Cyprus action is calculated risk to systemic stability, says JP Morgan PB’s César Pérez

César Pérez, chief investment strategist for Europe, Middle-East and Africa at JP Morgan Private Bank says that the proposals for rescuing Cyprus’ banks are a calculated risk, but the drip of one-off solutions for peripheral eurozone members means European assets will continue to trade at a discount to peers.

We believe Europe has taken a meaningful but calculated risk to systemic stability. In the short term, the risks of contagion or a bank run somewhere else in Europe are low, but not negligible. The agreement needs approval by the Cyprus government in the next days before the banks can reopen and we see this as the key hurdle in this process.

What happens next?

   • The updated package needs to be voted in Parliament until 25 March, as there is a hard deadline imposed by the ECB’s cut-off date for supplying Cypriot banks with liquidity, unless an EU-IMF programme is in place that would ensure the solvency of the banks. Given the previous package failing to pass in Parliament, we expect a more thorough proposal from the government this time round, including a smaller portion of the €5.8bn to be raised through a deposit levy. We also believe that it is more likely for the outstanding deposits above €100,000 to be taxed and therefore approval in Parliament would be less of an issue than it was for the last proposal.

   • We do not expect major issues when it comes to parliamentary approval from countries such as Germany, if the deposit tax is implemented. The Eurogroup said that even if the structure of the bailout will be adjusted to allow for different treatment of the small depositors, these countries should be satisfied if the €5.8bn deposit goal is reached.

   • The IMF has said it will contribute; Russian participation remains to be decided, but it is reported they will extend the maturity of their €2.5bn loan and lower interest rates.

   • The alternative of a negative outcome to the vote implies a default for the country in the absence of Euro area support. We believe that given the geopolitical position of the country, a euro exit would be problematic for the region.

What are the risks of contagion for the rest of Europe?

   • The higher cost of funding for the weakest banks may probably lead to the acceleration of the failure of some institutions. Those who would potentially need support from their governments should trade weaker as the risks for bondholders and depositors has significantly increased (risks increased by the restructurings of the SNS subordinated bondholders and Anglo Irish senior bond holders). In our view, this could affect other banks which use contingent convertible bonds as part of their capital structure.

   • There is a bigger chance of a bank deposit run if a European country encounters severe problems in the future. We believe this can be partially addressed with the implementation of the pan-European deposit insurance scheme. Before the Cyprus events, the main weakness of this scheme was that it did not address the potential currency convertibility but now this probability gets reduced.

Conclusion

   • The Cypriot rescue package solution has missed the opportunity to rescue the banking sector directly through the ESM, which would have been a step forward in the European banking integration. As a consequence it is likely that the rating agencies will take the news on the negative side on a European level.

   • However, the solution found for Cyprus has shown that, despite the increased risk to systematic stability, Europe can be nimble and find a different solution to each country’s specific problem. It has also proven that, as the European crisis evolves into its next phase, the solutions found become harsher for the different market participants. As a consequence of the series of one-off solutions that European policy makers tailor to subsequent crises, the continued discount to global peers at which European assets trade remains justified.

 

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