Bank bail-in plans finally agreed, but its only a small step towards banking union

Despite some sizeable differences, EU finance ministers finally managed to reach an agreement on the bank bail-in plans last night (after only 25 hours of talks in the past few days). As always with this type of EU deals, it is a compromise and often an imperfect one. The agreement was much as expected in the end, given the drafts circulating over the past week. Below, we lay out the key points and the positives and negatives of the deal as we see them.

Key points

• Some more flexibility included, with government allowed to inject funds but only after minimum bail-in of 8% of the total liabilities of the failing bank – although such intervention is capped at 5% of the bank’s liabilities.
• The ESM, the eurozone's bailout fund, can also inject funds but only after all unsecured bondholders wiped out.
• The UK secured wording which allows it to avoid setting up an ex-ante resolution fund, as long as it is already receiving funds from the bank levy and/or stamp duty. Sweden also secured an adjustment to the text which allows for it to maintain its current model to a large extent.
• The agreement sees the bail-in plans coming into force in 2018, while the directive as a whole still needs approval from the European Parliament - so it could yet change.
• Certain creditors are excluded: insured deposits, secured liabilities, employee liabilities, interbank and payment liabilities with maturities of less than seven days. National resolution authorities can also exclude other creditors in exceptional circumstances.
• As in earlier drafts, insured deposits are completely protected, and the preference given to SMEs and individuals deposits (see here) has been retained as well.

Positives

• Reaching a deal is positive in itself, as it adds some much needed certainty following the Cypriot crisis. It also keeps the progress towards banking union inching along.
• The burden has been shifted away from taxpayers towards bank creditors.
• The added flexibility is important between eurozone and non-eurozone countries, with the UK and Sweden scoring some important caveats. The deal highlights that non-eurozone countries can still have influence on such rules and the acceptance of the need for flexibility between the two groups.

Negatives

• From a eurozone point of view, the flexibility could be counterproductive, particularly the use of exemptions in exceptional circumstances. How exactly will this be defined and determined? If at national level, then there could be clear political pressure in a crisis to invoke this. For example, it is hard to imagine that the crises in Greece, Portugal, Ireland and Spain would not have triggered this in some way.
• Could see cost of bank funding rise, particularly in terms of unsecured credit due to fairly strong depositor preference.
• Lots of unanswered questions – not least, when and how will these rules apply? It’s not clear in exactly what situation and at what time the new rules would kick in. Does it rely on a request for aid from the bank or the national government?
• Furthermore, there are questions over how this will work practically in different circumstances – for example, the difference between a bank which has almost completely failed and one which is simply struggling to recapitalise.
• The timeline also still seems very long, with the actual bail-in rules not in force until 2018, even though the directive is due to be in place by 2015. That said, the broad template may well still apply, particularly where banking union is involved.

In the end, this seems to be a reasonable compromise - not least because all sides seem fairly happy. It’s clear than a new set of rules was needed with the focus on creditors rather than taxpayers. That said, though, this is in the end only a very small part of banking union and the pace at which the eurozone is proceeding towards it remains fairly limited.

The key remains the single resolution mechanism and/or authority. As we have argued before, until this is in place it is hard to see how the poisonous sovereign-banking-loop will be broken or how cross border lending will begin flowing freely again. Until that is settled, the effectiveness of other factors such as the bail-in plans will remain unclear at best.

Cyprus bailout: What are individual EU member states on the hook for?

Now remember, contributions via the European Stability Mechanism (ESM) are loan guarantees, not upfront cash. But here's the break-down of how much each EU country is on the hook for in the Cyprus bailout:



Update 05/04/2013 12.10: 
By popular request, we've been asked to put together a quick explainer/refresher of how this money will be provided. ESM loans do not require direct cash from countries but are based off loan guarantees which the eurozone countries give to the ESM. The ESM then issues debt on the market to raise the actual cash to provide the bailout loans. So, not extra cash contribution on the back of this bailout. That said, the ESM does require paid-in capital (€80bn), the payouts of which should have been factored into eurozone government budgets and certainly has been included in the bailed out countries. Also due to a eurostat ruling, each eurozone member's share of ESM bailouts will not count towards its national debt. As for the IMF, the funds usually come from the IMF's general reserve fund which countries will have already contributed their subscription (see here for more details). Again, in a sense, no new cash.

Details of Cypriot bailout agreement filtering through

The package is coming together. The IMF has officially announced that it will take part in the Cypriot bailout, providing €1bn of the total €10bn in loans - that gives a UK share of around €50m (see our thoughts here on UK IMF shares). That leaves €9bn to be provided by the eurozone, likely through the ESM. Below we breakdown the country shares (click to enlarge):

Other details of the Memorandum of Understanding (MoU) filtering through include:

• 2.5% interest rate on the loan, with a 10 year grace period on repayments, it will then be repayable over a 12 year period (repayments start in 2023 and finish in 2035).
• 4.5% in cuts/savings to be found before 2018 (on top of the 7% already scheduled by 2015) to drive Cyprus from a 2.4% primary deficit now to a 4% primary surplus in 2018 (two years later than previously envisaged).
• The figures given in the MoU leaked yesterday (which reports suggest are the same in the final agreement) imply an 8% contraction in GDP this year and 3% next year. This seems optimistic and could be closer to 10% and 5% respectively, if not worse, but ultimately depends on how long the capital controls are in place for.
• Eurozone officials will review the agreement tomorrow, with a final proposal to be presented on 9 April, which eurozone finance ministers are expected to approve at an informal Eurogroup meeting in Dublin on the 12 April.
• The Bundestag could vote on the deal around the 15 April. IMF board expected to approve the deal in early May.
• First tranche of bailout funds expected in early May, ahead of debt maturing at the start of June which Cyprus needs to pay off.

A few hurdles left to jump then in terms of approval from national parliaments – which is no mean feat given that the figures underpinning the bailout are likely to come under some well-deserved scrutiny.

Why is the ECB threatening to pull the plug on Cyprus? And how would it work?

