The Eurozone post Cyprus

Salman Ahmed, Strategist on the Global & Emerging Fixed Income team at Lombard Odier Investment Managers, outlines the key implications for the future of the Eurozone in the wake of the deal to save Cyprus.

Cyprus may be tiny, but where your euro is matters.

Historically, governments have created and interpreted 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 we are most likely to see draconian controls being implemented in Cyprus.

This means that Draghi’s now famous “whatever it takes” pledge is situation dependent. Such an all-encompassing promise did not apply when the European Central Bank threatened to pull emergency lending assistance to Cyprus.

Germany shows that enforcing moral hazard has a cost.

The German central bank holds claims of around EUR 600 billion against the rest of the euro system.

Germany’s reluctance to share her 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.

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.

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