As usual it will take a day or two for the markets to decide which of their initial reactions to the Cyprus bailout – relief that a deal has been struck, or concern at the implications of the terms imposed by the troika – will prove dominant. Some things do seem clear from what we have learnt already:
- This was the most acrimonious bailout negotiation yet, with little love lost between the Cypriot negotiators and the troika representatives on the other. Talks came close to breakdown on several occasions over the course of the past week. Apparently tipped off in advance that the Russians would not come riding to the rescue, the troika played hardball – and eventually won, although not before the Cypriot President had threatened to resign and/or take Cyprus out of the euro – a desperate course of action which the influential Archbishop of Cyprus, for one, has openly advocated.
- Although the deal will avoid the outcome of Cyprus leaving the euro for now, that still remains a possibility. The bailout creates a number of important precedents, raising the possibility that bondholders and depositors in troubled banks elsewhere in the Eurozone could be forced to pick up the tab if their bank needs to be rescued in future. The Dutch finance minister who now heads the Eurogroup said as much yesterday, and subsequent attempts to smooth over his remarks – which were remarkably explicit – have been less than convincing.
- Reports that the IMF and the EU are no longer in harmony on the issue seem well-substantiated. This was the first time that the two institutions went into a bailout negotiation without an agreed common position. The IMF rightly focuses on the issue of whether any bailout money it provides can be recovered, as its charter requires. The European Commission on the other is always prepared to do more to help keep the Eurozone alive – seemingly, sometimes, at any cost. Disharmony in the troika is not a good omen for the future.
- With Federal elections looming in September, the Germans were in no mood this time round to take a more lenient line, given the rising amount of popular bailout fatigue in northern Europe. As has been widely noted, the Germans are picking up the largest part of the tab for saving the euro – but are reaping only rising levels of anti-German hostility in return. (Gideon Rachman has a good piece in the Financial Times on this aspect). Anti-German feeling has also played an important part in the recent Italian and Greek elections.
- With Cyprus being forced to introduce capital controls to avoid large scale capital outflows, one of the original pillars of the euro project has been broken. The Cypriots say that they hope these capital controls will be temporary. Experience suggests that this is unlikely to be the case. Don’t be fooled into thinking that similar measures will not be introduced elsewhere in Europe the next time a bailout comes round.
- The Dutch finance minister’s comments raised the possibility that Europe will never now move towards direct recapitalisation of its troubled banks. If that proves to be the case (and it is not certain), then a key plank in the eventual banking union on which the European integration lobby has pinned its hopes has fallen by the wayside. Cross-border deposit insurance remains a non-runner politically for now, so progress towards banking union is likely to remain slow.
- On the positive side, it is reassuring to hear leading European politicians talking so openly and explicitly about the scale of the problems that Europe still faces. For too long politicians in Europe have hidden behind a curtain of obfuscation, verbiage and downright deception to keep their beloved project alive. Any opportunity to bypass the opinion of voters has been taken – a pattern repeated in the case of Cyprus, where the revised bailout plan does not have to risk approval by the Cypriot Parliament.
How will this play out in the markets? The Cyprus deal, though insignificant in macroeconomic terms, is an important reminder that the risks in Europe have not gone away. With more signs of recovery emerging in the United States, and some positive developments in the UK, there are some plausible reasons for investors to ignore the siren noises coming out of Europe, where recovery remains non-existent and a resumption of economic growth is not yet in sight.
The biggest problem is that despite some tentative signs of investors starting to switch out of cash and bonds into equities, the valuations of equities do not look cheap and anything perceived as even remotely a “safe haven” asset (quality equities, government bonds. London property etc) has been bid up to dangerously high levels. If the equity markets do go higher, therefore, it will still be more of a momentum/sentiment phenomenon – aided and abetted by quantitative easing – than one based on clear valuation appeal.