The ECB - which holds the key to Cyprus' future inside the euro by virtue of funding the country's banks - this morning issued a statement which essentially set Monday as the deadline for a Cypriot bailout deal. It said:

The Governing Council of the European Central Bank decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks.

Short but not sweet. It''s clear that Cypriot banks cannot survive without this liquidity. There either needs to be an EU/IMF bailout deal agreed by Monday or some deal with Russia to prop up Cypriot banks (although the political implications of this would be significant). Remember the four scenarios that we set out on Tuesday night following the No vote in the Cypriot parliament (which now many other analysts are echoing).

 In our flash analysis, we questioned whether the ECB might do this. We noted:

Would the ECB really pull the plug on liquidity to Cypriot banks?  

The key turning point here will be whether the ECB cuts off Cypriot banks...To pull the plug on ELA the ECB needs a 2/3 majority (15 out of 23 votes) at the ECB Governing Council. Although the Bundesbank and maybe the Dutch and Finnish central banks might vote to turn off the ELA a 2/3 majority is not certain. In fact since Mario Draghi took over the ECB it has not been particularly hawkish. Bloomberg reports that the ECB said after the vote: “The ECB reaffirms its commitment to provide liquidity as needed within the existing rules”. The crisis has shown so far that the rules of the ECB are incredibly malleable, so what exactly that statement means is unclear, but the vote could certainly go either way.

But why has the ECB taken such a tough line with Cyprus? Below we outline a few potential reasons behind its thinking (some of which were touched upon by @KarlWhelan on twitter yesterday):

• ECB rules clearly state that ELA must be provided only to solvent but illiquid banks - without recapitalisation (under a bailout deal) Cypriot banks would certainly be insolvent.
• Continuing to provide liquidity to Cypriot banks could also amount to a huge transfer of risk from depositors and investors to the ECB.
• Even if a deal is reached there are likely to be huge deposit outflows particularly from foreign depositors (even more so if the banks open without a clear deal).
• Cypriot bank ELA is currently around €9bn. Russian deposits total between €15bn and €20bn. If Russian depositors are hit hard, much of these deposits could be withdrawn.
• At almost 30% of all deposits, this would bring the solvency of Cypriot banks into question. The ECB would have to extend ELA massively to keep banks afloat – possibly by another €10bn to €15bn.
• This liquidity would therefore indirectly help fund outflows of deposits.
• Even increasing the ELA would not be sufficient if this turns into a full deposit run. This means the banks could still collapse and Cyprus could leave the eurozone. In this scenario, the Cypriot Central bank would default on its Target 2 imbalance with the Eurosystem (currently €7.5bn but it could double if the outflows are significant) leaving the ECB with a loss.
• Financially this loss would be bearable but it would hit ECB credibility hard and break the taboo of the ECB not suffering losses in the eurozone crisis, a No-No for Germany.
• If the banks collapsed but Cyprus stayed within the eurozone, the eurozone would likely have to stump up further funds to keep the country afloat. 
• Any losses from the ELA are the responsibility of the Cypriot Central Bank (and the Cypriot state which backs it), so they would not become a Eurosystem/ECB issue directly. That said, with Cyprus under a bailout programme the burden will likely fall on the eurozone since the Cypriot state would be unable to backstop the central bank alone.

So, extending the ELA without a clear deal could lead to a significant transfer of risk towards the ECB and questions over its credibility. This would be a particularly poisonous debate in Germany, something which neither the ECB nor the German government would want ahead of the German elections in September.

With this in mind, it is possible to see why the ECB has taken such a strict line here. That said, it certainly ramps up the pressure over the next few days.

Lastly, although the ECB is taking the decision based on technical considerations, it's clear the good folks in Frankfurt are now deeply embroiled in a highly political debate - precisely what the ECB wants to avoid at all costs.

What if the Cypriot parliament votes against the deposit levy?

This is the question which is now holding global financial markets on the edge - could it really happen and what would it mean, we assess the possible scenarios below.

Could the Cypriot parliament vote against the levy?

According to Reuters, Cypriot government spokesman Christos Stylianides told state radio that the vote “looks like it won’t pass”. Meanwhile, via Zerohedge:

• CYPRUS PRESIDENT: PARLIAMENT BELIEVES BAILOUT PLAN UNJUST, GOVERNMENT MAKING OTHER PLANS.
• CYPRUS PRESIDENT: PARLIAMENT WILL REJECT BAILOUT PLAN

As we were tweeting yesterday, the DIKO party (junior coalition member with 8 MPs) had said it would not vote for the deal without some improvements, although we suspect reducing the burden on small depositors could help convince them. The European Party (2 MPs) had previously said it would not support he levy, however, according to CYBC, it has now said it would support the levy if depositors are compensated with interest bearing government bonds (we assume linked to gas revenues, something which the government has already offered).

That said, according to the Cypriot press, the latest proposal sees deposits below €20,000 exempt, deposits between €20,000 and €100,000 taxed at 6.75% and deposits over €100,000 taxed at 9.9% - this is unlikely to satisfy demands to exempt smaller depositors. It also seems unlikely to raise the required €5.8bn, not least because it applies the same rate as the original to a smaller pool of deposits.

Separately, there are conflicting reports this morning on whether the vote will be delayed again. The government is unlikely to put this to a vote until it is almost near certain of getting it through.

What would the fallout be?

The fallout of voting down the package could be explosive and we can only speculate about what could happen next, but its eurozone membership would likely be brought into doubt. As we noted in our flash analysis, there are few other alternatives for Cyprus to raise the necessary cash, while the eurozone has made it clear it cannot foot the entire bill (such an option would make Cypriot debt unsustainable anyway).

The eurozone would likely give Cyprus a few days either to change its mind or come up with an alternative way of financing the €5.8bn. Another parliamentary vote could be held (the EU of course has form when it comes to demanding the 'correct' vote).

The ECB has already reportedly warned that rejecting a levy would have dire consequences. Specifically, the two largest Cypriot banks would go without recapitalisation and could see their liquidity from the ELA (sanctioned by the ECB via the Bank of Cyprus) cut off, leading to them becoming insolvent and collapsing – putting their €30bn of deposits at risk, since the government obviously cannot guarantee them. This would likely bring down most if not the entire Cypriot financial system.

