Cyprus is a small island in the Mediterranean Sea, located East of Greece and South of Turkey. Cyprus has always been a popular tourist destination receiving two million visitors who come to the beautiful white sand beaches to soak in the Mediterranean sun. Until a few weeks ago, Cyprus was a developed country well sought after as an offshore tax haven. As a member of the European Union, Cyprus had strict laws in place to protect the offshore financial sector. Cyprus could have been considered a low-tax haven since the country had a low tax regime in place for offshore companies and resident companies, paying just 10 percent, the lowest in the euro zone, below Ireland’s 12.5 percent and well under the 29.5 percent rate in Germany and 33.3 percent in France.
Fast forward to this Monday morning, and it was announced that the Eurogroup just reached an agreement with the Cypriot authorities on the key elements necessary for a macroeconomic adjustment program. The agreement was supported by all euro area member states (it was swiftly endorsed by euro zone finance ministers) as well as by the troika, the International Monetary Fund, European Central Bank and European Commission.
The program would address the exceptional challenges that Cyprus was facing and attempt to restore the viability of its financial sector, with the view of restoring sustainable growth and sound public finances over the coming years. How could they do that?
- Laiki (the second largest bank, also known as Cyprus Popular Bank, with a history that spanned beyond 110 years) is resolved immediately, with full contribution of equity shareholders, bond holders and uninsured depositors, based on a decision by the Central Bank of Cyprus.
- Laiki would be split into a good bank and a bad bank. The bad bank would be run down over time.
- The good bank would be folded into Bank of Cyprus (BoC), as one of its branches in Limassol experienced an explosion produced by a home-made bomb. It would take 9bn Euros of the Emergency Liquidity Assistance (ELA), the support given by central banks in exceptional circumstances and on a case-by-case basis to temporarily illiquid institutions and markets. Only uninsured deposits in BoC would remain frozen until recapitalization has been effected.
- The Governing Council of the ECB would provide liquidity to the BoC in line with applicable rules.
- BoC would be recapitalized through a deposit/equity conversion of uninsured deposits with full contribution of equity shareholders and bond holders.
- The conversion would be such that a capital ratio of 9 percent is secured by the end of the program.
- All insured depositors in all banks would be fully protected in accordance with the relevant EU legislation.
- The program money (up to 10bn Euros) would not be used to recapitalize Laiki or Bank of Cyprus.
It was expected that these measures would form the basis for restoring the viability of the financial sector. In particular, they safeguard all deposits below 100.000 Euros in accordance with EU principles, which were initially at risk based on a prior proposal. The program stressed that there would be an appropriate downsizing of the financial sector (Cypriot banks had assets equal to 750 percent of the country’s gross domestic product), with the domestic banking sector reaching the EU average by 2018 (less than half of the current ratio), while encouraging Cypriot authorities to step up efforts in the areas of fiscal consolidation, structural reforms and privatization, in addition to increasing the withholding tax on capital income and of the statutory corporate income tax rate.
What is the message that the incidents of the last week tell depositors around the world? Move your deposits out of Greece, Italy and Spain; think about outside Europe. While in the case of Cyprus a significant component came from Russian companies and individuals (an estimated $31 billion, according to Moody’s Investors Service), it is clear that the attitude of the European authorities is now to consider public deposits as the new ATM for governments, at least the uninsured deposits of 100.000 Euros or more . No matter what the authorities say to coat the pill (black money might have been present, savers have enjoyed years of high interest rates, etc.), this is a clear message that will reverberate throughout the continent: deposits are not safe anymore. The strict enforcement of the rule of law is gone, and with that the tax haven status that Cyprus worked so hard to build; Cyprus bet its future on it and lost.
Where deposits will go? America. Why? Says FDIC spokesperson David Barr: “During the current economic crisis, consumers have seen firsthand how the FDIC protects their money by swiftly making deposits available when a bank is closed. In the FDIC’s 80-year history, not a single depositor has ever lost a penny of insured money as a result of a bank failure. Our proven track record has helped prevent bank runs during some very difficult economic times.” It doesn’t take a rocket scientist to understand that deposits will be coming to America shores to earn almost zero, courtesy of Fed Chairman Bernanke; depositors worldwide now know that earning zero is definitely better than experiencing a 40 percent haircut, too bad it is too late for Cypriot (and Russian) depositors.Read Full Post | Make a Comment ( None so far )
Stocks in the US markets slipped on Friday, ending the Dow Jones Industrial Average’s (DJIA) longest winning streak since 1996, just after snapping a 10-day run. Data from Thomson Reuters’ Lipper service showed that investors in U.S.-based funds had poured $11.26 billion of new cash into stock funds this last week, the most since late January. The DJIA slipped 25.03 points, or 0.17 percent, to 14,514.11 at the close. Meanwhile, it was announced that the fewest workers on record were fired in January and job openings rebounded, showing employers were gaining confidence the U.S. expansion would be sustained.
