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  1. 1. Europe Cyprus 18 March 2013Macro Data Flash (Euroland) Economics Research Team Cyprus bailout: a new Peter Sidorov Global Markets Research Economist +44 (0) 20754-70132 peter.sidorov@db.com precedent Renewed talks on the Cyprus bailout reached a dramatic conclusion in the early hours of Saturday morning as the Eurogroup meeting reached political agreement on the key measures of the assistance programme. The agreement set a new precedent in the management of the euro area crisis, introducing a higher than anticipated one-off levy on deposits – 6.75% for deposits under EUR 100,000 and 9.9% for those above. The levy is expected to raise EUR 5.8bn, shifting over half the burden of bank recapitalisation onto depositors. Together with smaller revenue measures including a rise in the corporate tax rate this will reduce the size of the Cyprus bailout from around EUR 17bn to ‘up to EUR 10bn’. This would lead to a sharp improvement in the Cypriot public debt trajectory with debt/GDP falling to 100% by 2020. The deposit levy is yet to be approved by the Cypriot parliament with a vote postponed to Monday 18 March. The risk of rejection is high. The government may be seeking a rebalancing of the levy from the smaller to the larger depositors, which could make it easier to sell politically. Other steps, including extension of a loan from Russia and approval by the German Bundestag, are needed to finalise the deal. The agreement signals a greater commitment in Europe to sovereign stability of the periphery. However, this may well be more than offset by contagion risks that the deposit levy could pose to financial stability. We do not expect deposit flight in the EA periphery in the near term, but the bar may now be lower in the event of a future banking crisis. A firmer move towards banking union is needed to offset this risk. A rapid and dramatic conclusion Nearly nine months after Cyprus first asked for assistance in June last year, the sometimes snail-like pace of the negotiations on the deal reached a dramatic conclusion as political agreement between the Troika, the Eurogroup ministers and Cypriot officials was reached in the early hours of Saturday (16 March). The election of the centre-right Nicos Anastasiades paved the way for a fresh start in the bailout talks after his government took power on 1 March. The negotiations intensified last week with the Troika and Cypriot officials working on ways to reduce the size of the bailout. A special Eurogroup meeting to follow the EU summit was announced. The result was an agreement on a one-off levy on deposits as well as an increase in the corporate tax rate and an extra tax on Economics interest income. The ‘stability levy’ on deposits, at 6.75% for deposits under EUR 100,000 (the limit of the deposit guarantee) and 9.9% for those above, is larger than we anticipated Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MICA(P) 072/04/2012.
  2. 2. 18 March 2013 Data Flash (Euroland) and is expected to raise around EUR 5.8bn. The additional revenue measures will reduce the size of the bailout package from the around EUR 17bn initially suggested to ‘up to EUR 10bn’. This will result in a more sustainable trajectory for debt/GDP which is projected to return to 100% of GDP by 2020. While this achieves greater credibility on debt, the deal could seriously damage the popularity of the recently elected President and his government, potentially hindering any future measures. There are mixed implications for the euro area crisis management. On one hand the deal shows unity within the Troika and that the Troika is learning what makes a sovereign’s debt sustainability credible. On the other hand the deposit levy sets a potentially dangerous precedent for financial stability. While the immediate effect is likely to be limited, the risk of deposit flight in the event of future banking crises has increased. A greater commitment on progress towards banking union will likely be needed to offset this. Several events remain in finalising the deal– the deposit levy needs to be approved on Monday by the Cypriot parliament, which is far from certain. On the same day the Cypriot Finance Minister will be in Moscow seeking to extend an outstanding EUR 2.5bn loan from Russia. The risks to German parliamentary approval have decreased but it remains an event to watch. Deposit levy - a new precedent The agreement reached in the early hours of Saturday morning sets a new precedent in the euro area crisis management in shifting much of the cost of a banking crisis from the government onto bank depositors. Indeed, the noise from policymakers in the last two weeks signalled that a tax on deposits and/or a capital gains tax on interest income were being considered as ways to reduce the bailout cost. However, the magnitude of the deposit levy announced is larger than anticipated. A ‘stability levy’ of 6.75% will be imposed on deposits up to EUR 100,000 (the limit of the deposit guarantee) and 9.9% for those above. This is expected to bring in some EUR 5.8bn based on EUR 68bn of deposits held in Cyprus, of which around EUR 30bn fall within the EUR 100,000 limit1. The levy is due to be applied by Tuesday 19 March (Monday is a public holiday in Cyprus) with Cypriot banks limiting internet transfers and cooperative banks closing on Saturday to avoid a bank run. The curtailment of internet transfers is in practice the first time capital controls have been established in the EMU. Depositors will be partially compensated for the levy by receiving equity in the banks, although the exact details of this are not yet clear. Press reports have suggested that the value of these will be in part guaranteed by future natural gas revenues. Cypriot officials have tried to sell the deal as the only option offered to them. President Anastasiades stated that the government were presented with a ‘fait accompli’ at the Eurogroup meeting. He presented as the alternative a disorderly bankruptcy of one of the banks as soon as Tuesday (19 March) as the ECB would withdraw the provision of ELA, with the other major bank also unable to avoid collapse. However, with the deal requiring approval by the Cypriot parliament, it is still far from certain that Cyprus will accept this ‘fait accompli’. 1 ‘About EUR 30bn’ is the figure that President Anastasiades said the state would be liable for under the guarantee scheme in the event of a collapse of the banks, which according to him would follow if he had not agreed to the deal. We do not have recent official data on the size of deposit guarantees in Cyprus, but as of the end of 2011 EUR 35bn of EUR 70bn total deposits fell under the scheme according to the Ministry of Finance.Page 2 Deutsche Bank AG/London
