Eurozone Crisis Test Case

Neil Irwin at Wonkblog on the events in Cyprus:

In a lot of ways, it is separate from the rest of the euro zone, and not just geographically. Its population is a mere 1.1 million (the Greek population is 10 times as large). It has an unwieldy banking system with liabilities equal to eight times its economic output, versus 3.5 times for the euro zone as a whole. Many of those deposits are held by wealthy Russians who use Cyprus as a convenient place to park money.

Those are the reasons the IMF has insisted on losses for depositors — those, and the fact that rescuing Cyprus’s finances without the 5.8 billion-euro contribution represented by depositors’ losses would have meant a bailout approximately equivalent to the country’s annual economic output, too much for the fund to stomach.

“The challenges we were facing in Cyprus were of an exceptional nature,” said Jeroen Dijsselbloem, the Dutch finance minister who helped engineer the plan, according to the Financial Times. “Therefore, unique measures were determined to be necessary.”

The European Central Bank will now be on high alert, monitoring activity in Greece, Spain and beyond for evidence that the Cyprus precedent will result in new runs on those nations’ banks. Expect a flood of central bank liquidity into those nations if there is any hint that depositors across Europe seem to be thinking that Cyprus is the new normal and that their seemingly safe bank deposits could be reduced 10 percent without warning.

The best the rest of the world can hope for is that Cyprus’s case is sufficiently unique that it won’t spark panic in Athens and Madrid (or in Lisbon, Dublin and Rome).

For the past six months, the global financial markets have become increasingly complacent, convinced that the euro-zone crisis is, for practical purposes, over. Cyprus is the test of whether that is correct, or whether the complacency was instead misplaced.

In other words, if there is going to be a new wave of crisis in Europe, historians will be able to trace its starting point back to today’s Cyprus bank bailout.

And Tero Kuittinen at Forbes:

Europeans are trying to come to grips with the shocking decision of Cyprus to abruptly declare a stiff levy on bank deposits, even those under 100’000 euros. Everyone is now waiting for Monday morning and how depositors in Southern Europe will react to the sudden realization that 7-10% of their savings could be abruptly confiscated on any given weekend. Photos of Cypriots lining up in front of ATM’s that no longer work will be splashed across the Sunday editions of European newspapers.

The sheer weirdness of the Cyprus move means that European leaders must deliver two conflicting messages simultaneously. First, they must argue that the sudden bank account levy was absolutely necessary right now. Second, they must convince Europeans that it will never, ever be repeated.

The President of Cyprus has already delivered a dramatic statement. According to it, not confiscating some of bank deposits would have meant that the banking system of Cyprus would have collapsed immediately. That’s it. The only two options right now were allowing the banking system collapse or implementing the 6.75 – 9.90% shock levy on savings accounts. Needless to say, very few people in Europe had any idea that Cyprus is facing these two drastic options in March 2013.

Yet on the very same day, the European Union Economic and Monetary Commissioner Olli Rehn stated that there won’t be a repeat of the tax on bank deposits that was imposed as a part of Cyprus’s aid program. He bluntly claimed that “there is no concrete case where it should be considered.”

How can both statements be credible? How can regular EU citizens with savings accounts in the Mediterranean banks possibly gauge the risk level accurately? The messaging challenge here is profound. By the time the Spanish and Portuguese banks open on Monday morning, Europeans must believe that A) The Cyprus crisis was so acute and dreadful that the unprecedented savings tax was the only possible alternative and B) Another similar situation will never materialize, so there is no reason to pull money out of southern banks.

The Club Med economies simply cannot handle another crisis of confidence. During the calm month of January, Spanish retail sales plunged by -10% and the December sales collapse was recently revised to -11%. Multinational companies from McDonald’s to Tiffany have started warning about weakening European trends. Apple‘s Christmas quarter weakness stemmed partly from a pronounced European revenue growth slow-down over the past three quarters. Qualcomm recently downgraded the North American 3G/4G device volume growth to under 2% in 2012; the consumer electronics industry can hardly absorb a new European consumer sentiment crisis without a significant hit to global growth trends.

How is EU going to thread this needle? The next 48 hours are going to be pivotal. By making its move on Saturday, EU has given Europeans time to fret and mull over the Cyprus shock for most of the weekend. There will be no shortage of bank line pics on Twitter come Monday morning.

Monday and Tuesday are going to be very interesting days to watch the markets.

Just as a reminder, the bank runs and bank failures during the Depression came a couple of years after the market crash.