The Cypriot bailout is likely to mark a new turning point in the euro area’s debt crisis. Akin to the declaration of Deauville in October 2010, when German Chancellor Merkel and then French President Sarkozy first threatened private creditors with losses in future rescue packages, post-Cyprus bailout comments by Eurogroup Chairman Dijsselbloem (and others) sent a strong signal to markets that bail-ins of bank creditors will now be the norm rather than the exception.
As we argued last week, bailing-in bank creditors is not inappropriate per se. But it is dangerous when the banking sector as a whole remains fragile and funding remains constrained. Market developments over the past few days have clearly highlighted these risks. Since the Eurogroup announcement of the details of the Cypriot bailout deal on 15 March, European banks’ generic 5Y CDS index has risen by more than 35% to its highest level since October last year.
European financial CDS index
Source: Bloomberg and Daiwa Capital Markets Europe Ltd.
Similarly, financing costs for banks in the periphery have also risen sharply since the decision to bail-in depositor in Cyprus. Bond spreads of Italy’s two largest banks have widened by approximately 40bps and by as much as 80bps for more vulnerable second-tier banks in Italy, Portugal and elsewhere in the periphery. This will not only put further upward pressure on bank lending rates, but also aggravate peripheral banks’ already strained market access.
Indeed, a continuation of the recent successful bond market returns of many peripheral banks seems unlikely. Moreover, downward pressure on deposits is likely to increase too in coming months, further adding to peripheral banks’ funding constrains. With household net disposable income expected to decline, on average, by around 2%Y/Y this and next year, negatively affecting savings rates, deposit growth will slow considerably or remain negative in the periphery in the foreseeable future. And having seen what's happened in Cyprus, depositors will now be much more careful about where they put their money for fear that it will be frozen or, even worse, expropriated.
But the ramifications are broader than this. With funding pressure on peripheral banks intensifying, their dependency on cheap ECB liquidity is bound to increase. This comes amid pressure on banks in Portugal and Spain to lower their reliance on ECB liquidity as part of their respective adjustment programmes, substantially aggravating the required deleveraging process in these economies. Portuguese banks, for example, are required to lower their loan-to-deposit ratio to 120% by end-2014, from currently close to 150%.
Of course, all of this will contribute to deepen the credit crunch in the periphery, choking economic recovery. The latest ECB data released today highlight the scale of the problem. In February, compared to a year earlier, loans to non-financial companies were down by 12% in Spain, and by 8% in Portugal, crushing investment. And in light of the renewed deterioration in business sentiment amid the broad-based return of political uncertainty, downside risks to the euro area’s growth outlook have clearly increased in recent weeks.
This has not left sovereign bond spreads unaffected. Although a stronger focus on private sector involvement (PSI) should arguably have reduced the potential bailout costs of weak sovereigns in the absence of a true banking union, Italian and Spanish sovereign bond spreads edged up by around 30bps in the past few days and by 50bps in Portugal. Indeed, if the Cypriot bailout creates a precedent, which we think it does, the risks of a restructuring, sovereign or otherwise, have clearly increased in the periphery.
Even if a sizable share of creditors are non-residents as in the case of Cyprus, any decision ultimately to go down the PSI route in Spain, Italy or Portugal would almost certainly go hand-in-hand with a deeper recession and a steeper rise in the debt-to-GDP ratio than otherwise would be the case. Moreover, if accompanied by eye-watering fiscal consolidation, which seems likely to be the norm in the euro area, bail-ins could well lead to economic depression and further default.
PSI, therefore, has to be used carefully, has to be predictable and must be accompanied by a major institutional overhaul of the euro area. But this looks unlikely to happen anytime soon. Indeed, the approach taken towards Cyprus, and the subsequent comments of various euro area policymakers, not least Dijsselbloem, suggest that there is little appetite among the Northern countries in particular for closer fiscal integration.
So, the markets’ reaction to the events in Cyprus appears warranted. Just how far the correction will go, of course, is impossible to tell. Following the Deauville declaration in October 2010, Irish and Portuguese 2Y sovereign bond spreads rose by more than 300bps. Thanks to the ECB’s OMT programme and its generous liquidity provisions to euro area banks, however, this is unlikely to be repeated. But with senior creditors, including uninsured depositors, now facing significantly larger risks of bail-ins in future crises, and with risks high that economic conditions deteriorate beyond current expectations, credit and sovereign spreads don’t look set to return to their post-Draghi “whatever it takes” lows anytime soon.
Tobias S. Blattner
Euro area Economist