By Andrew Wilson, head of investments, Towry
The bulk of the losses from the ongoing Financial Crisis are yet to be "apportioned", and it is unknowable to what degree they will fall on tax payers, bond holders, creditors, and debtors. All of these have now taken an initial hit to one degree or another, depending on locale.
In the case of Cyprus, the banks (ECB about to pull funding) and the government (running out of money in May) are essentially bust, with this now coming to a head as the ripple hits, from the stone of Greek default being thrown in the pool. Technically, depositors were supposed to be insured up to €100,000 , but the government is in no position to honour this, and there is little reason to expect Eurozone tax payers to fund something when there is little chance of them ever seeing the money again - Cyprus, like Iceland was, being so small relative to its financial system.
There are no good options, and taking only a 6.75% or 9% hit on your deposit, may turn out to be a good deal, considering the insolvent nature of the banks and government (and it is still not clear how either can survive a "bank run"). The tax could have just been levied on foreigners, but then Cyprus is finished, in terms of attracting foreign deposits and investments. If Cyprus instead elects to leave the Eurozone, then there might instead be a 50% currency devaluation, so you lose 50% of purchasing power - a far worse fate - and invite inflation in to your economy, which would ravage the real value of deposits anyway. As it is, and assuming this passes Parliaments, Cyprus is funded for about the next 3 years, while it attempts to straighten itself out (e.g. halving the size of the banking sector) and retreat from its offshore tax haven nature.
The reason that depositors, in this case, take the hit, is simply because that is where the money is - some €70bn. At least in this way the pain is shared by foreign depositors too (probably well over half the amount the tax will raise), as opposed to the Cypriot tax payer wearing the whole lot. The softener to this blow is that depositors will get shares in their bank - so a kind of debt for equity swap - and locals should also receive a bond tied to future gas revenues, if they keep their account open for at least a further two years. The real and unlikely winners are holders of Cypriot government debt, who, perhaps due to the need for an immediate solution, remain whole, and have a supported and improved financial system behind them now.
Clearly the main risk to financial stability, and hence to investors, is psychological, i.e. "contagion" - why would anyone now keep a deposit in a Mediterranean bank? The ECB can, however, offer unlimited funding to banks, and so something of a firewall can be used to contain the crisis, if desired.
This event is illustrative of the way that an economic crisis has morphed into a political crisis. We suspect that the date that an electorate chooses to leave the Eurozone is being brought ever closer, for better or for worse. Our concerns that we might see a stressed world of increasing trade barriers and capital controls, are played out in this case by what is effectively a violation of property rights, and indeed actual capital controls.
One commentator has asked, rhetorically, "Is it now reckless to keep your money in cash?" That has been our view for the last year or so, but also for the related reason of Financial Repression. The end result is similar after all, for e.g. a UK depositor has been earning negative compound interest, in real terms. Equally, a Vince Cable-imagined Mansion or Wealth tax would be essentially a similar result for Brits, if proposed as a one off.
Much of "peripheral Europe" will require (further) write-downs of its debt, in one manner or another, and so there is a huge amount more pain to come, even though politicians have been putting off the day of reckoning for as long as they feasibly can. This may not be confined to just the periphery, and arguably people in core developed world countries are suffering death by a thousand cuts anyway, as their standard of living falls - on Financial Repression, higher taxes, increased cost of food and energy, and so on.
For investors, the best antidote is a wide spread of investments in real assets, and different jurisdictions and currencies. One needs to play off a balance of exposure to regions which are not financially stressed, and have growth, and those where property rights and the rule of law is most ingrained. Hiding in cash has again been shown to be the wrong option, and who knows what the unintended consequences, or contagion effect will be. One must stand ready with an active approach to asset allocation, but which also includes the ability to take advantage of valuation anomalies and swings in sentiment, as such times may also lead to opportunity.
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