Lombard Odier Investment Managers’ Salman Ahmed sees lessons in Cyprus
Salman Ahmed, strategist on the Global & Emerging Fixed Income team at Lombard Odier Investment Managers, sees a number of key lessons for investors in the recent way Cyprus was treated as a eurozone member.
Let’s take a step back to assess the implications for the future of the eurozone from recent events in Cyprus.
The bailout numbers may have seemed like rounding errors in the wider scheme of things, but actions taken regarding Cyprus will have long-lasting implications for how the eurozone crisis proceeds from here.
Following the deal, we are still struggling to find any long-term positives to take from the situation, apart from the short-term relief factor of avoiding an immediate exit from the single currency union.
The first lesson is that the exact residence of euros within the system matters. In the post-Cyprus world, euros sitting in a weaker country have a higher potential for being confiscated, compared with euros residing in a stronger country.
The second lesson is more in line with history, which shows that when needed, governments can create and interpret rules to suit their needs.
According to the EU treaty, controls that inhibit the free flow of capital within EU borders are illegal and yet draconian controls have been implemented in Cyprus. This is not only unprecedented but also raises serious questions in our mind about whether such policy measures are legal.
The final lesson from the Cypriot situation is also worrying. European Central Bank President Mario Draghi’s now famous “whatever it takes” pledge is situation-dependent. Such an all-encompassing promise did not apply when the ECB threatened to pull emergency lending assistance to Cyprus, which could have easily precipitated a Cypriot exit from the currency union.
Another conclusion: enforcing moral hazard pain on non-compliant members has a cost for Germany. It skews Target 2 balances, the distribution of which tends to worsen after each phase of the crisis. These balances are the assets and liabilities of each country’s central bank in the euro settlement system. The Bundesbank is by far the dominant creditor: the implicit lender of last resort.
Currently, the German central bank holds claims of about €600bn against the rest of the euro system. It is no surprise to note that the peripheral countries are the debtors. Recent history shows these claims tend to increase further during episodes of crisis and should a weaker country exit the currency union, Germany will suffer from its claims on the exiting country’s debt defaulting.
Put simply, Germany’s reluctance to share its balance sheet leads to even higher exposure to the rest of the euro system via the resulting intra-country flows generated in the European financial sector. Indeed, in pursuit of a principled stance, potential costs to Germany from the break-up of euro have also risen significantly over recent years.
Overall, we will not be surprised to see that developments in Cyprus reverse the downward trend in the Bundesbank’s claims on the euro system, in coming weeks and months.
We believe developments in Cyprus have further dented the euro’s fledgling status as a reserve currency.
It is now clear that in stress situations with mitigation of moral hazard an important driver, the current rules governing the single currency area may be changed to suit the creditors. We also note the reports of tangible disagreements within the Troika (specifically between the IMF and the European Commission), which are likely to complicate further any future bailout situations.
In terms of strategy, we have been surprised by the sanguine response of markets to developments in Europe. However, our stance on the euro continues to be negative, which is now starting to get reflected in market action.
We are also cautious on eastern European currencies, and in emerging markets we continue to favour currencies which are less exposed to the European sovereign risk factor on a relative basis.