Cyprus’ Calamity Won’t Change the Eurozone

This ordeal is nothing compared to the 2012 turmoil over Greece, Spain and Italy

   

I’ll give the European Union credit: At least it’s creative at finding new ways to upset the world’s capital markets.

Instead of demanding just the usual austerity measures of higher taxes and lower spending — and a potential haircut on speculative creditors such as hedge funds — the EU bailout negotiators insisted over the weekend on extracting a pound of flesh from the customers of Cypriot banks. Savers would see as much as 10% of their checking and savings accounts expropriated to help cover the cost of the bailout, and the levy would apply even to accounts insured by the Cypriot equivalent of the FDIC.

Ouch.

Needless to say, the news didn’t go over well in Cyprus; it led to a small-scale bank run as depositors rushed to get to their cash.

It also didn’t go over particularly well in Russia. Cyprus is notorious as a haven for Russian funds of (ahem) questionable origins. Roughly a quarter of all Cypriot bank deposits are owned by Russians.

As of this writing, it looked likely that Cyprus’ parliament would shoot down the bailout agreement hammered out between the government and the European Union on the grounds that it wasn’t fair to small local savers who assumed their deposits were protected by government guarantee. (Imagine any Democrat or Republican approving something like that here; it would be political suicide.)

The government also is reluctant to “soak the Russians” out of fear that it will destroy confidence so badly as to end Cyprus’ existence as an offshore financial center. And I can’t say I blame them for not wanting to anger the Russian mafia dons or Russian President Vladimir Putin. That’s not good for your health.

So what happens now?

My best guess is that the deal will be slightly tweaked to allow the Cypriot government to save face, but that the bailout goes through and the depositors get hit. Politically, German Chancellor Angela Merkel and French President Francois Hollande cannot ask their taxpayers to come to the rescue of dirty Russian money, nor should they.

If the bailout flops, the options quickly get messy.

I don’t see the EU backing down this time and watering down the deal, nor do I see the European Central Bank continuing to provide emergency liquidity. This means that without the bailout, the Cypriot banking system will collapse — and given that the banking system is eight times larger than the economy, there is no way Cyprus will be able to make its depositors whole. Barring some sort of last-minute emergency loan from Russia (which would presumably come with some pretty wicked strings attached), Cyprus either accepts the EU bailout and goes about its business or it drops the euro, issues a new currency, then falls into hyperinflationary oblivion.

What does this mean for the eurozone?

The fear was that seizing bank deposits would set a terrible precedent and lead to bank runs in Spain, Italy and other indebted countries and plunge us back into crisis mode. Once bank depositors are seen as a viable target, you create a slippery slope.

But judging by the market’s reaction, this is a non-event. European stocks took a small hit on the news, though it caused nothing like the turmoil over Greece, Spain and Italy last year. Bond yields in these problem countries spiked — but hardly to levels that would cause alarm.

There are a couple reasons why the bank run didn’t happen … or at least hasn’t happened yet.

To start, Spain and Italy already effectively had bank runs last year. Funds have been leaking out of both since the onset of the crisis, and their respective banking systems have been kept solvent by the ECB. But more basically, it’s an open secret that Cyprus is a haven for dirty money (wink wink), and investors see clear differences between their own banking systems and that of Cyprus.

There is also the “Draghi Put,” or the belief that ECB President Mario Draghi will live up to his word to do “whatever it takes” to keep the euro intact. This, more than anything, has been what has stabilized the eurozone over the past nine months.

And finally, don’t underestimate the effects of “crisis fatigue.” After three years of crisis, these sorts of headlines simply don’t have the ability to move the market like they used to.

Things could still get very ugly very fast in Europe if the feared contagion finally does happen. But for now, it looks as though this too shall pass.

Cyprus might choose to leave the eurozone before this is over or might well become a Russian client state; anything is possible at this point. But I don’t see any of these outcomes changing the direction of events. The eurozone will undergo deeper integration. With or without Cyprus, the eurozone will sink or swim together.

This makes things a little awkward for non-eurozone EU members like the U.K., Sweden and Demark. But even as the cumbersome, confusing mess it is, the eurozone will muddle through.

Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management.  As of this writing, he did not hold a position in any of the aforementioned securities. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.


Article printed from InvestorPlace Media, http://investorplace.com/2013/03/cyprus-calamity-wont-change-the-eurozone/.

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