1. Capital controls are back – Typically associated with emerging markets crises and Bretton Woods, the eurozone is developing its first set of capital controls. Capital controls will create a defacto new euro currency in Cyprus, where the local currency will not be able to buy the same goods and services as it would in the rest of the eurozone. Cyrpus imports everything, but money can’t leave to buy imports. When money can’t leave the country, it creates scarcity which drives inflation and an internal devaluation of the currency.
2. Insured deposits are no longer untouchable – Even if deposits are insured, the Troika, comprised of the ECB, EU and IMF, made it clear that deposit insurance, and national law, is subordinate its demands. The appropriation of Cypriot deposits will make depositors across the eurozone think carefully about pulling cash out of banks if there is an indication of further banking sector trouble.
3. National champion banks are in play – Spain, Italy, France and Greece have all protected their national champion banks regardless of the banks’ sustainability. In Cyprus, the Troika is breaking the two national champion banks into a good-bank/bad-bank structure that effectively kills off the second-largest bank and neuters the largest bank. Now that national champion banks are in play, creditors may pull back bank financing if the Troika indicates it is not satisfied with banks’ health.
4. Senior bondholders suffer losses – While far less aggressive than the raid on deposits, punishing bondholders does impact the way banks capitalize themselves. If bondholders perceive risks to have increased across the eurozone after the Cypriot banks’ bondholders were wiped out, they may demand higher interest rates to refinance banks limiting the ability of banks to lend to customers.
5. Germany makes the rules now – Eurozone decision making is now clearly in the hands of Germany which has contentious elections coming up this fall. German demands about the structure of the bailout look good at home but undermine the ECB commitment to do “anything it takes” and the broader European vision of cooperation.
What this means for your business: Expect any eurozone recovery to be pushed out further into the horizon as banks will be cautious about recapitalization, and as a result, lending. If lending can’t restart, the economic cycle will remain stalled. Also expect interest rates to increase in the short term outside of Germany while the probability of a eurozone default increases. For a more detailed analysis of the crisis and what it means for emerging markets, FSG clients may download the EMEA Regional Overview released today.
Just when it appeared that stability was returning, late on Friday, tiny Cyprus announced that its banks bailout will be paid for by depositors rather than the banks’ creditors or the pooled resources of the EU stability funds. Predictably, the announcement caused runs on the banks, which promptly shut down, as households attempted to remove cash before the government appropriates up to 10% of savings. The decision was made following talks with the EU and IMF and is subject to parliamentary approval on Monday.
The Cypriot bailout provides a new twist to the ongoing eurozone story. For the first time, depositors who may have had nothing to do with risky lending practices are asked to pay the bill to avoid default. Creditors including the ECB and German banks would be kept whole.
The bailout sets a dangerous precedent. Depositors in larger countries like Spain and Italy may see the situation in Cyprus as a catalyst for withdrawing savings before it’s too late. Until now, households in these markets have kept their savings in domestic banks though corporate depositors have not. If the decision to appropriate savings is approved, the thinking may change: since deposits can be appropriated in one EU country, why not in another?
A run on banks in a larger market would reverberate through the eurozone causing sharp economic contraction in that market and steep losses for creditor banks in neighboring northern European countries.
Implications for Your Strategic Planning:
- Eurozone recovery pushed further into the horizon – Countries will be less likely to take immediate action to address insolvent banks because the new tradeoffs are so steep. As a result, bank lending will remain stalled and troubled economies will continue to contract.
- Eurozone bank runs more likely – Even if depositors in weak eurozone markets do keep their cash in banks this week, the risk of bank runs will not dissipate. Because bailouts for markets like Greece and Portugal are ongoing, future negotiations may include demands to appropriate deposits from savers. There is no EU-wide deposit insurance and the deal with Cyprus superseded Cypriot deposit insurance law, wiping it out.
- Creditor countries will make the rules – Harsh policy proposals coming from Germany and other creditor countries should be taken seriously as they are more likely to be enacted without support of countries in crisis. The precedent created around Cyprus protected Germany as the primarily German-funded ECB will not lose any money on its loans to Cyprus.