  3. 3. 18 March 2013 Data Flash (Euroland) Getting parliamentary approval – far from certain The Cypriot parliament was due to vote on the deposit levy on Sunday to facilitate the implementation of the levy. However the vote has been postponed until Monday to give more time for consultations between the parties. The risks to getting approval are high, with the vote looking too close to call at the time of writing. Anastasiades’ centre-right DISY is the only party wholly committed to backing the deal so far. Holding 20 of the 56 seats in parliament2 (hence a 29 vote majority threshold), it would first need to get the backing of its centrist ally DIKO (8 seats). While the DIKO party line should support the deal, it would not be enough to guarantee approval and at least one defection within DIKO looks possible. Meanwhile, the communist AKEL (19 seats), the social democrat EDEK (5 seats) and the Green party (1 vote) have positioned themselves against the levy, making the support (or lack thereof) of the 2 MPs of the European Party (EVROKO) potentially decisive. The struggle to get support may have led the Cypriot side to seek a change in the deposit levies imposed (reported on Sunday). In particular this would involve reducing the levy for the smaller deposits (below EUR 100,000) and increasing it for the larger ones. In addition to being easier to sell politically in Cyprus, such a change would reduce the magnitude of the precedent set by hitting guaranteed deposits, which may reduce the potential contagion risks. We expect that the EU would likely react favourably to such a request. Should the parliament reject the deposit levy, measures would need to be taken to avoid the disorderly bankruptcy scenario spelled out by Anastasiades. According to the scenario the ECB would withdraw ELA funding this week. To reduce depositor panic, limited access to deposits, financed by reduced ELA funding, could be arranged. Limiting access would reduce the risks of a bank run that could potentially spill over into other peripherals. It might also buy time for Cypriot politicians to accept that the offer on the table is the best they can get and avoid a disorderly collapse, or, less likely, get concessions from the Troika to soften the terms. Even if the levy is approved, the Eurogroup deal is likely to lead to a sharp fall in popularity for Anastasiades, who less than a month ago was elected with a strong mandate. This could spell trouble should there be the need to revisit the terms of the bailout (e.g. implement further austerity measures) at a later date. Changes to the bailout agreement The deposit levy is the highlight of several measures agreed by the Eurogroup to appease concerns among the lenders. Ensuring debt sustainability The EUR 5.8bn is the main source of funds for a reduction in the size of the bailout from the around EUR 17bn initially anticipated to ‘up to EUR 10bn’. Other revenue measures agreed include an increase in the tax on interest income and an increase in the corporate tax rate from 10% to 12.5%3. The notable measure, of those floated in recent weeks, that Cyprus managed to avoid, is a financial transactions tax. The result of the additional revenue is an improvement in the debt/GDP trajectory with the Eurogroup projecting a 100% debt/GDP by 2020. Indeed, our own debt trajectory analysis 2 The situation is further complicated as one of the DISY MPs is reported to be currently out of the country, potentially reducing their votes to 19. 3 Based on the EUR 670m corporate tax receipts budgeted for 2013, the corporate tax increase could generate up to EUR 170m (25% increase) annually at the moment. This figure should rise once the economy begins to improve.Deutsche Bank AG/London Page 3
  4. 4. 18 March 2013 Data Flash (Euroland) suggests that with a EUR 5.8bn reduction in the size of the bank bailout, debt/GDP would peak at a little over 110% of GDP under the growth assumptions of the draft MoU4 compared to close to 145% of GDP previously. However, some aspects remain unresolved – with the stance on potential privatisations unclear. Ensuring financial stability EUR 10bn was initially pencilled in for bank recapitalisation under the draft MoU, with EUR 8.9bn reported as the capital shortfall under the adverse scenario in PIMCO’s stress test (no official announcement on the size is to be made until the agreement of the MoU). The deposit levy would thus shift around 60-65% the costs of the Cypriot bank recapitalisation onto depositors. In addition to addressing the capital shortfalls, the Eurogroup agreement addresses a reduction of the exposure to Greece (important in our view) by transferring Cypriot banks’ Greek operations to, as yet unspecified, Greek bank(s). This would account for a part of the envisaged reduction in the size of the banking sector (from around 8 times GDP currently) to the EU average (around 3.5 times) by 2018. Implications for euro-area crisis management The political agreement is likely to have twofold implications for euro area crisis management. On one hand the agreement signals a consensus within Europe on credibly dealing with sovereign debt crises. A 100% debt/GDP is a more credible starting point for debt sustainability than previous programmes. Also, the support of the IMF for the deal (although the size of IMF’s financial involvement is still to be decided) signals greater unity within the Troika following what had been quite public disagreements between the EU and the IMF. The coincidental agreement to extend the EFSF