The market reaction to the weekend announcements regarding Cyprus shows the degree to which confidence and context affect investors’ and traders’ decisions. It is impossible to believe that European Union, IMF and Cyprus government officials were not aware of the effect their proposal would have on confidence in the entire banking system in Europe. It is likely they simply believed that confidence would not suffer unduly.
The initial proposal—negotiated between the Cypriot government and the IMF and EU—to confiscate up to 9.9% of savings account deposits was without a doubt a radical proposal. More than one commentator called the proposed government action “unprecedented.”
Nevertheless, the US market reaction was relatively mild and definitely not out of the ordinary in relation to recent problems in either the US or Europe. The S&P 500 futures contract gapped down by roughly eight points on Sunday night and continued to slide into the market open in Europe. Despite delays by the Cypriot parliament in holding a vote on the measure, however, the S&P rallied consistently in the US trading session on Monday.
The reaction in other markets was more in line with the negative news from Europe. The flight-to-quality trade has returned, but the reaction remains muted. Since the announcement, gold has risen by about $20 per ounce, while the yield on the 10-year US Treasury Note has fallen about 7 bps. The US dollar has strengthened by about 1.1 percent against the euro.
There are a number of reasons to believe that the EU/IMF didn’t believe that their action would cause contagion (or at least that it was worth the risk).
First, problems in the Cyprus banking system were a result of their exposure to Greek sovereign debt, which was restructured—unfavorably for debt holders. So the direction is the opposite of a typical contagion effect. In a more typical contagion, problems at the banks in one country could cause deteriorating asset quality in another countries banks that lent to them. These problems could lead to loss of confidence among depositors in the second country. If the direction of the problem had run the in the direction as just described, the possibility of loss of confidence leading to contagion would have been greater.
Second, Cyprus has such a small economy and banking system to begin with, that the magnitude of the exposure of other countries is small relative to the size of their economies.
Third, Cyprus is an outlier with respect to the size of their banking system in relation to their economy. According to IMF data, bank deposits in Cyprus are roughly double the level of their GDP. By comparison, in the United States, bank deposits are about the same size (one times) GDP. Even Greece only has about a 1-to-1 ration of deposits to GDP.
That brings us the the fourth reason EU official may not have been as concerned about a contagion effect—what one commentator called “Russian hot money”. Although the politics are still playing out, if the EU and IMF have believed that it would be Russian oligarchs who were the primary victims of their confiscation of deposits, so be it.
The problem with the EU/IMF’s actions is that it is the policy response that has caused the loss of confidence of depositors, not the health of the banks directly. The factor that the EU/IMF axis failed to consider was the effect of their policies on confidence in the safety of the public’s deposits. The question immediately raised in other countries was “If they are willing to do this to Cyprus, would they do it here?” It was their own handling of the Greek bailout that was partly responsible for the Cypriot problems. The law of unintended consequences is in full effect here.
What investors and traders in other countries should look for is not so much the market response to what happened in Cyprus, but what signs are there that officials in Europe are willing to attempt such a policy in other larger, more systemically important countries in the region. That is the context in which a policy-induced contagion could take hold – with bank runs occurring not only because of banks’ health, but because of the over-reaching policy response to it.