According to some pundits, recent market activity is essentially driven by positive corporate earnings. The S&P500 Price/Earnings (PE) ratio is currently slightly high at 16.5, if we compare with past indicators. The median S&P500 Trailing Twelve Months (TTM) PE ratio has been about 14.5 over the last 100 years; average is around 16. It was during much of 2009 when the disconnect between price and TTM earnings was so extreme that the P/E ratio was in triple digits, as high as the 120s. Going back to the 1870’s, the average P/E ratio has been about 15; therefore, the US equity markets are not excessively valued, leaving some room for further growth.
Other pundits point to the Federal Reserve’s determination to continue stimulating the economy with increased liquidity. Mohammed Apabhai, head of Asia trading at Citigroup Global Markets, favors this train of thought. He has noted that there is a 70 percent correlation between stock market performance and liquidity, “whether it’s through the promise of lower rates, QE (Quantitative Easing) or promise of more QE.” The Federal Reserve has launched three rounds of Quantitative Easing since the financial crisis hit in 2008.
More likely, both factors are in play, very good corporate earnings and monetary policy that pushes investors to take risks in equities. So is the earnings momentum sustainable? Unfortunately, savings from the smaller share of the pie from labor, government spending and earnings coming from emerging markets (EM) outside the US are all factors that will be curtailed at some moment. Is the Fed eager to continue being the huge player in this equation? Some of its members are increasingly worried about the effectiveness of the continued QE; if the labor market recovers, as the January numbers showed, the Fed most probably might be ending its bond purchases soon.
As pointed out by James Saft, wages in the US have taken a smaller and smaller piece of the pie; now below 44pc of GDP and dropping, down several percentage points since 1999. That is in part the consequence of globalization and the offshoring of jobs. However, the labor which can be offshored largely has already been and the likely trend is for new manufacturing technologies to start pushing jobs back into the US. As has been of national knowledge as well, there is a real danger of declining government spending. A dollar spent by the government is a dollar that supports household income, and consumption, and of course corporate profits; there will be less dollars starting this month thank to the sequester, a series of spending cuts and tax increases aimed at reducing the budget deficit.
Emerging markets are looking overstretched heading into the second quarter, Barclays Capital said in a report dated March 15, pointing out that the cyclical recoveries in EM have slowed down. Consensus growth forecasts (according to Bloomberg) have been revised down by 0.75 percentage points on average since mid-2012. EM equities have been slow to react to these developments due partly to the continued inflows into the asset class from retail clients. The correction has started recently and the performance by country year to date has been mixed, but the most pronounced selloffs have been associated with the largest revisions to GDP growth forecasts. Adding to this dire situation, the economies of emerging markets grew at a slower pace in February than the month before, according to HSBC’s monthly purchasing managers’ index. The PMI recorded a level of 52.3, down from 53.8 in January, its lowest since August. The index covers 16 leading emerging markets, including India, Brazil and China, which all saw their rate of growth fall. Investors had been questioning whether emerging markets, whose growth depends in part on exports to mature markets, could continue to expand at fast rates of almost 10% in some cases.
What the equity markets want indeed is stable and/or predictably increasing US profits and the Fed to stay in the bond markets. Saft ironically suggested that markets’ best hope might be a cut in government spending deep enough to kill job growth and indefinitely extend QE, something that nobody else would agree with. Instead, markets would be happy with a bit of positive news today followed by another bit of negative news tomorrow. Unfortunately for the markets, profits will start showing stagnation starting with first quarter results. Federal Reserve said in September 2012, when QE3 was announced, that it would start pumping $40 billion a month to purchase agency mortgage-backed securities (MBS) until the labor market improves substantially. When will the Fed determine that the job market has made enough progress to reduce stimulus? The numbers for February will prove paramount in this regard. As these two important factors converge in a nightmarish scenario, equities markets should beware of the ensuing correction, coming as early as in the second quarter.Read Full Post | Make a Comment ( None so far )