Cyprus closes a Deal but its future remains at Stake

So, in yet another eurozone fudge, the Cyprus’ government acquiesced to the Troika in a last minute deal to raise the necessary funds in order to save the Cypriot financial system and avert bankruptcy. In the event, the final arrangement was really just a variant of the initial EU proposal but this time the deposit levy will be applied only on deposits over €100,000.

Cyprus and its lenders reached the deal over the weekend in yet another race against time to avoid the disastrous consequences of a disorderly default. Unfortunately for the Cypriot people, there weren’t many alternatives left besides either leaving the Euro and being forced likely to go to the IMF for a loan, or accepting the onerous EU terms with the ECB even threatening to cut financing from today if a deal wasn’t reached.

The infamous troika initially wanted Cyprus to apply a levy of 6.75% to deposits under €100,000 and 9.9% to all others but, the measure was widely rejected in the country’s Parliament, leaving the country in a desperate fight against time to find alternative solutions under heavy pressure from European institutions and leaders. Michael Sarris, Cyprus’ Finance Minister, flew to Russia last week in what was ultimately a frustrated attempt to sell the country’s future earnings deriving from natural gas exploration in return for offering a major stake in Cypriots largely worthless banks. Unsurprisingly, the Russians weren’t seduced by his proposal!

Even though the final solution is not yet official and many of the finer details are still to come, deposits under 100,000 won’t be levied with a discount, no matter on which banks they deposits are held at. Deposits over €100,000 at Bank of Cyprus, the largest bank, will be cut by around 30%. Deposits at the troubled Laiki Bank are said to be levied above the 30% although we still don’t know the final number. Laiki will also be split into two banks: a good bank and a bad bank. The idea is to sell bad assets and restructure the bank. Depending on how much can be raised from the sale of the bad assets, the final levy on deposits over €100,000 at this particular bank may be adjusted but deposits are likely to be frozen until assets are effectively sold.

With this deal, it is expected that Cyprus could raise €4.8 billion, an amount that is still short of the initially demanded €6.8 billion by the EU. This may leave the gate open to further cuts, or to higher levies applied to depositors.

Even though the deal is better for deposit holders below the  €100,000 deposit protection threshold instituted by the EU, it is still a confiscation. Make no mistake about that. In a worrying sign, larger depositors are effectively being treated as bondholders. Bondholders are usually much more protected than any other investor class with liens and charges over assets. That’s not the case with depositors who aren’t investors and  don’t have a say in any financial matters regarding the bank. It is this point that has been played to good effect in this debacle. A haircut on deposits is unfair and Cyprus is selling its soul to the devil whilst creating a major distrust in the integrity of the peripheral European financial system.

Regarding the safety of deposits in other countries, the statement from the President of the Eurogroup at the meeting in Brussels probably rings somewhat hollow today:

“I would like to emphasize that none of these measures will affect deposits below 100,000 euros there should be no doubts about that…We reaffirm that importance of fully guaranteeing these deposits in the European Union.”

From the beginning of this saga, the Troika tried to impose a levy of 6.75% on those deposits – that will not be forgotten in a hurry and is directly at odds with the statement above. It was the Cypriot Parliament which actually rejected the proposal. These words are deemed to give a false impression of safety for all other peripheral Europeans to keep their money at banks. Will they trust the politicians now or vote with their feet? Time will tell…

Tomorrow, Cypriot banks are expected to open but we believe another extension will most likely occur allowing politicans more time to iron out some of the details. When they do open, knowing human nature, I would expect a run on the banks, striking workers and social demonstrations.

Markets have risen so far on the news and the Euro recovered to above 1.30 against the US dollar overnight but the gains will most likely be short lived. We still expect the Euro to lost terrain over the next few weeks, gold to benefit from it, and sterling to be another winner.