"Cyprus is too small even to be a black cygnet. It is however, likely to be the fourth patient of the European Financial Stability Fund within the next couple of months. It has come to prominence as the latest victim of Moody's belated conversion to puritan sovereign ratings.
Moody's have shed publicity on Cyprus's problems, which given its cultural and economic links to Greece are hardly surprising, but as Mark Twain said "many a small thing has been made large by the right kind of advertising".
"Moody's downgrade from A2 to Baa1 still leaves the island with an investment grade rating. This is too kind, we believe that Cyprus will be downgraded to junk over the next few months and will follow Greece into default over the next twelve months. S&P reduced Greece's rating further yesterday by two notches to CC with a negative outlook, concluding that the proposed restructuring would lead to a selective default. The CC rating implies a recovery rate of between 30-50%. This is consistent with our view that last week's European Council agreement creates a Debt Reduction Mechanism that is the natural successor to the Exchange Rate Mechanism and that there will be further haircuts and debt devaluations over the next few years.
"As the recent stress tests highlighted Cypriot banks are highly exposed to the Greek crisis. They have benefitted from the deposit outflow from Greek banks over the past eighteen months, but these funds are likely to seek safer homes now that Cyprus's problems have been brought into sharp relief. According to the Central Bank of Cyprus, deposits held by other financial intermediaries fell from €7.5bn in May to €6.1bn in June, showing the start of this process. This leaves domestic banks highly vulnerable. Moody's point out that banks' assets are 600% of GDP and a substantial proportion of these loans have been provided to Greece. The rapid expansion of financial sector leverage fuelled average annual growth of 7.5% between 2000 and 2008. The build-up of financial assets created an unsustainable Ponzi scheme similar to Ireland. Irish banks have been bailed out by the state and the EFSF. The Cypriot ratio is unsustainable and as Moody's noted with masterful understatement that "there is a material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece".
"Moody's cited the increasing fractious domestic climate. The tragic explosion two weeks ago of confiscated Iranian munitions (from 98 containers of explosives that had been left in a field close to the main power station for two years) severely damaged the economy's main power station. The political fallout from this has seen the minority government struggle to gain support for an austerity package that is designed to reduce the budget deficit of 5.3% of GDP. The economic consequences will be slower economic activity, which coupled with the likely deposit flight and deleveraging of the banking sector suggests that real GDP will contract during 2011 and 2012.
"Cyprus is a small butterfly in economic terms but as Benjamin Franklin noted "beware the little expenses, a small leak will sink a great ship". Last week's proposed changes to the European Financial Stability Fund will allow the organisation to provide funds to countries to recapitalise their banking system. The country could become the first protectorate of the fund. Much more likely will be a small bailout from the EFSF. More importantly, will be the likely imposition of economic governance from Brussels. This would be consistent with German Finance Minister's recent comments that countries that seek funding from other Eurozone members will need to surrender some sovereignty. Cyprus will be an obvious test case of this new hardline policy. It will be the first sign that volatility is being transferred from interest rates to politics. We believe that this will ultimately be bearish for the Euro."
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