With the financial sector close to or in the process of collapsing and no support forthcoming from the eurozone or ECB, since Cyprus rejected their terms, Cyprus could even be forced to leave the eurozone and begin printing its own new currency, one that would have little international trust and could lead to a spiral of hyperinflation, etc, etc (i.e. a very nasty scenario).

There is, of course, a chance that if faced with the prospect of Cyprus leaving the euro, the rest of the eurozone could blink and find an alternative way to bailout Cyprus but the politics of such a scenario would get very ugly indeed. The ECB may not follow through on its threat to withdraw liquidity for Cypriot banks but this would only be a temporary reprieve. The Cypriot government will run out of cash at the start of June when it needs to pay off a €1.4bn bond, while the banks' position could be worsened by the likely deposit outflows once banks open, even if the tax is not applied.

What are these “other plans”?

It’s not clear exactly what Cypriot President Nicos Anastasiades meant when he suggested the government is making 'other plans'. We have long noted that deeper connections to Russia remain a viable option for Cyprus. With Russia angry at the eurozone for trying to burn some of its depositors, some more financial support could be forthcoming (but maybe only for Cyprus outside the eurozone) – with significant geopolitical implications as we noted here.

Other options which have been bandied around include: a financial transaction tax and the recent proposal from Lee C. Buchheit and Mitu Gulati (the men partly behind the Greek restructuring) to convert deposits into deposit certificates with fixed long term maturities. However, the former has been widely rejected by Cyprus and may not yield sufficient funding. The latter is an interesting proposal but may only offer liquidity support rather than solvency, while the banks would still remain under-capitalised. Such a proposal would still require significant backing from the eurozone and Russia – both of which are likely to come with onerous terms – and present similar obstacles to a deal.

So, all in all a 'No' vote, however tempting to Cypriot MPs, only leaves more drastic alternatives, hence it remains a possible but not probable outcome.

Eurogroup distances itself from decision to tax small depositors in Cyprus

At some point yesterday, it became clear that Cypriot President Nicos Anastastasiades would not have sufficient support to push the deal on the deposit tax through parliament – at least not in its current form.

That led to an extension of the bank holiday to at least Thursday, the parliamentary vote being moved to 4pm GMT today (from yesterday) and the Eurogroup holding a teleconference yesterday evening.

The result of the conference was this statement, the key part being:

The Eurogroup continues to be of the view that small depositors should be treated differently from large depositors and reaffirms the importance of fully guaranteeing deposits below EUR 100.000. The Cypriot authorities will introduce more progressivity in the one-off levy compared to what was agreed on 16 March, provided that it continues yielding the targeted reduction of the financing envelope and, hence, not impact the overall amount of financial assistance up to EUR 10bn.

The statement seems to be more of a hand washing exercise than a definitive end to the issues plaguing the Cypriot bailout – i.e. do whatever you need to in order to raise the €5.8bn but don’t blame us for your political troubles.

Ultimately, it is not clear that deposits below €100,000 will not be taxed. The two options on the table remain:

-          Depositors with up to €100,000, taxed at 3%; those with €100,000 to €500,000 taxed at 10%; and those with over €500,000 taxed at 15%. (This could also include an exemption of deposits below €20,000).

-          Tax deposits over €100,000 at 15.2% and exempt deposits below €100,000.

How much difference will this move make?

Well, removing the burden on smaller depositors would be a positive one, as we have suggested. That said, with the cat out of the bag as it were, this is unlikely to dial down frustrations or concerns significantly. This option is now on the table and the political divisions it has exposed are unlikely to be easily papered over.

Despite the fact that it seems the Cypriot government played a large role in the decision to structure the tax to hit smaller depositors in the first place, the anti-German feeling seems to be rising. Meanwhile, we still believe that the position of the government – which was elected on the basis of ruling out losses for any (large or small, foreign or domestic) depositors – remains precarious.

The Great Cypriot Game - How important is gas to Cyprus' economic and geopolitical future?

Update 12:00 18/03/13:

Russian Finance Minister Anton Siluanov has had some interesting things to say on the deposit levy (via Reuters):

"We had an agreement with colleagues from the euro zone that we'll coordinate our actions."

"It turns out that the euro zone actions on the introduction of the deposit levy took place without discussions with Russia, so we will consider the issue of restructurisation of the (Cyprus) loan taking into account our participation in the joint actions with the European Union to help Cyprus."

It seems Russia is none too happy with the eurozone approach, unsurprisingly. If it does refuse to ease the terms of the €2.5bn bailout loan it previously gave Cyprus, it could hit Cypriot funding requirements, although probably not by a substantial amount. Still it could result in eurozone bailout funds being used to pay off a Russian loan in the near future - something which may not sit well with German taxpayers. Again, the interesting fall out will be to see how this impacts Russia's approach to Cyprus and the EU more broadly.

***************** Original post ********************************

In the middle ages, Cyprus was a key battle ground between great powers seeking dominance in the region. Well, the country - which, remember, only accounts for 0.2% of eurozone GDP - could become a hotspot once more (though we shouldn't be over-excited about this).

According Greek Reporter, Gazprom made an offer over the weekend to the Cypriot government to fund the bank restructuring planned under the Cypriot bailout (which is set to cost up to €10bn) in exchange for exclusive exploration rights for Cypriot territorial waters. How reliable this story is remains to be seen, but it does hint at the geopolitical tension which we have been warning about.

Gazprom is known to be very close to the Russian government and despite Russian President Vladimir Putin overtly slamming the deposit tax - calling it "unfair, unprofessional and dangerous" -  it is unlikely that they would let this opportunity pass untouched. Fortunately, the Cypriot government is said to have rejected the deal off the bat, but if displeasure towards the eurozone and the EU grows, the Russian option may become increasingly appealing.

