The main elements in the resolution of the Cyprus crisis have clarified this weekend. Although there are many specifics still be be settled, it appears that large depositors in the Bank of Cyprus are likely to lose 40-60 per cent of their original worth, while those in the Laiki Bank will probably lose almost all of their money.
Most observers agree that this second attempt at a resolution is highly preferable to the first, largely because it avoids imposing losses on small scale deposit holders (under E100,000, which are intended to be “insured” under the eurozone’s future bank insurance regimes). However, the brutal losses imposed on large depositors this weekend will come as a shock. And all those with money in Cyprus now face severely impaired liquidity because of draconian capital controls.
The calmness of the financial markets in the face of the deteriorating Cyprus crisis in the past week has been remarkable. Although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone.
Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis, if a microcosm on steroids. The manner in which the crisis has been handled by the Eurogroup and the ECB will have demonstration effects on other economies, for good or ill.
At the time of writing, the outcome of this weekend’s negotiations remains uncertain. However, assuming that there is no catastrophic breakdown in the talks, leading to the exit of Cyprus from the euro area, the broad outline of the settlement seems to be taking shape. It is reported that the Cypriot government will accept a “bail in” of depositors in one or both of its troubled banks, allowing the release of eurozone financial support, while still keeping the government debt/GDP ratio under 150 per cent.
Predictably, the chancellor has rejected calls for a radical change in his economic strategy. Plan A has not morphed into Plan B. If anything, it has become Plan A-plus, with the underlying path for fiscal tightening left unchanged, and a little more flexibility for the Bank of England to pursue unconventional monetary stimulus.
UK real GDP is still stuck some 5 per cent below its pre-crisis level, the worst record among the major economies, apart from Italy. Some of this is certainly due to the problems which the Coalition inherited. However, about half of the shortfall in UK growth in recent years, compared to that in the US, is due to the tightening of 5 per cent of GDP in fiscal policy since 2009/10.
The dominant criticism of the government from mainstream economists is, of course, that the poor performance of UK GDP is due to a shortfall in aggregate demand, which in turn is primarily due to these fiscal measures. The Chancellor’s reply is that the UK could have faced a fiscal crisis without his budgets. The fact that public debt is now forecast to rise to 85 per cent of GDP in 2017/18 suggests that his concerns are not easy to dismiss as scare-mongering.
The FOMC will meet on Wednesday with the markets feeling confident that there will be no change in monetary policy. This means that the $85bn per month rate of balance sheet expansion will probably remain in place. But recently chairman Ben Bernanke has conceded, rather reluctantly, that the Fed’s exit strategy from quantitative easing will soon need to be reconsidered by the committee, and the debate could start at this month’s meeting. In any event, with economists now upgrading their forecasts for US GDP for the first time in quite a while, the markets are increasingly focused on whether the exit can be handled successfully.
The first question is whether the exit will be gradual or abrupt. The chairman’s personal preference is very well known: it should be gradual, and extremely well flagged in advance. But Mr Bernanke might not be in office after next January, and there are others on the FOMC who could have different ideas. Furthermore, economic and market circumstances could change. In 1994, GDP growth and inflation both rose markedly, and the Fed slammed on the brakes without any warning. The resulting 3 per cent rise in the Fed funds rate delivered a major shock to the financial system.
The sterling exchange rate has now declined by about 7 per cent this year, thus eliminating all of the rise which occurred when the euro crisis was in full flood in 2011-12. Investors are asking three main questions about the drop in sterling. When will it end? Will it succeed in boosting UK economic growth? And could it, conceivably, lead to a full blown sterling crisis?
Exactly four years ago, amid almost universal pessimism, global equities embarked on a massive bull market which remains intact to this day. US equities have been flirting with all-time highs and many other global markets are near to their 2000 and 2007 peaks. Investors are naturally very focused on whether equities, having failed twice before to break above current levels, can finally overcome vertigo and sustain a bull run into unprecedented territory. After all, it is now 13 years since US equities first touched these levels, and US corporate profits have approximately doubled since then.
The market mood is optimistic. For example, Andrew Parlin of Kotell Advisors, a man who exactly called the bottom four years ago, remains bullish in this recent article. But sceptics argue that the rise in equities is just another example of the successive financial market bubbles which have been created in the past two decades. As each bubble has burst, the central banks have set about creating another, larger bubble, the latest of which, sceptics claim, is based entirely on quantitative easing, and not on the fundamental soundness of the underlying economy.
If this proves to be the case, then equities could be tracing out a massive triple top formation, which will ultimately be followed by a major crash. Which is it to be: a move into uncharted territory, or a triple top?
It is now almost universally accepted that the major central banks were woefully mistaken in ignoring the build up of credit risk in the years before 2008. Whether they should have acted through raising interest rates or by tightening regulations on the financial system is still under dispute, but the abject consequences of doing nothing are plain for all to see.
This has naturally made policymakers very determined not to make the same mistake again. But they are also aware that they do not want to be a group of generals focused on winning the last war. In the past, these decisions have not proved easy to make in real time. Consequently, a great deal of recent research has been aimed at doing better in future.
The Fed has been in the front line of this work, but the Bank for International Settlements has joined in with some very valuable insights and empirical work, led by Claudio Borio. Although there is clearly a very active exchange of views occurring at the Fed, the bottom line for investors is that restrictive monetary action in the US, in response to a build up of excessive financial risk, is not likely for quite some time.
The legal enactment of fiscal sequestration in the US last Friday brings to an end a series of haphazard measures to tighten budgetary policy since the Obama fiscal stimulus was reversed in 2010. The overall result has been to raise $3,500 billion over the next decade, around 2 per cent of GDP.
Taken together with other measures which were already in the baseline for policy, the cumulative fiscal tightening will amount to 4.8 per cent of GDP from 2010-14, of which 1.5 percentage points will occur this year, and 0.6 percentage points will come from the sequestration order itself.
This tightening has set in stone the fiscal stance for President Obama’s second term and it will ensure that the US budgetary position is “sustainable” over that period. It is not yet clear, however, whether the economy can grow robustly while the measures take effect.