cyprus, regardless of the competitiveness of the Cypriot business services sector, which is one of the best in the world.

    C)  The moral of the story is that politics need to listen to basic economic principles
The basis of any successful capitalist economy is the protection of the right of personal property. This decision to punish all savers equally across all banks, regardless of the bank’s solvency, violates this principle. Note that depositors under 100,000 were insured against losses even if the banks failed, but are now forced to bear the brunt of the banking recapitalization. Thus the majority of depositors and shareholders of the two major banks actually had an incentive to let the two major bank fail, as they would not have their deposits haircutted.

This matters: when the right of personal property is violated the whole capitalist system, or institutions, that underlie the correct running of an economy, are threatened. And when such basic principles are disturbed, neither does the IMD, the Eurogroup of the EU commission can estimate the repercussions for Little Cyprus, but also for the Eurozone as a whole. 

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