So how important is the gas element for Cyprus' economic and geopolitical future? Well, there is no denying that Cyprus could potentially be sitting on top of gas reserves worth many times its GDP. However, as a revenue stream it is far from a sure thing. Here is how we put it in our flash analysis released on Friday:

Recent exploration has suggested Cyprus may have between €18.5bn and €29.5bn (103% - 163% of GDP) in untapped gas reserves lying in its territorial waters (according to Deutsche Bank). There have been rumours that this future revenue stream could be incorporated or used to backstop the bailout somehow. Although an appealing idea, there is still a huge amount of uncertainty around the real value of these reserves and how soon they can begin producing revenue

So far, one field has been explored (known as Block 12) and estimates of its potential value go as high as €100bn. See below for a useful diagram (via Baker Tilley):

However, there are a few key points to remember when considering the impact of this on the Cypriot bailout:

• Exports from the gas fields are not expected to begin until 2019 at the earliest. Cyprus runs out of cash in June this year, a short and medium term solution is needed now. Tapping the further reserves (beyond Block 12) will take even longer.
• There needs to be significant investment, potentially up to $4bn to begin extracting the gas – the Cypriot government certainly cannot afford this. Although there is sizeable interest in the exploration rights, the FT’s Nick Butler notes that Noble Energy (which explored Block 12) is not bidding for further rights, which raises some concerns.
• Furthermore, Turkey is still contesting Cyprus’ ownership of these reserves. Although Cyprus currently has the backing of the international community, this dispute could further hold up progress in tapping these reserves. Many of the energy companies looking into Cyprus also have interests in Turkey and may not want to put those at risk.

To us then, the offer by the Cypriot government to provide Cypriot depositors with bonds linked to gas revenues sounds like a nice idea, but will not compensate these depositors for some years, at best.

But, remember with a view to Moscow, this is definitely one to watch.

A vote on whether to leave the euro? What's next in Cyprus?

This will be another eurozone nail-biter. 

The deal agreed by eurozone finance minister on Friday to tax Cypriot depositors (and some other conditions) in return for a €10bn bailout still needs to get passed some hurdles. As ever, there's one huge "hurdle": democracy.

The Cypriot parliament needs to approve the deal before it can become reality. The parliament was due to begin debating the issue today, but his meeting has now apparently been postponed. As things stand at the moment, the Parliament is due to hold a vote at some point before Monday night (although we imagine they will be under some pressure to get it done sooner rather than later. Monday is a bank holiday in Cyprus, but markets will be watching).

Here are some key questions about the next steps:

Could the Cypriot Parliament vote the package down?

A statement from the Cypriot President Nicos Anastasiades last night made it clear that he considers a No an effective vote to leave the euro. As in so many of these "desperately needed bailout meets parliament  scenarios, Cypriot MPs will probably be too frightened of the consequences to vote the package down. After all Cyprus is a very small country, having its own free floating currency is probably not a sustainable long term option, especially since leaving the euro would likely see a complete collapse of its banking sector and a very large default – very few people would have much trust in any new currency.

But a No is still not out of the question. As Kathimerini points out, the Democratic Rally (DISY) and the Democratic Party (DIKO), the parties which supported President Anastasiades in his recent election, do not have a majority – only 28 out of 56 MPs. AKEL the main left opposition party (which has 19 MPs) has said it will vote against the package, while DIKO has recently seen at least one MP who does not support Anastasiades split off.

The package may also get support from the European Party (2 MPs), but the Movement for Social Democracy and the Ecological and Environment Movement (5 and 1 MP respectively) have suggested they could vote against the deal.

So, currently the vote could be 30 in favour and 26 against. However, one of the reasons for postponing the vote seems to be to give the government more time to rally support, so it's still a very fluid situation.

What happens if the Parliament rejects this deal?

Unclear. But it could be down to two options: either Germany and other creditor countries soften up the conditions, most likely on depositors, or Cyprus may be forced into default, which most likely means leaving the euro.

Political and popular support may align against the euro

And regardless, much of the population and at least half the political establishment do not seem to support this deal and although there may be few other options on the table in the immediate future, that could seriously undermine the country’s political stability or its long term membership of the Eurozone.

Pushing Cyprus closer to Russia?

As we have noted before, the geopolitics of the situation here are very delicate. Most other small European countries have few alternatives in terms of support structure, however, Cyprus has Russia. Russian support could begin to look increasingly attractive due to fewer overt conditions (although the more covert conditions are likely to be onerous). Comments by certain European leaders over the weekend have suggested the situation in Syria could escalate. As we have pointed out before, Russia has previously sought to move its only naval base in the Mediterranean from Tartus, Syria to Cyprus – an escalation could renew this desire while financial support could provide an avenue to make it happen.

This is of course a distant prospect, but the point is that, the political fallout of this move could be very significant not just within Cyprus but for the EU as a whole. This needs to be handled with utmost care...

Cyprus bails-in depositors to reduce cost of Eurozone bailout - a turning point in the Eurozone crisis?

Well, we said it was going to have an impact well beyond its size (0.2% of Eurozone GDP).

Overnight, the Eurozone and Cyprus took the unprecedented step of announcing a tax on depositors in order to raise the necessary funds to recapitalise Cypriot banks and reduce the cost of a bailout. Have no doubt, this is a very radical measure and one that, admittedly, we did not believe would happen for just that reason.

Here are the details of the plan:

One-time 9.9% levy on deposits over €100,000
6.75% levy on deposits below that level
Cypriots hit by the deposit levy will be given bank shares of equal value
Increase in corporate tax rate to 12.5% (from 10%)
€1.4bn in privatisations
€10bn bailout loan (likely including the IMF)
Cypriot debt to GDP to be at 100% in 2020

The seizure of deposits will happen over the weekend, while there is conveniently a bank holiday on Monday in Cyprus. Depositors will be unable to move funds, even electronically, before the move is complete on Tuesday (more on this further down). As we said, this is clearly an unprecedented move and the fallout will be interesting, below we list the key points to watch as this progresses.

This will hit normal Cypriot taxpayers hard: Perhaps the most surprising (and worrying) point of the deal is that even those with deposits below €100,000 will be hit. Cypriots will receive bank shares in return but surely after this move they will decline in value quickly and are no comparison to a deposit in terms of risk and liquidity.

