Cyprus contagion dangers still present: strategists

25/03/2013 | Emerging Markets

Market enthusiasm over the solution found for the Cyprus crisis could quickly wane in the face of new hurdles, strategists warn

The markets rallied Monday morning as Cyprus found an 11-th hour solution to its crisis that protects deposits below the European Union-guaranteed 100,000 euros ($130,000) limit but takes a bigger chunk of those above that amount, but fell in the afternoon as the risks became obvious.

The bailout creates a dangerous precedent and does nothing to eliminate risks of contagion and loss of confidence, various strategists said.

Monday morning, stock markets rallied across the globe, with the Emerging Markets MSCI index up more than 1%, while the FTSE 100 and the DAX rose nearly 1% and France's CAC-40 advanced by 1.5% in mid-morning London time.

They fell back in the afternoon following remarks by Eurogroup head Jeroen Dijsselbloem, who is the Dutch Minister of Finance, in which he suggested that the approach taken on bailing out Cyprus could be repeated for other countries.

"If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'. If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders," Dijsselbloem said, quoted by Reuters.

The solution found for Cyprus involves winding down its second-largest bank, Laiki, with deposits under 100,000 euros moved to Bank of Cyprus, the largest bank.

According to various press reports, depositors with over 100,000 euros stand to lose something like 30% of anything they have above that level. No official figure for the haircut for depositors was available.

"The agreement reached today on Cyprus provides a comprehensive and credible plan to deal with the current economic challenges in the country," Christine Lagarde, Managing Director of the International Monetary Fund (IMF), said in a statement after the Cypriot authorities announced their decision.

"This agreement provides the basis for restoring trust in the banking system, which is key to supporting growth," Lagarde added.

But some analysts disagree, saying the hardships not just for Cyprus but for other countries are just beginning.

Flows into emerging markets fell in both fixed income and equity asset classes last week, when developments in Cyprus deteriorated, strategists at RBS noted.

ECONOMIC SHOCK

Michala Marcussen, an analyst with Societe Generale, said that the reaction in Cyprus over the coming days will be "important to watch."

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"For Cyprus, the tumultuous events of last week have deepened the economic shock. For the euro area, this has not done much for confidence in its ability to resolve crises," Marcussen said.

She noted that as part of the agreement, the Cypriot financial sector – roughly 7 times the country's gross domestic product - will be cut to match the EU average by 2018, an independent evaluation will be carried out on the implementation of anti-money laundering framework and capital income tax and the corporate tax will be increased.

Even though Cyprus is too small to matter too much to the eurozone from an economical point of view, "contagion remains a risk," she added.

The first risk that Marcussen sees is that of a "depression for Cyprus," with a drop of 20% in GDP by 2017 and the country needing further financial assistance.

Another risk, this time broader than just for Cyprus, is that of a "loss of trust," because events in Cyprus "will have given food for thought" to depositors with over 100,000 euros.

"Just how much trust has been lost will in our opinion only really be put to the test if another country were to request an adjustment program." Marcussen said.

Yet another risk that she sees is the fact that there is "more appetite for bail-in," with the tough stance taken by leaders in the eurozone showing that their patience is wearing thin when it comes to negotiating conditionality.

AUSTERITY STILL PREFERRED

The fact that "conditionality remains tough" is also a risk, as the program for Cyprus came with the same harsh conditionality seen in previous programs, despite repeated calls from various leaders in the eurozone and from the IMF to favor growth rather than austerity.

"The view that a painful diet of austerity and deep-rooted structural reform ultimately delivers the right results is alive and well," Marcussen wrote in a market note.

Danske Bank chief analyst Allan von Mehren believes that the crisis is not over, although the fact that a deal was reached is a positive feature that calms markets over the short term.

The solution found for Cyprus sets "a very dangerous" precedent in the areas of capital control and losses on deposits above the deposit guarantee, von Mehren wrote in a market note.

"Savers in Greece and Spain will most likely react much faster and pull their money out if new negotiations with the EU become necessary at some point," he said.

"A flight of deposits above the 100,000 euros guarantee could already take place in these countries in the short term as these savers feel less secure about their deposits."

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