Cyprus’ rescue frightens markets

Details: Cyprus was the latest of a string of countries requesting financial assistance, as its banks suffered heavy losses on investments in Greek Government bonds when Greek debt was restructured, nearly twelve months ago. Negotiations on the Financial Assistance Programme started on Friday.

The most striking feature of the programme known so far has been the agreement to impose a levy on Cyprus’ bank deposits. The details released over the week-end point to a levy of  9.9% on deposits over and 6.75% on deposits below €100k. Official lenders have reportedly been concerned that the €17bn under negotiation are a rather large share of Cyprus’ €17.9 bn economy, therefore making it very hard to pay back. As a result, lenders request more guarantees than in previous programmes.

These news led to significant markets’ losses as investors fear the impact it may have on the European financial sector as a whole.

Macrometria’s take: The deposit levy is a novel feature of the financial assistance programmes and is probably designed to target foreign deposits, which represent 37% of total deposits, reportedly belonging mostly to wealthy Russians. However, the details released so far suggest that national’s deposits, including very small savings will be affected by this measure. The Government is reportedly negotiating to raise the levy on the larger deposits in order to relieve the pressure from the smaller ones.

While this measure is likely to lead to capital flight and raise the risk of a bank run in Cyprus, it may also have significant repercussions beyond Cyprus’ borders. Because this levy goes against the spirit of the guarantees given to deposits below €100k that was established in the EU after the Lehamn’s bankrupcy, despite assurances that this feature is unique to Cyprus, investors, including small savers, may now reasonably fear that a similar measure may be applied to countries currently under a financial assistance programme, or that are likely to request one. Therefore, the risks of bank runs and capital flight in many EU countries have increased. 

This measure should also lead to higher risk premia in most asset classes, by raising the level of risk of the arguably most risk-free asset. This should have a lasting impact on the markets, though we would expect the initial sharp negative reaction to be somewhat reverted in the coming days.