There is a palpable sound of ticking coming from under the euro. The crisis in Cyprus is a time-bomb waiting to explode. Over the next few days the fall-out could be really severe. Markets are waiting for the crisis to be disarmed and hoping for a credible resolution. That looks heavily in doubt. The credible option has gone away with the government ruling out a levy on depositors to help pay towards the implied 16 billion bailout cost. If the government cannot work out a bail-out for the banks by the end of the week, the odds are that the ECB will pull the plug on its support operations, Cyprus will be in default and will quickly exit out of the euro. It is a result that nobody wants, not least Cyprus. The fact that the Austrian Chancellor Werner Faymann and ECB chief negotiator on Cyprus, Joerg Asmussen are openly talking about it underlines the systemic risk.
Risk assets and the euro have managed some semblance of short squeeze on the notion that a compromise can be slipped in at the last minute. But the cupboard is bare there right now. Either Cyprus compromises and concocts a new deal with the EU, or alternatively Russia coughs up some new cash, or else the country defaults. If nothing is in place by the time the banks re-open in the next few days it will only be a matter of hours before the banks’ balance sheets go into cardiac arrest. The only way that the ECB can continue their lines of support is that the banks are recapitalised and the only way for that to happen is for the Cyprus government to accept bail-out conditions in their entirety from the EU, IMF and ECB. Right now, the political will is not there to achieve this.
What seems to have happened is that the political tables have turned. It is not a question of the Germans blinking at some stage. They are throwing down the gauntlet that things must change. Germany has key elections looming in the autumn and voter tolerance for never-ending bail-out charity money has not only worn thin, but also worn right through. That is why the liability has been thrown back on depositors. It is not that Cyprus is a special case due to its offshore banking status. Germany is throwing back moral hazard and responsibility to its local source. Collective Eurozone responsibility is being railed in and domestic economies are being made to pay. Whether or not it is the burden of severe austerity or the new precedent of depositor scalping, it is not a situation that can last forever. The sudden rise of political populists like Beppe Grillo in Italy underline the risks that public opinion will say ‘no more’. When that happens the system will pop.
In the next few days these pressures will resurface again for the euro. The currency is on a collision course now with its own bad history. It is all down to confidence and that is fast diminishing. In the past the euro has generally sprung back from disaster. More recently since the financial crisis began, the euro’s rally has been predicated on the reserve recycling of debased US dollars into euros, especially by central banks of trade surplus Asian economies. If the euro’s very existence starts to come into question, then this currency reflex reaction is not going to work in future. And if central banks start to dispose of their glacial holdings of euro reserves, based on euro survival fears, the meltdown effect could be traumatic in the coming weeks. Cyprus might mark a small drip in the meltdown process, but the repechage effect into Spain and Italy will turn into a deluge of investor money away from the euro. The euro is not off the hook here and a concerted break down towards USD1.25 should be on the cards very soon. Longer term, the old adage of dead as a parity still comes into play.
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