Banks and funds have escaped somewhat: With all the focus being on ‘illicit’ Russian deposits it seems that the usual steps of bailing in bank creditors and sovereign creditors have been skipped, this will make the point above even more painful. As we noted in our analysis yesterday, writing down bank creditors or sovereign creditors would be tricky and yield little monetary benefit. However, it is still strange that when taking a step as radical as this the Eurozone did not force some losses on banks and those holding sovereign debt, even as a gesture to the taxpayers who are now footing the bill. The fallout of this politically could be serious (see next point).

The Cypriot government position looks almost untenable: During the recent election campaign and the start of the negotiations the new Cypriot government flat out rejected a deposit tax, even just on foreign depositors. It has now rolled over and accepted one on domestic depositors as well. Surely, it cannot last out its 5 year term. It is not yet clear whether new elections could be on the cards, but the potential for civil unrest is significant – not only is the Cypriot population footing much of the bill but since there is still a Eurozone loan they will also likely face austerity conditions.

Germany put its foot down: By many accounts, Germany entered the negotiations with a radical stance, arguing from the start for a large hit to depositors. It is clear that, with elections looming, the German government is no longer willing to simply foot the bill to avoid contagion. This could be a very important turning point for the Eurozone crisis.

Does this move break EU rules on capital controls and/or deposit guarantees? As noted above, it seems that depositors will be blocked from withdrawing their funds from banks. For other EU depositors this surely amounts to a form of capital control – strictly forbidden under the EU Treaty. Furthermore, as Sharon Bowles MEP has been tweeting, this move makes a mockery of the current EU rules on deposit guarantees below €100,000. The Eurozone may protest that the bank shares given in exchange are of the same value, but this is a very thin argument. Either of these issues could be challenged at the European Court of Justice.

It seems some lessons of Greece et al. have been learnt: As our flash analysis yesterday showed, our main concern with Cyprus was that the Eurozone has failed to learn lessons from its experience in Greece et al. Clearly, the need to put debt back on a sustainable footing has been realised – although 100% debt to GDP in 2020 is still not entirely sustainable, we will wait for more details before passing final judgement on this.

Contagion could be significant: The Eurozone is arguing that Cyprus is a one-off – sound familiar? This is unlikely to hold. The on-going backstop of the ECB OMT will help, as will the fact that the bailout countries already have funding secured. That said, with many of their debt levels still do looking unsustainable ,it is very possible that depositors could become increasingly skittish.

Such a radical move was necessary because the Eurozone lacked more precise tools: Cyprus is a cut and dried case of where a bank resolution fund would have solved most of the problems. The fund could have bailed out the banks directly and restructured the financial sector without burdening the state or depositors. The state’s funding gap could have been covered by privatisations and tax increases, and possibly a very small international loan. It should not be lost on the Eurozone or anyone else, that this situation partly arose due to complacency and a failure on the part of Eurozone leaders to move swiftly to correct the structural flaws in the Eurozone.

This decision is ultimately a very mixed bag. On the one hand the Eurozone has taken a radical step to try and put debt on sustainable footing rather than just proceeding with a massive taxpayer funded bailout (although it must be remembered Cyprus is still getting a bailout worth almost 60% of GDP). That said, the decision to force the losses on all depositors is a radical and politically explosive one. The fact that losses were not enforced all round, on banks and funds, leaves a bad taste in the mouth. On a wider scale, the fact that Germany is no longer willing to provide bailouts at any cost must mark a big change in the crisis. With Italy and Spain still mired in political and economic problems this point will surely be in the back of their minds from now on. Can German approval of access to the ESM and OMT be taken for granted anymore? It may be that Cyprus is small enough to be a special case, but that cannot be a given.

In terms of forcing a change in the Eurozone crisis it seems that Cyprus may be the straw that broke the camel’s back.

Are Greek banks improving or struggling for liquidity?

Those who followed our analysis of the Greek bond buyback will remember that we warned at length that it could have some adverse effects, one of which would be to hit bank liquidity at a time when Greek banks could least afford it.

In the end Greek banks were pushed to take part by the government but their resistance (despite being reliant on the Greek Central Bank for liquidity and the eurozone for a recapitalisation) was quite telling.

In any case, data is now beginning to emerge which sheds some light on the issue but also provides plenty of questions (as always with Greece data releases are some months behind elsewhere so the latest data available is for January 2013).

Greek bank borrowing from the ECB and the Greek Central Bank (via ELA) has dropped significantly since the bond buyback at the start of December (down €21.3bn since November 2012).

 

Now, normally a sharp drop in borrowing from the ECB and ELA would be a positive thing since it suggests reduced reliance on official funding. However, in this case, we suspect that rather than improving their position, banks are actually struggling to find sufficient assets to post as collateral with the Bank of Greece to gain liquidity.

Other factors do support this argument. The Bank of Greece annual accounts show that the overall collateral pledged for central bank liquidity fell by €11.7bn in the aftermath of the bond buyback, while borrowing from the central banks fell by €7.5bn (data for January is not yet available). Furthermore, with total assets pledged for collateral still totalling €217.1bn or 50% of all bank assets in Greece it is easy to imagine that the banking sector is working under significant collateral constraints.

Are there any other potential explanations?

Well, the first would be that banks repaid their borrowings from the ECB’s Long Term Refinancing Operation (LTRO) in January. This seems very unlikely. The LTROs coincided with a period of extreme turmoil in the Greek banking sector due to the Greek debt restructuring, a period in which Greek banks could not access the ECB. Therefore, it is unlikely that Greek banks borrowed much if anything from the LTRO. Besides, if they did, it seems strange that they would give back a key source of long term funding early.

The second explanation could simply be that confidence has returned somewhat. There is some evidence to support this, not least the return of domestic deposits, which have increased by €12.1bn since November 2012. However, that still leaves a drop in central bank borrowing of €10bn which does not seem to have been filled by other sources of liquidity.

Lastly, the bank recapitalisation is being enacted, which could reduce the Greek bank demands for liquidity, although since it isn’t expected to be completed until end of April it would seem strange if the impact showed up this early on.

