The Systematic Significance of the Cyprus Bailout

By Andrew Kassen      News of a Troika-orchestrated bailout of the Mediterranean island nation of Cyprus spilled from European newswires early this past Saturday morning while most of the Western world lay sleeping. In testament to its place of primacy at the new media table, breaking developments, terse-yet-incisive commentary and links to the best long-form analysis coursed through Twitter all weekend, hopelessly outstripping traditional outlets in speed-to-market and breadth. The race to cover the Cyprus bailout was on!

To the casual financial news consumer watching the stream whir by, the €17 Billion price tag of the Cyprus bailout negotiated by newly-elected Cypriot President Nicos Anastasiades and members of the Troika might be underwhelming. Cyprus is a small country of 800,000 people with a GDP dwarfed by the state of Vermont (dead last among its peers in US output), amounting to a rounding error of EU-in-aggregate production. Even if this weren’t quite so unremarkable, the bailout is anything but unanticipated.

But in an epoch where unconventional monetary and fiscal policy has routinized and inured us to money-talk denominated in the hundreds of billions, this paltry €17 Billion figure belies an ominous development – one that may have far reaching and disproportionate implications.

Unlike any of its peers in the Eurozone periphery that have accepted bailouts, Cyprus was compelled to raise 7 of the €17 Billion through domestic means, most notably procuring €5.8 billion by levying a tiered tax of all monies on deposit in Cypriot banks, including all deposits <€100k covered by Cyprus’s DPS (their FDIC).

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The coerced participation of depositors is a span of policy the Troika has never crossed. That is, until now. For systemically significant EZ countries with hobbled banking sectors such as Spain and Italy, depositor haircuts was/is a policy Rubicon. Now crossing over this bridge in a befuddling unforced error the question is: in so doing, are they burning their way back – their credibility?

Though not everywhere in equal measure or operative at all times, Central Bank (CB) monetary policy has been the living breath animating and pushing forward global equity rallies since 2009. As the utility of quantitative measures (drastic rate reductions, QE, LSAP, loan facilities, etc) has produced diminishing returns with each accommodative iteration, CB governing bodies – most notably the FOMC at the Fed and the Governing Council at the ECB – have progressively turned to “communication” as their favored method of policy transmission.

This doesn’t mean CBs have turned from the policies that have borne their economies hence from the brink of collapse. But they have found by speeches, minutes, and press conferences they are able to efficiently guide markets with tactics of moral suasion, producing the tangible impacts on sentiment and consequently asset prices necessary to lift their quantitative programs above the marginal utility plateau to which they were succumbing.

Unequivocally stated: Central Banks are reliant, perhaps now more than ever, on a long-building and carefully-fostered reserve of credibility to effectively carry out their “communication” policy. And most importantly, their desire is to induce a favorable response in financial markets. In short: our trust (or fear, if that’s what gets the job done) in our Central Banks as lender of last resort and all-sufficient backstop is vital to their work.

That trust – and the ubiquitous admonition reminding us “don’t fight the Fed”-  has been enough to induce a virtuous cycle resulting in trillions in wealth creation; while “realized,” quantitatively-grounded policy has mostly tread water.

No better example in recent history exists than ECB President Mario Draghi’s masterclass introduction of OMT last year. On July 26 at an investment conference in London at the beginning of the Olympics, Draghi now-famously stated, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” A week later on August 2, the ECB announced its OMT program and cessation of the SMP.

What OMT is matters little: the program (about which pressing questions linger) has never been utilized. Since its “soft opening,” ECB policy has mostly remained in a holding pattern.

Not so in financial markets! Since July 2012, sovereign debt spreads have tightened dramatically, pulling Spain and Italy far back from the brink of being locked out of their funding markets and staving off bailout requests that would have dealt truly crippling blows to the Euro. At the same time, the representative German DAX and French CAC  are each up over 25% from their early Summer lows. Whatever the actual efficacy of its policy – untapped, untested – the ECB’s credibility has sufficed to transform repeated overtures since to do “whatever it takes” into ardent promises and to effect massive shifts in bond and equity markets.

€5.8 Billion could change all this. Somewhat inscrutably, the value of the ECB’s credibility (previously incalculable) has been marked-to-market through its active role in “negotiating” the draconian tax on account holders in Cypriot banks.

The individuals affected receive equity in their banks as compensation. The likes of Ollie Rehn insist this is a “one-off” (though he was contradicted by Euro Group and ESM President Dijsselbloem).  But depositors across the EZ periphery know their capital, long sheltered behind a sacred veil, is no longer sacrosanct. They know deposit insurance schemes can be arbitrarily contravened according to the Troika’s directive; and will be, where politically expedient. Perhaps worst of all, they know the ECB is not above extorting conditions from the government of a sovereign nation under threat of dismantling their TBTF banking sector – and blowing up their economy –  to exact the results it deems appropriate.

In the weeks ahead, the Troika will put its considerable power toward mitigating negative sentiment. As a risk proposition, its members know the max gain of €5.8 Billion is hopelessly small compared to the qualitative loss they may incur through the Cyprus bailout. With their efforts, markets may give them a pass, agreeing diminutive Cyprus poses no systemic threat and that there is no reason to panic about additional deposit taxes – that the bridge, once crossed, remains passable.

But, the ECB’s credibility may finally be put to the test, finding itself on the other side of a deepening valley it can no longer traverse without rebuilding the means to do so. Perhaps it’s improbable; but, at least in Europe, the days where rhetoric alone is sufficient to compel market optimism may be shortly numbered.

Twitter:  @andrewunknown and @seeitmarket

No position in any of the mentioned securities at the time of publication.

Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.