What do recent events in Cyprus spell for global deposit holders? Matthew Sherwood finds out.
Every nation, no matter how small, eventually gets its 15 minutes of fame and it’s usually not for good reasons.
So it is with Cyprus, where the plan to fund a bailout program by taxing bank deposits has prompted emotional responses from every Cypriot resident to Russian President Putin.
The photos of long lines leading up to ATMs have been great public relations for the anti-austerity movement, but nothing says potential economic upheaval as clearly as a bank run.
While Cyprus is ranked 95th in the world in terms of nominal economic output in 2011 (of USD25 billion), the country is ranked 23rd in terms of quality of life and it is ahead of many of its European peers such as France (25th) Germany (26th) and the United Kingdom (29th).
Over the past nine months, the European Central Bank has taken the necessary action to break the lethal nexus between government funding stress and financial system stress through its Outright Monetary Transaction program.
However, the announcement of a deposit levy could undo all of that hard work.
The sheer size of the Cypriot economy indicates it is too small to bring down the global financial system by itself if a bank run occurs, but the country is larger than Iceland (AUD14 billion), which was the first country to go broke during the GFC.
Some have called the deposit levy decision a ‘blunder of historic proportions’ as the safety of bank deposits is one of the most entrenched trusts that people have.
Nevertheless, it beats a run on the banks and is relatively no different to currency depreciation or higher inflation, in that savers are punished and have less spending power.
It is the same end result, just by different means. The only difference between a deposit levy and a currency depreciation or inflation, is that the levy is transparent, measurable and unavoidable to households, whereas the other options are harder to gauge and measure and can be avoided depending on consumer preferences.
The fact that this approach of haircutting depositors was sanctioned by European leaders could lead the public to think it could happen again.
Despite talk of the levy being a ‘one off’, statements have been made that the approach could become the norm as government balance sheets are exhausted from previous bailouts.
Accordingly, the risk is not Cyprus, but is contagion into larger countries and it is reasonable to expect a high level of uncertainty among depositors across stressed European countries.
While a crippling Cypriot bank run remains a tail risk, were periphery depositors to withdraw funds from stressed regions, it would make weak institutions even weaker and in this way, the bailout and deposit levy can be seen as a backward step.
With the levy having negatively impacted the public’s perceived integrity of deposits, a key question to ask is which countries are most exposed to financial stress and a potential bank run.
The two key metrics are the size of the deposit base and the magnitude of government debt.
Examining these indicates that four countries have above average debt and below average deposit bases: Greece, Italy, Belgium and Germany (see Chart 1, where the top left quartile is the worst place to be).
While Germany does not appear to be at risk, given its industrial base and superior economic growth rate, its continual bailing out of its regional peers has impacted its balance sheet and its growth rate.
However, the most likely bank run target appears to be in Greece where government debt to GDP is high and deposits to GDP low (both at 170 per cent).
The next most ‘at risk’ country is Italy, which has high debt, low deposits and a dysfunctional political system, whereas Moody’s says the outlook for Belgium’s banking system remains negative due to weak regional conditions, low asset quality and tough funding conditions.
Another important trend to consider is the trajectory of the countries through time on this matrix.
Given the absence of any economic recovery in Spain and France, it is likely that their debt will continue to rise throughout time and this should push their current debt positions higher and it may also have the potential to encourage investors to move deposits to other countries, placing them at increased risk in deposit markets.
Since June 2012, the share prices of global banks have all rallied strongly and the southern European banks have participated strongly in this trend, but (unlike their northern European and global peers) they have still been unable to raise their price-to-book value beyond what it was at the start of 2009 (see Chart 2).
As such, despite a strong price increase in the past eight months, the largest risk for southern European banks is not valuations, it is the state of their balance sheets and the fact that they need large equity injections to stabilise their situation and to best protect them from the impact of potentially large capital flights.
The 25 per cent rally in global shares since June 2012 has primarily been driven by strengthening views that the worst of the crisis is over and the tail risk of a Euro break-up is fading.
While the latter is clearly not the case, the keystone for the market’s resilience to increased European stress has been the solid (albeit sub-trend) US recovery, including a turn-around in its housing market.
Over the past year, house prices, construction jobs and housing construction have all turned and are pointing in the right direction.
While this improvement has not led to a strengthening in the global or US economic and earnings outlook (although Japan has strengthened recently), the more robust foundations in the US growth trajectory and continued policy support have increased investor confidence and underpinned higher valuations as over-sold stocks rallied.
The US recovery has also taken place in the US labour market, where the average monthly jobs growth in 2012 (+182k per month) has been the second highest since the turn of the century, with the number of job openings back at a five-year high, which has helped lower the US unemployment rate to its lowest level since 2008 (see Chart 3).
Nevertheless, understanding what has been driving markets over the past eight months partially justifies the limited market reaction to the Italian elections and Cypriot developments.
The other side of this question is how much further the market can rally on things being normal and below-trend, and also how long will it be before investors realise that the debt problems aren’t resolved and that de-leveraging will have to occur at some stage, as default and inflation are not policy options in large economies.
Over the past nine months, markets have rallied hard in all regions as expectations strengthened that the worst of the post-GFC world was behind us.
Indeed, regional market valuations have increased an average 20 per cent since June 2012, even though expected earnings have declined in all regions other than Japan and the US.
Meanwhile, Australia is the only region (of the US, Europe, Japan and non-Japan Asia) where the market valuation is trading above its 10-year average (based on expected earnings).
Implication for investors
Although at 0.03 per cent of global GDP, Cyprus is too small to cause any systemic risk to the Eurozone, the primary risk is contagion.
While there was no other option for the Cypriot Government than to accept what was demanded by their creditors, the deposit tax is likely to have a sizable impact on depositor behaviour across peripheral Europe.
The key short-term risk remains bank runs and while bank runs are typically irrational when they begin, it can be equally irrational not to join the queue when they do.
Fortunately, this recent bout of European stress has occurred at a time of US economic stability, with a sustainable sub-trend recovery brewing.
Although this provides a foundation for global risk markets, a clear slowing in non-Japan Asia and rising valuations indicate that risks need to be managed.
In this environment, companies with quality operating models that can produce surplus cash-flow in a subdued economic climate are likely to outperform in a capital-constrained world.
While valuations are a bit stretched for some of these stocks, investors seem willing to pay a bit more for reduced risk.
Matthew Sherwood is the head of investment markets research at Perpetual Investments.