loans for Ireland and Portugal (details to be agreed next month) sends a message that the euro area is willing to make concessions to guarantee sovereign success stories. This underlines a political will to assist crisis sovereigns. However, this positive tone for sovereign stability may well be outweighed by the potentially dangerous precedent for financial stability that the deposit levy sets. European policymakers have been quick to highlight that Cyprus is a special case due to the sheer magnitude of the banking crisis relative to the size of the economy. Indeed, we do not see the Cypriot story causing deposit flight in the periphery in the near-term. There are no other major pending banking crises at the moment, with Ireland, Greece and Spain all having seen or undergoing bank recapitalisations5. This lack of immediate direct contagion risks may well have contributed to EU policymakers’ acceptance of such a radical solution. However, the involvement of depositors poses questions over the protection offered by the EUR 100,000 deposit guarantees and over future burden-sharing in a banking crisis. There is as yet no common deposit guarantee scheme in Europe and as Cyprus shows some countries may be unable to shoulder the burden of a deposit guarantee. The Cyprus case also shows how the guarantee does not protect you against a deposit tax. These factors are bound to increase the risk of a run on deposits next time concerns over a potentially unsustainable bank develop in the euro area periphery. 4 Note however that the additional taxation measures are likely to negatively impact the growth trajectory. 5 Bank of Spain was quick to assure that there was no sign of deposit flight in Spain as a result of the Cypriot developments.Page 4 Deutsche Bank AG/London
  5. 5. 18 March 2013 Data Flash (Euroland) To compensate for this precedent, we would likely need to see a firmer move towards greater financial integration in the euro area. Political commitment behind the Single Supervisory Mechanism has been shaky and would need to be improved. Clearer steps towards direct bank recapitalisation as well as progress towards a common bank resolution scheme and stronger deposit guarantees would need to be taken. We wonder whether the ECB’s seeming willingness for force the Cyprus deal – the ‘fait accompli’ – was in return for assurances on greater progress towards banking union. We still feel that political progress on the matter may be difficult to achieve in the coming months. In Germany Merkel is likely to find it politically difficult to pursue this ahead of the elections, although achieving a politically sustainable deal on Cyprus may allow ‘core’ countries to invest more political capital in banking union. Should progress be lacking, the Cypriot deal could pose a potentially dangerous precedent. Italy, where a deposit tax (albeit a much smaller one at 0.6%) was implemented back in 1992 is one country where this could resonate. The Cyprus precedent could be a catalyst for the unstable political situation to lead to greater doubts over economic and financial stability. On a political note, the Cypriot deposit levy could be used by anti-EU parties trying to undermine the ‘establishment’, including Grillo’s 5SM in Italy, as an additional argument against the European anti-crisis policies. Finalising the deal Several steps still remain in finalising the deal. The most immediate and most risky is the Cypriot parliamentary approval due on Monday (18 March) we discussed above. On the same day the Cypriot Finance Minister will be in Moscow seeking an extension and a reduction of the interest rate on an outstanding EUR 2.5bn loan from Russia6. The Russian stance seems favourable towards an extension although recent Russian press reports suggested that the Russian Ministry of Finance may ask for details on Russian depositors in Cyprus in return for the extension which could be a possible sticking point. Approval of the Cypriot deal by the German Bundestag is another event to watch. The Finance Minister Schaeuble has said that he will put it to a vote (to give Troika the mandate to finalise the details) as soon as possible – likely in the coming week, ahead of an Easter break. The risk of German opposition has eased – burden-sharing by depositors, an increase in the corporate tax rate and a planned audit of implementation of anti-money laundering measures are all measures addressing a number of concerns raised by German politicians – but approval is not yet certain. Pending the above approvals, the emphasis will be on the Troika to finalise the terms of the MoU. Barring any further delays the assistance package should be in place to be formally approved by the ESM Board of Governors by the second half of April, which would then allow funds to be disbursed. In any case, we can expect plenty more news flow on Cyprus in the coming days and weeks. 6 The loan is due to mature in 2016. Cyprus is seeking to extend it to 2021, with repayment in instalments from 2018 onwards. The interest rate is currently at 4.5%.Deutsche Bank AG/London Page 5
  6. 6. 18 March 2013 Data Flash (Euroland)Appendix 1Important DisclosuresAdditional information available upon requestFor disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please seethe most recently published company report or visit our global disclosure look-up page on our website athttp://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr.Analyst CertificationThe views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, theundersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view inthis report. Peter SidorovPage 6 Deutsche Bank AG/London
  7. 7. 18 March 2013 Data Flash (Euroland)Regulatory Disclosures1. Important Additional Conflict DisclosuresAside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the"Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing.2. Short-Term Trade IdeasDeutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistentor inconsistent with Deutsche Banks existing longer term ratings. These trade ideas can be found at the SOLAR link athttp://gm.db.com.3. 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