Overall then, there seems to be some strong evidence that the Greek bond buyback has hit the liquidity access of Greek banks, albeit not in a catastrophic way. More importantly though it has happened at a time when credit provided to the real economy continues to contract and economic growth remains some way off.

Update 16:30 13/03/13: 
@EfiEfthimiou has flagged up a good point over email. In December 2012 the ECB began accepting Greek government bonds as collateral again, this allowed banks to switch from using the more expensive ELA to standard ECB liquidity. The haircut on collateral may also be lower under standard ECB lending (we can't be certain since ELA terms are secret). This could have allowed the banks to reduce their liquidity needs and the level of collateral posted - another potential explanation then.

Could the UK be asked to contribute to a Cypriot bailout?

As we have noted before, the potential impact of the Cypriot bailout has the capacity to extend well beyond what would be expected of a country accounting for only 0.2% of eurozone GDP.  This impact is now also lapping at the UK shores.

As we flagged up in our press summary today, new Cypriot Finance Minister Michalis Sarris said over the weekend:

"There are indications that London would participate in a package…for a country that has special links with the U.K., if it were necessary, some way could be found to help in a transitional manner."

This comes a bit out of the blue since there has generally been an unspoken agreement - as well as some formal guarantees - that the UK would not participate in any further eurozone bailouts.  That said, the inclination here seems to be that given the historic ties between the UK and Cyprus, the UK may be more willing to contribute – similar to the Irish bailout.

Apart the IMF - which could play a role and to which the UK contributes - there's another plausible avenue: the European Financial Stabilisation Mechanism (EFSM), which the UK partly underwrites via the EU budget. This fund has around €11.5bn left to lend if needed, while there is always the Balance of Payments facility (which we discussed in our paper on Grexit last summer). The EFSM is also decided by QMV although consensus is usually sought since it is politically controversial to activate. In any case, theoretically the UK could still be dragged in.

That said, it seems pretty unlikely and it would be seen as a pretty hostile move – we also imagine other non-euro countries such as Sweden, Denmark and Poland would not be keen to fund a country to which they have few links. Unsurprisingly, the WSJ cites UK diplomats dismissing the prospect out of hand.

But Sarris’ comments are a reminder that the eurozone crisis continues to impact the UK in a number of ways.

Monti's candidacy set to make Italy's election season a rollercoaster ride

Last month, the Economist used the Oscar-winning exhortation, "Run, Mario, run" to urge Mario Monti to "come out fighting" in the Italian general elections. Detto, fatto. Monti has put his boxing gloves on and entered the ring. On Friday, he unveiled the logo for his new list (probably not the most exciting one, as you can see from the picture).

However, in what is a high stakes game for Italy's future, Monti's candidacy may ultimately turn out to be more divisive than initially thought - particularly since Italian voters do not seem particularly receptive to his reformist message. 

Democratic Party leader Pier Luigi Bersani had initially claimed he was willing to broadly continue with the reforms initiated by Monti's government, and be "open and generous" towards other centrist, pro-reform forces. However, Monti has now become the leader of those centrist forces - and a rival in the race for Italian Prime Minister. As a result, the Democratic Party is now focusing its efforts in stressing the differences, rather than the similarities, with the 'Monti agenda' - and is strengthening its ties with the smaller left-wing SEL party, which wants a "radical change" in the economic policies implemented by Monti's technocratic government

It is hard to see such a coalition making significant progress in opening up Italy's labour market - something which should top the agenda of the next Italian government, if the economy is to do more than simply run to stand still.

As we have mentioned before, Italy's complicated electoral law is going to play a key role in determining the final outcome of the elections. The rules for the lower chamber of the Italian parliament basically establish that the winner takes it all - and guarantee a solid majority of seats for the party/coalition which gets the most votes. Monti and his centrist bloc are currently polling at 14-15% - well behind the centre-left coalition (on 38-39%) and even the centre-right coalition between Silvio Berlusconi's PdL party and Lega Nord (on 26-28%). Therefore, Monti's clout in the Camera dei Deputati is likely to be marginal. 

However, there are different rules for the Italian Senate - the upper chamber. Italy's electoral law establishes that seats in the Senate are assigned on a region-by-region basis. More specifically, the party/coalition which gets the most votes in a specific region automatically wins 55% of the seats up for grabs in that region. This means that, even with almost 40% of votes nationwide, the centre-left coalition led by Bersani could have a majority in the lower house but fail to secure a majority in the Italian Senate.

And this is where Monti could still potentially have some decisive influence - he knows he might end up being the kingmaker in the Italian Senate (which has equal powers to the lower house). Monti has effectively ruled out working with a government with which he does not agree "on at least 98% of policies", but this could yet prove to be a pre-negotiation tactic designed to entice the Democratic Party to the centre ground.

To sum up, the arithmetic of the polls and Italy's complex electoral rules mean that the outcome of Monti's jump into the fray remains far from certain. His candidacy has injected some much-needed economic reality into Italian political debate - which has in turn increasingly made him a focal point of opposition from both the left and right. Yet, he might still wield influence in the formation of the next government.

Berlusconi's Senators fire warning shot across Monti's bow

We told you that the four months to the next Italian general elections could be a very long time. And the political situation in Italy could be set for more ups and downs due to the events of the last 24 hours.

This is what happened:

• Last night, Silvio Berlusconi put out a communiqué saying that he is "besieged" by people asking him to run in next year's elections, and will make his final decision "within the next few days". 

• This morning, Italian Economic Development Minister Corrado Passera (in the picture) was critical of Berlusconi's declarations, arguing that "anything that can make the rest of the world even only imagine that we are going backwards is not good for Italy". A clear invitation to Il Cavaliere to enjoy a peaceful retirement.

• Retaliation has been immediate. Mario Monti was facing a confidence vote in the Italian Senate this morning on a new set of (badly needed) measures to boost the competitiveness of the Italian economy, drafted by Passera himself. A majority of senators from Berlusconi's party did not take part in the vote, while a smaller group abstained. 

• Crucially, the leader of Berlusconi's senators, Maurizio Gasparri, said ahead of the vote, "Our attitude [today] signals...the shift of our group to a position of abstention towards the government." This seems to suggest that Berlusconi's party has withdrawn its support for Monti's government.