- Increased probability of eurozone breakup – The new tradeoffs imposed by creditor countries makes staying in the eurozone less attractive. Governments will have to appropriate assets from savers, overturn national deposit insurance laws, and neuter domestic banks’ ability to recycle savings to restart economic growth. Popular support for anti-euro parties, like Beppe Grillo’s in Italy, will only increase.
Signposts to watch:
- Cypriot parliamentary decision – Cyprus’ parliament will vote Monday to pass the bailout terms. A ‘no’ vote will make a eurozone exit more likely and a ‘yes’ vote will make bank runs more likely, both setting dangerous precedents.
- Bond yields – While the value of bank deposits is a more important indicator, it is not published frequently. As a result, look at bond yields on Spanish and Italian banks. Rising yields indicate potential trouble, and flat yields indicate that contagion has not spread.
- ECB response – Watch for an announcement about bank deposit insurance or cash injections into national banking systems. If there is a run on banks, these actions will be needed at the onset to stop them. Lack of an ECB response will confirm that the central bank does not “stand ready to act” as it publically stated.
Suggested Actions To Consider:
- Remove any remaining corporate deposits from Portugal, Spain, Ireland, Greece and Italy.
- Immediately communicate the significance of this seemingly minor event to corporate stakeholders who may believe the eurozone is entering a recovery.
Revisit and update your eurozone contingency plans or work with FSG to create them if they are not in place.
From Matt Lasov, Head of EMEA Research:
“Unfortunately, some bad news out of Greece to start the new year. Things are deteriorating and it’s more important than ever to monitor events there.
In Athens, shots were fired into the offices of the ruling party including the Prime Minister’s office. Nobody was hurt but this represents an escalation in social tension. The trend is worrying as bombs were also detonated at other government offices, the homes of journalists and banks during the last week.
The economy is still shrinking under austerity and voters will ask for change one way or another. Banks are still bust and more people are losing their jobs.
Making things worse socially, the Greek government is clawing back some austerity measures for the rich and well-connected, property taxes for example, and arresting reporters who published names of those who evade taxes. The country is ripe for real social unrest. Syriza, the anti-Europe opposition, was ahead in opinion polls until the government secured the most recent round of bailout funding. When that round begins to dry up, Syriza’s case will be even stronger. Ultimately, default is a political decision.
Meanwhile, in Germany, the economy contracted more than expected, 0.5%, in the fourth quarter. With a contracting economy and an upcoming election, it’s hard to imagine that meaningful external support is on the way.
If the eurozone moves back to the brink of breakup, emerging markets that share trade and financial links, particularly in Central and Eastern Europe, will be impacted.
Spanish depositors withdrew nearly $100 billion in July, more than double the existing record for one month. The jump in withdrawals was likely driven by households joining corporations in the flight to safety. The Spanish Central Bank says the spike was due to the “July effect of tax payments and by the expiry of securitized funds,” but the Spanish Central Bank has zero credibility after their bogus stress-tests. The system still has roughly $2.9 trillion in deposits according to Morgan Stanley, but that will not be able to withstand an accelerating run on banks without ECB support.
This will be a race for the ECB. During the ECB’s meeting on September 6th, markets and critically, depositors, will be watching for actions that support eurozone member-states. Bond purchases are the key action that will buy time to allow for economic recovery, but they cannot be limited. It’s too late for that.
While we do expect an announcement around bond purchases, we will focus on measuring the extent of program. Limited support cannot plug monthly losses of $100bn in member-states’ balance sheets. Purchases need to be messaged to the market as unlimited, something we doubt the ECB will do because the politicized nature of ECB negotiations.
Domestic politics are such that any bond purchases will alienate German and Dutch voters. If the ECB is set to launch a bond-buying program, it is better off going all the way as it may not get another chance. You can imagine a scenario where electorates in the creditor states put the program to a vote as a way to stop the flow of funds to debtor states. We hope the ECB can take bold action in light of domestic political realities, but they have yet to take bold action at any point during the crisis.
