27th March 2013
Robert Farago, head of asset allocation at Schroders Private Bank has compiled a list of the eight lessons for investors to learn from Cyprus. It’s one of the best summaries of the situation and the implications we have read.
1) In an imperfect, seventeen-country currency union, no country is too small to matter. Cyprus is a country of just over one million people at the very periphery of the euro area. The enormous size of its banking sector relative to the underlying economy means that if it were outside the euro area it would likely have followed the path of the Icelandic bust. Instead, Europe and the IMF were impelled to step in with additional support rather than risk the loss of a single member of the currency union.
2) The markets continue to have faith in Mario Draghi’s statement of last summer that the European Central Bank will do “whatever it takes” to keep the currency intact. Prices of European stocks and peripheral euro area bonds have so far been barely impacted by this crisis.
3) Investors should expect the unexpected in the form of rule changes from overly indebted governments. While ultimately rejected, the fact that anyone in authority could have proposed a tax on small depositors is shocking.
4) Capital controls will likely top the list of rule changes for any country heading into a crisis from now on. The attack on bank depositors in Cyprus will clearly increase the risk of a bank run in the next country that runs into trouble.
5) The event is a reminder that financial crises and government debt crises are intrinsically interlinked. The financial crisis of 2008 saw governments around the world step in to prop up ailing banking systems. Now we see a government forced to tap bank deposits to fill the holes in its own balance sheet. While the Cypriot tax on depositors is for now a one off, banks in the UK and elsewhere have been forced to increase their holdings of government bonds in the name of prudent capital management.
6) Gold remains the obvious safe haven when money itself is under threat. The amount of gold held in exchange traded funds had been shrinking this year as investor confidence in the rebound in the US economy grew.
7) A Euro area banking union remains some way off. Yet this is the necessary next step towards a stronger currency union. It was clearly politically unacceptable for German taxpayers to support the Cypriot banking sector, where a fifth of deposits come from Russia. Yet a true banking union would not allow the authorities to be selective about which country’s banks they wish to support.
8) Finally, investors should not dismiss the Cypriot’s appeal to Russia for help as a one off. The current crisis has parallels with the late nineteenth century. Back then, a small number of London-based merchant banks formed a closely-knit group that dominated lending to the developing world. When a borrower ran into trouble, they cooperated to ensure they achieved the best possible outcome for the lenders. However, as the number of problem loans multiplied, eventually a bank would break ranks. They negotiated a bilateral arrangement that protected their own interests ahead of their peers. It would not be without precedent, therefore, if Cyprus had reached a financing deal with Russia using their gas fields as collateral.