Eurozone Roulette

The $13 billion bailout in Cyprus is small (in 2011, France and Germany made $80 billion of loans and grants to developing countries) and as JPMorgan's CIO, Michael Cembalest, notes the situation is in many ways unique. However, he warns, the latest melodrama reinforces the inconsistent and chaotic nature of EU policy-making. Bondholders, equity investors, bank depositors and citizens of Europe are at risk of unpredictable outcomes as they play Eurozone Roulette. Here’s where they might land on any given spin:

Depositor confiscation and subordination: The EU eventually backed off, but the initial proposal for Cyprus involved a confiscatory tax on small and large Cyprus depositors, both foreign and domestic, with no loss to senior bond-holders (effectively subordinating the depositors). It was a shocking policy proposal in a region where confidence is everything: uninsured bank deposits range from 45% (Spain, Germany) to 80% (UK, Italy) of total bank deposits. Note: Laiki bank branches in the UK were not subject to deposit withdrawal restrictions, even though their branches in Cyprus were.

Zero risk weight applied to sovereign bonds: Even after Greek bonds suffered principal losses, EU banks have the flexibility to use 0% risk weights on EU sovereign debt as per “IRB permanent partial use rules”, regardless of the country’s credit rating.

Maastricht Ja/Nein!!!: From the inception of the Maastricht treaty in 1992 to 2008, there was not a single year when both France and Germany were in compliance with Maastricht debt and deficit targets.Today, Southern Europe is pushed to get in line ASAP.

Loss of tax rate sovereignty: Throughout all the difficult negotiations and bailouts, Ireland was able to keep its 12.5% corporate tax rate despite pressure from the EU to raise it. No such luck for Cyprus, which is being forced to raise its corporate tax rate from 10%. As far as I know, homogenization of EU personal or corporate tax rates was never a condition for Eurozone membership.

Changing protections for senior bank bondholders: There is nothing wrong with bondholders, uninsured depositors or other creditors suffering losses when they are owed by insolvent banks whose asset values are insufficient to cover them. In Ireland however, a bailout was structured to avoid losses on some unguaranteed senior bank bonds which were subsequently repaid (a wealth transfer from Irish citizens to bondholders). In Cyprus, some senior bank bondholders are no longer protected.

Tax Haven Designation: Germany’s Federal Intelligence Service concluded last fall that an aid program for Cyprus would benefit certain Russian depositors with billions of dollars in deposits in Cyprus, and that “Cyprus is a gateway for money laundering activities in the EU”. Fair enough; Cyprus is seen as a personal tax haven. But according to a US Congressional Research Service report in January 2013, tax havens cater to both individuals and corporations. One measure of a corporate tax haven is when foreign sourced profits are very large relative to GDP, such that in the words of the CRS, “profits in these countries do not appear to derive from economic motives related to productive inputs or markets, but rather reflect income easily transferred to low-tax jurisdictions”. On this measure, Luxembourg leads the pack at 18% of GDP, 2x higher than Cyprus and 6x higher than Switzerland, Singapore and Panama. The degree, time and place of EU concern about tax havens can vary substantially.

ECB asserts preferred creditor status: The ECB owned ~50 billion Euros of Greek sovereign debt that was not restructured along with the private sector. Typically, preferred creditor status is reserved only for entities like the IMF and World Bank.

Proposed bonus caps on stand-alone asset management firms and UCITS funds (including regulated hedge funds): Because their investment activities played such a large role in the EU sovereign debt crisis? Because they were beneficiaries of official sector deposit insurance and lots of ECB lending? I can’t find evidence of either one happening, but maybe I am not looking hard enough.

Defenestration of your Prime Minister: As in the Prague defenestration of 1618, when the imperial governor was thrown out of a window. Circumstances will never be known with certainty, but it is clear that the EU put enormous pressure on Italian Prime Minster Berlusconi. In August 2011, ECB President Trichet sent a letter to Berlusconi asking for a long list of reforms and a balanced budget in exchange for the ECB’s bond purchasing program. Berlusconi’s responses were seen as inadequate by other EU leaders, and Italian spreads widened further. Berlusconi lost the support of the Liga Norte, and was forced to resign. Circumstances were not that different in Greece, where Papandreou resigned in favor of a unity government that would execute EU-sought structural reforms, and in Spain, where Zapatero stepped aside to allow for early elections.

Source: JPMorgan (Michael Cembalest - full pdf)