Monti, who rushed to Palazzo Madama to cast his vote, given that he is a 'senator for life', survived this time. But if all of Berlusconi's senators show next time and abstain (which, by the way, cannot be taken for granted, given the internal divisions created by Il Cavaliere's latest hints to a comeback), Monti would be in danger of losing his majority - since absent Senators' votes do not count and bring the required majority down, as happened a couple of hours ago.

The big question is: was today's an isolated incident or a definitive change of position? Gasparri's words seem to suggest the latter could be true. Should this be the case, Berlusconi could be about to trigger another round of political uncertainty Italy really doesn't need.
 

Political risk and uncertainty remain Italy's Achilles' heel (an early pre-election overview)

We have not looked at Italian politics for a while on our blog, but do not think the Italian political scene has been uneventful, with the general elections scheduled for April (although they could still be brought forward one or two months).

There is still huge uncertainty in Italian politics and one important question remains completely unanswered: will the next Italian government be able to continue Mario Monti's reforms, needed to convince markets and EU partners that Italy can be competitive inside the euro?

As we have argued before, while the short-term risks in Spain relate to banks and funding needs, the trigger points in Italy are largely political.

An overview of where Italian politics is at explains why. Bear with us:

The Five-Star Movement: The one to watch

The Five-Star Movement, led by comedian Beppe Grillo, remains the dark horse - not least since it remains broadly 'anti-euro' and in favour of a referendum on the country's membership of the single currency. Grillo is not himself going to run for Italian Prime Minister. Instead, the party is currently selecting its candidate through a four-day online internal election - with over a thousand candidates taking part in the experiment. Grillo and his grillini are still polling at around 20% but have ruled themselves out of any alliances with the 'old political establishment'.

The question is whether people will actually vote for the party in the end, given that it has said it will not be in government no matter what happens (perhaps not wanting to 'waste' the vote). But if the party does perform according to current polls, expect shock waves through Italian politics.

The centre-left and the alliances dilemma

On Sunday, Italy's largest centre-left party - the Democratic Party (PD) - named Pier Luigi Bersani its candidate, the party's Secretary General, who won the final run-off of an internal election against Florence Mayor Matteo Renzi. Not exactly the 'fresh face' many think Italy needs - he has already served four times as a minister. He is also an old communist.

However, despite his political past, Bersani did push through a couple of laws aimed at opening up certain 'closed' professions during his years as Economic Development Minister (2006-2008), so he may not be all bad news.

Alliances are the real problem for Italy's centre-left, though. It looks certain that Bersani's candidacy will be backed by the smaller Left, Ecology and Liberty (SEL) party - led by Nichi Vendola, the Governor of Southern Apulia region. Vendola has already made clear that he wants to support a government whose agenda "has the scent of the Left". Therefore, his presence in a hypothetical coalition will make it far more difficult for Bersani and his party to pursue the necessary reforms - particularly when it comes to Italy's labour market, which clearly still needs to be opened up.

In addition, according to the latest opinion polls, PD and SEL would together secure around 36% of votes - which means that more allies would probably be needed to form a stable government (unless the existing electoral law remains in place, which may be the case in the end). Bersani has floated the idea of joining forces with Pierferdinando Casini and his centre UDC party. But Casini addresses a Catholic, socially conservative electorate - which does not sit well with Nichi Vendola, who is, among other things, a staunch supporter of gay marriage in Italy.  

The centre and the 'List for Italy': Working for 'Monti reloaded'

Given the difficulties in finding a place in the centre-left coalition, the UDC party is working on a 'List for Italy' along with two other smaller centre parties - Future and Freedom for Italy (FLI), founded by Silvio Berlusconi's former ally, Gianfranco Fini, and Italia Futura, the new movement founded by the Chairman of Ferrari, Luca Cordero di Montezemolo.

The aim is to give Mario Monti a political platform to remain as Prime Minister. This would make Monti a 'phantom candidate'. On paper, this is a smart way to get around the fact that Monti cannot stand in the elections, because, as a 'senator for life', he already has his seat guaranteed in the Italian parliament. However, the latest polls show that, together, the three parties would only win less than 10% of votes. And Monti's support amongst Italian voters is in free fall.

The centre-right: Silvio still hasn't left the building

The fate of Italy's centre-right depends on Silvio Berlusconi's final decision - in case you thought Silvio was going anywhere. Will he run for Prime Minister or not? On this blog, we followed all Il Cavaliere's deliberations closely (see here and here). The Italian press speculates frequently about the risk/chance of Berlusconi announcing a comeback. There are also growing rumours that Berlusconi may set up a new political party.

For the moment, the internal elections to choose the centre-right candidate for Italian Prime Minister have  been put on ice - waiting for Berlusconi's decision. Berlusconi's comeback - given that the guy has so far faced around twenty different trials, a couple of which still under way - would raise a lot of eyebrows but also upset many people within his own party. PdL is also currently polling at less than 15% and seems to be heading for a bitter defeat.

So all of this points to a lot of post-election political uncertainty in Italy - as we have noted before. A new, quite complicated electoral law, that would make 38% of votes sufficient to secure an absolute majority of seats in the Italian parliament, is currently being negotiated and could also change the dynamics (although it is far from certain that the law will be passed).

Four months can be a very long time in Italian politics, so watch this space for further updates.   

Spanish deficit: The saga continues

Keeping count of how many times Spain's deficit targets and forecasts have been revised has become a challenging exercise. Following the publication of its draft budget for 2013, the Spanish government has admitted that Spanish deficit at the end of this year will be as high as 7.4% of GDP - with the EU-mandated target fixed at 6.3% of GDP - once the potential losses on the government's recent cash injections in the banking sector are taken into account.

However, pending official confirmation from the EU's statistics body, Eurostat, it looks like aid to banks will not be counted in the Excessive Deficit Procedure (EDP) currently open against Spain. Speaking after his meeting with Spanish Prime Minister Mariano Rajoy yesterday, EU Economic and Monetary Affairs Commissioner Olli Rehn suggested,

It can be expected that this kind of element of increase in the fiscal deficit related to bank capitalisation will be treated as a one-off and will not affect the structural deficit.  