Watch for Europe to waste another opportunity to slow the crisis and instead continue to kick the can down the road.
Interview with Matt Lasov, head of EMEA research for Frontier Strategy Group:
“There is a lot of tough talk coming out of Germany after the government approved the Spanish bank loans. Some officials are essentially challenging Greece to leave, claiming that the Greek problem is ring-fenced. It’s mostly rhetoric designed to rile up domestic voters. We are very skeptical that we’ll see German-led action to force Greece out. Politicians are simply jockeying for power as the domestically unpopular Spanish loans created a political opportunity. Forcing Greece out still has the potential to destabilize thinly-capitalized German banks and the broader European financial system.
The next signpost to watch is the upcoming Troika visit. Greece has closed only 12 public agencies from a target list of 120. At the same time, the Greek government is expected to ask for a budget deficit cut extension that will cost the Troika an additional 30-50 billion Euros. This will be hugely unpopular with taxpayers across Northern Europe.
Markets are not taking the news well and, as a result, Spanish 10yr yields shot to a record 7.5% today. A bit more under the radar, 2yr yields shot up to 6.4%, so even rolling over short-term debt will be painful and difficult. When yields spike in Spain on the back of Greek news, it highlights the continued interconnectedness of the European financial system despite German claims that Greece is ring-fenced. A disorderly Greek exit still has the potential to create bank runs and bond strikes in Spain. The market’s response to Italy has been more measured. 10yr yields increased to 6.4%.”
Spain –Take today’s banking stress test results with a grain of salt because the hired consultants were not permitted to audit the banks directly and instead could only review Spanish central bank records. These are the same records that showed Bankia earning a profit, not a multibillion euro loss. Bizarrely, the government also hired the big four to audit the banks directly, but those results are not set to be released publicly.
Regardless of the opacity surrounding the stress test, one thing we have learned is that the capital needed after stress tests has tended to be 2x or 3x the stated amount. This was the case in the US (take Citi, or Bank of America for example) and has been the case in Europe. Be wary of the results.
Italy – There are concerns that Berlusconi will use an anti-austerity platform to reshape government and regain power. Berlusconi has been completely out of the political spotlight as his reputation recovered. He chose these comments to mark his return:
“The day we stop supporting this technical government, we will recover a lot of votes”
“If we continue on with the policies of Signora Merkel,” Mr. Berlusconi said referring to German Chancellor Angela Merkel, “We will end up in a worsening recessionary spiral. This is really the wrong policy.”
Berlusconi still has a tremendous amount of power in Italy and is the leader of the party that backs Monti’s technocratic, unelected government. Any moves in the opposite direction will roil markets, as the Italian government loses credibility.
Politically, there is zero will to allow Spain to default but markets have moved faster than politicians every step of the way. It’s very difficult to view European politicians as credible at this point, the markets certainly do not. Remember, default is always a political decision (or in this case indecision). There are policy tools available to fix this crisis, debt monetization for example. The challenge is in getting 17 eurozone governments to agree when they are beholden to domestic voters, though they share a supranational currency. As of now there is no path to solve this fundamental challenge in a timely manner.
Here’s what we know about Spain – and why we think risks are very high:
The story for Spain is bust banks and a dose of social unrest
CDS spreads show 40% chance of default, up from 30%
Youth unemployment at 50% with zero public benefits (there is no available cash for extended unemployment etc…) is a recipe for disaster
12-month yields at 5% and 10-yr at 7% is not sustainable from a funding point of view – borrowing at these rates only compounds the debt crisis.
With high borrowing costs and the 100bn euro loan, Spain’s government debt to GDP jumped to 90%, it was at 60% last year. The credit crisis was effectively transferred from Spain’s banks to its government – a government that lacks cash and the typical policy toolkit – ie printing money, devaluation.
Spain’s bond purchases are fully subscribed but there is zero foreign participation which will be necessary to bring in rates. The only buyers are Spain’s bust banks which are now reliant on government funding. This is a less-than-virtuous circle that cannot last.
