From Goldman's Francesco Garzarelli
In the early hours of Monday 25 March, Cyprus and the Eurogroup have reached a deal on a financial support package.
As before, the Eurogroup will contribute, via the ESM, up to EUR 10bn (roughly 60% of Cyprus’ GDP), the bulk of which is to be used to cover debt roll-overs and the primary deficit now that the country has all but lost market access.
The idea of using a one-off levy on all bank deposits to cover the hole (estimated at EUR 5bn) left in domestic banking institutions by exposures to Greece has been ditched. Instead, Laiki Bank will be immediately resolved, with a ‘good’ bank carved out and folded into Bank of Cyprus, and a ‘bad’ bank run down over time. The ECB will provide liquidity to the new recapitalized institution, which will inherit the Emergency Liquidity Assistance positions of Laiki.
The restructuring of the two banks will be conducted under the new and extensive bank resolution authority conferred to the Central Bank of Cyprus last week, and will not require parliamentary approval. The operation will involve losses being inflicted on the (few) junior and senior bank bondholders of the two institutions and, more crucially, on deposits above the EUR 100K threshold (a communiqué by the Eurogroup talks about a deposit-to-equity conversion, but no details are provided).
From a markets standpoint, our reaction is as follows.
(i) A policy preference for not transferring banks' liabilities onto the government sector where possible has once again transpired, increasing the policy ‘distance’ between Ireland on the one side, and Spain and Cyprus on the other. This was one of the two main ‘read acrosses’ we mentioned in a note published last Sunday (see Market Views Two Lessons from Cyprus). On the expectation that public debt held by private hands will be mutualised onto the Euro area’s balance sheet, short-dated Cypriot debt has rallied. But with large uncertainties over what the economy will do over coming years, longer-dated Cypriot bonds trading at yields below their Greek counterparts offer little value.
(ii) The restructuring of the two main Cypriot domestic banks seems a big task to take on, going by what happened in Ireland. More generally, ahead of the deployment of a common bank resolution framework steered by a central European authority, the winding down of insolvent banks appears to be conducted on a case-by-case basis, with all the associated uncertainty. All else equal, this should be detrimental for creditors in weaker banks in other Euro area countries, particularly those in the fiscally weaker states.
(iii) On broader market sentiment, investors had anticipated that a resolution in Cyprus would ultimately be found. This was the line we also held coming into last week. But reaching a deal has raised awareness that inter-country fiscal transfers in the Euro area remain a messy business, leaving public opinion damaged. In the European macro space, the spread between Italian 10-year BTPs and German Bunds now looks too wide relative to what would be justified by macro and fiscal factors, according to our models (we mentioned that the spread should be around 275bp, and fair value is currently 225bp). Until more clarity emerges on how Cyprus will settle after the banks re-open, however, and with an attempt under way to form a new government and find a new President, we prefer to stay on the sidelines until the dust settles.