We would not be too sure that this settles the question, though. First of all, the EDP covers more than just the structural deficit while other one off impacts (such as Portugal's transfers from its pension funds) have counted towards reducing the deficit. Secondly, it will be interesting to see how Germany, Finland and others will react - given that, in practice, Spain has just said that it will fail to meet its deficit target again.

In the meantime, as we pointed out on this blog last week, the time for big decisions is approaching for Rajoy. The results of the stress tests have been published, and the draft budget for 2013 has been unveiled. In particular, both the European Commission and Spanish Economy Minister Luis de Guindos have stressed that the measures planned by Madrid for next year go "beyond" the recommendations Spain has been made under the new 'European Semester' - potentially paving the way for an EFSF/ECB bond-buying request without unexpected additional conditions attached to it.

Unsurprisingly, rumours of an imminent request have kicked off. According to a senior European source quoted by Reuters,

The Spanish were a bit hesitant but now they are ready to request aid.

With the next meeting of eurozone finance ministers taking place on Monday, this weekend looked perfect for Madrid to apply for an EFSF/ECB bond-buying programme. However, Rajoy reportedly told a meeting of regional Presidents from his party that he would not make the request this weekend. During a press conference less than an hour ago, he also replied with a curt 'No' to a journalist asking whether the request was "imminent."

The domestic political reasons for a delay in the decision (key regional elections in Basque Country, Galicia and Catalonia over the next two months, plus the obsession with avoiding humiliación) are well-known. Apparently, Germany is also standing in the way. Sources have suggested that the German government is keen to "bundle" Spain, Cyprus and Greece into a single dossier, rather than submitting individual aid requests to the Bundestag for approval.

Beggars cannot be choosers, and Rajoy cannot simply ignore Germany's reservations. Luckily for him, they could even turn out to be convenient on the domestic front. As in previous instances, though, the markets will likely play a big role in the timing of any bailout: a sharp surge in Spain's borrowing costs could certainly precipitate a request. Should this happen, Rajoy would find plenty of occasions to present a formal request for aid - the next one potentially being the EU summit on 18-19 October...  
 

Too soon to jump to conclusions: the Dutch debate on Europe has only started

As we said in our pre-election briefing, the Dutch elections saw a shift back to the centre, compared to the early signs of the campaign. Granted, a stronger combined majority for the two main parties - centre-right VVD and centre-left PvdA - than many had expected. The Socialist Party stayed on the same number of seats as last time around, while the populist Party for Freedom suffered a pretty heavy defeat (losing nine seats).

Senior Brussels figures were quick to hail the result as a victory for the pragmatic, pro-European centre over the crazy fringe. A victory for further European integration, euroscepticism can't win votes, sort of thing. Some media outlets drew similar conclusions - with some exceptions - claiming the anti-bailout mood in Europe is much over-stated. But is this interpretation right?

There's no doubt that the centre parties mounted a strong comeback, in the face of an increasingly sceptical public on Europe. But to see this election as a victory for the very specific vision of Europe that involves "ever closer union" is spurious. A few points:

First, Geert Wilders is no proxy for unease about where Europe is heading. In almost all aspects of policy Wilders is extreme, and his decision to bring down the last government has undoubtedly worked against his party. The Dutch may not like bailing out other countries, but they do not like reckless politicians either, and some voters considered a vote for him wasted.

As we noted in our pre-election briefing, the centre parties too - particularly VVD - have struck a more euro critical tone of late, perhaps in response to the strong rhetoric coming from Wilders and the Socialist Party. On Europe, the VVD may have crowded out Wilders, particularly by talking tough on bailouts. Regarding Greece, almost exactly repeating Wilders's words, Prime Minister Mark Rutte said, for example, that:

“Enough is enough…An exit may be inevitable, but it will be up to Greece to make that decision…An orderly exit is possible, but not desirable.”

In a comment piece in the FT last year, Rutte was one of the first to call for a clear mechanism to push countries, which do not meet the austerity targets, out of the eurozone – at the time widely acknowledged to be a shot across Greece’s bow. On the EU budget, he has sided with the UK in trying to achieve a real terms payments freeze in the EU's 2014-2020 budget, saying, "If we countries need to cut our budgets, also the European institutions need to do with less."

The Social Democrats, led by Diederik Samsom, played a role in triggering the elections by refusing to support the previous government’s budget dictated by EU deficit rules. It is true, this was their prerogative as the opposition. Nonetheless, they did their fair share of anti-Commission posturing such as:

"[It's about] how the Treaty is being applied…The economy is suffering damage in an unnecessary way because of the demands of the Commission".

And during the election campaign, the party had some other interesting things to say about European integration, such as:

“I’d reserve [Eurobonds] for the moment Europe is away from the abyss. Eurobonds are no rope to drag you out of the abyss. Economies need to converge and public debt needs to stabilise first.”

“I don’t support the blueprint of [EU-federalist D66 leader Alexander] Pechtold with his European government, Finance Minister and Parliament.” 

In the party manifesto, it called for a reduction to both the EU budget and the Dutch contribution to it - not even the UK Tories did that.  

Equally, Europe Minister Ben Knapen, a CDA member - whose party may be needed to achieve a government with majority in both houses of the Dutch parliament - said that "there should be a legal possibility for countries to voluntary or forcefully leave the eurozone. Only then the moral hazard - which is like a hostage - can be dealt with". He also urged to "correct the power the European Commission, which has been enormously growing in recent years."
 
On the wider point about the Netherlands in Europe - and whether this election will make it more or less assertive - the centre parties may be far more supportive of the status quo in Europe, but they are different on economic and social policy, completely different sides of the political spectrum in fact. Making the coalition work at all will be a huge challenge. Throwing the difficulties of the eurozone crisis into the mix makes the task even harder, while any pressure for greater integration may force the governing parties to be seen as acting tough, under the pressure from opposition parties.

No, the Dutch haven't turned into head-banging eurosceptics. But all of this is to say that the debate about the Netherlands' role in Europe, in the face of further euro integration, may just be kicking off.