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March 18, 2013

Chart of the Week: Euro Bank Jog turns into a Bank Run-Cyprus Tax

by Fathom Consulting.

As part of its international rescue package, Cyprus will impose a one-off tax on depositors at its banks. Depositors in other peripheral countries may feel their savings are less secure. If that is the case, we would expect to see a surge in the absolute size of Target 2 balances, with the core balances becoming more positive, and the periphery balances more negative. The bank jog had slowed to a walk. Indeed, during the second half of last year, depositors had started to move money back into Portugal, Greece and Spain. All this now risks being thrown into reverse – the jog breaking into a run.

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In the early hours of Saturday, Euro Area finance ministers formally announced details of the latest bail-out. It turned out to be in large part a “bail-in”, and one that must be a strong contender for the title of ‘least shrewd response to a brewing financial crisis’ since the US authorities decided to let Lehman Brothers go bust in September 2008. After all, what is the worst that could happen?

We now learn that on Friday Cyprus was effectively given the option of seeing two of its largest banks fail, and potentially being forced out of the single currency, or staying in but only after instituting a one-off Cyprus tax on deposits held in domestic banks. It was an unenviable position. The Cypriot rescue package is worth €17 billion, close to the annual output of that small island economy. According to Saturday’s proposals, only €10 billion of the total amount will come from other member states. The remaining €7 billion will come from Cyprus, of which €1.2 billion would come from further austerity measures, and the remaining €5.8 billion from a ‘one-off’ levy on depositors.

The decision by the Cypriot government to hit small-time depositors, in addition to those above the insurance threshold of €100,000, was presumably made to appease foreign investors. Cyprus is keen to retain its status as an off-shore banking haven. But at what cost, both to its own residents, and to other members of the single currency area?

The crisis had abated somewhat in recent months. As our chart shows, target 2 balances had begun to unwind, while the deposit flight that had taken hold across much of the periphery was reversing course. Markets had become convinced that European policy makers had stared into the abyss, realised both the nature and the magnitude of the crisis, and decided to do something about it. Nothing fundamental had changed: the hard work was all still to come. But things were moving in the right direction, and policy makers appeared to be back in charge. All of a sudden, things now look shaky.

Talks between Eurogroup ministers are ongoing. They may yet decide not to shoot themselves in the foot, and find a way to avoid levying a tax on deposits of less than €100,000. The alternative, without the imposition of capital controls, would almost guarantee a bank run in Cyprus, alongside most of the peripheral Euro Area nations.
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