Various eurozone bailout funds have the cash to string Greece along, but not Spain/Italy. A true bank recapitalization would overwhelm the size of current facilities.
We’ll know more about the willingness of policy makers to credibly solve the problem by June 30th. At that point the European summit will have ended, the G-20 will be over, and Greece will hopefully have been extended. The pendulum will have hopefully swung from harsh austerity to the balanced deleveraging approach.
If things have not made progress by June 30th, we will need to talk about broader eurozone contingency planning. Policy makers are running out of chances and markets don’t give mulligans.
Meanwhile in Greece:
Looks like a weak coalition of pro-Europe parties will govern Greece.
Greek parties have told the Greek people that they will modify bailout terms but simultaneously told European leaders they would not ask for this.
Driven by the cycle of austerity, social pressures in Greece are too high to bear and coalition parties realize they will need to soften austerity if they are to stay in power for any period of time.
This coalition will not be long lasting. Aside from historic domestic political competition between the parties, the coalition’s legitimacy now depends completely on Europe’s willingness to modify loans. Germany has not indicated it is willing to do this in a meaningful way.
“The risk of default and devaluation in Europe is still high. Bailout discussions focused on Spanish banks buy time and businesses should use this time to set plans in place to protect themselves against a Spanish exit from the euro.
So what’s changed in Europe since the last update? Not much. The crisis is playing out exactly as anticipated. The likely scenario remains deep recession. The risk of eurozone break up remains high and businesses should continue to plan for this. Greece is off the rails, waiting for elections in the middle of June to determine its fate inside or outside the eurozone. Meanwhile, Spain entered a full-fledged banking crisis that requires a coordinated European bailout.
The bailout for Spanish banks should buy time and avoid a run on banks in the immediate term. It will not fix the structural issues that will plague Spain in the medium term.
It is important to note that the bailout deal is not done. Spain will still have to accept the terms of the agreement, which will require harsh austerity and a transfer of fiscal sovereignty to Germany. Can the Spanish government force this on its people, especially when Prime Minister Rajoy ran on a platform guaranteeing that this would not happen? If Rajoy can push it through, how long will Spain be able to weather a cycle of harsh cuts to public services while unemployment remains at record highs?
Even if the bailout goes through, and we expect that it will, Spain will still require cost cutting of 30-40% to compete globally. This will be immensely painful whether it is done slowly over a decade, as every labor and government contract is renegotiated at competitive rates, or through a quick but highly disruptive devaluation. As cost cutting continues, the economy will shrink, and more debt will go bad because there are fewer available revenue streams that can be used to pay it off. Another bank bailout will be required to clean up the remainder of the debt overhang and the cycle will continue. Some estimates show an additional $300bn euro gap in the medium term. The current package amounts to $100bn euro.
We have seen this movie before. The cycle playing out in Spain is exactly what happened in Greece. Europe stepped in with bank bailout money to avoid imminent implosion of the member state. In exchange for funding, Greece accepted austerity measures which reduced the size of its economy. While the economy shrank, the debt burden with long term maturities stagnated. Debt to GDP ratios soared and Europe called for further austerity. The result for Greece is higher unemployment and extreme social pressures that are leading to an exit.”
“The crisis in Spain is accelerating faster than expected. Again, it’s all down to the banks. While everyone’s attention is on Greece, Spain is quietly struggling to pull off the Bankia bailout. Spain planned to provide Bankia with $24bn government debt that Bankia could post at the ECB in return for loans. The ECB said they would not accept that as collateral. Now Spain is back to the drawing board because it’s unclear where $24bn cash will come from. They only have $12bn cash left in their bailout fund. They can issue debt to fund the gap, but who is going to lend to them at this point? The solution is probably to force a merger with a healthier bank. This will buy a bit of time, but will compound the problem. Can a bank like Santander really handle a large, toxic portfolio?”
What do you think? Leave a comment and join the conversation.