2013-03-29 06:10 GMT

The Cyprus moment

The euro zone could be slipping into a new period of turbulence even before it has had a chance to return to growth. And yet the improvement previously discussed in these pages has been confirmed: borrowing conditions for governments have improved and some, such as Ireland, have made a successful return to the markets. Ratings on sovereign debt have stabilised. One sign of an easing of financial tensions in the zone is that the internal balances in the Eurosystem, as reflected in Target 2 balances, have narrowed to a degree. These are encouraging but fragile signs that could be compromised by the difficulties in managing the Cypriot crisis or by the political uncertainty in Italy. Is there a new European crisis brewing in Cyprus? The country’s banking system needs to be recapitalised, failing which the European Central Bank (ECB) – which is not responsible for solvency issues – could cease to provide support. However, given the size of the banking sector (seven times GDP) the sums in play by far exceed the country’s repayment capacity. The EUR 17bn of total needs (of which EUR 10bn for banks) account for one year’s GDP for Cyprus, which is only the 26th biggest economy in European Union. A loan of this amount from the European Stability Mechanism (ESM) would push government debt up to the unsustainable level of around 200% of GDP. The main risk would then be the snuffing out of the Cypriot economy for many years, with no certainty that any financial aid would in fact be repaid.

Deposits are the main resource of Cypriot banks, and at least one-third of the total is held by Russian individuals and companies. Thus, the choice before the euro zone was not easy : use public funds to protect deposits which, in large part, have nothing to do with the region, or tax them. The initial proposal made by the Troika undermining the €100,000 guarantee would have created a dangerous precedent, and was rejected by the Cypriot parliament. At the time of writing, a compromise is emerging that will protect smaller depositors whilst still respecting EU legislation. Only unprotected deposits of over €100,000 will be affected, however to a significant extent, following the initial proposal of the ECB. The plan includes a restructuring of Laiki, the second largest bank of the country, and clearly involves big losses for nondomestic depositors, namely Russians. But one can say this is the price Cyprus accepted to pay for staying in the EMU. If the problems in Cyprus are not sorted out, one could at least hope that it will not have a systemic impact, given the small relative size of the problem (one-twentieth of the support provided to Greece). However, as with the political log-jam in Italy, the timing is unfortunate. The euro zone had been gradually returning to stability, although it was struggling to return to growth, at a time when the US and Japanese economies, as well as those of some major emerging countries such as China and Brazil, have shown signs of improvement. Economic indicators (purchasing manager surveys, industrial production indices, retail sales figures) have come out of the recession zone, but remain negative. Unemployment is continuing to rise, particularly in the south of the region where it has reached hard-to-bear levels (26.2% of the workforce in Spain, 17.6% in Portugal). -FXstreet.com

2013-03-29 12:30 GMT

United States. US Core Personal Consumption Expenditure - Prices Index (YoY) (Feb)

2013-03-29 12:30 GMT

United States. US Personal Income (MoM) (Feb)

2013-03-29 12:30 GMT

United States. US Personal Spending (Feb)

2013-03-29 13:55 GMT

United States. Reuters/Michigan Consumer Sentiment Index (Mar)

2013-03-29 07:07 GMT

EUR/USD hovering around 1.2800

2013-03-29 06:00 GMT

GBP/USD holding around 1.5200

2013-03-29 05:36 GMT

Japan data disappoints; Yen advances a bit

2013-03-29 03:53 GMT

EUR/JPY gravitating around 120.70