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Moody's: Cyprus crisis is credit negative for euro area sovereigns.

Euro area policymakers' handling of the Cyprus crisis to date, the increased risk tolerance apparent in their actions, and the uncertainty that a more uncompromising and less predictable approach to crisis management creates for investors' assessment of risk, are credit negative for euro area sovereigns.Even if negotiations are successful and Cyprus remains within the euro area, policymakers' recent decisions raise the risk of deposit outflows, capital flight, increased bank and sovereign funding costs and broader financial market dislocation throughout the euro area in the future, even if those decisions do not disrupt financial market calm in the present. If negotiations fail and Cyprus exits the euro area, the disruption could prove to be beyond policymakers' ability to manage.Shift in policymakers' risk tolerance increases exposure to high-severity tail risksThe conditions imposed by euro area policymakers for financial assistance, which seek to reduce moral hazard and limit future liabilities by imposing discipline on recipients of financial assistance, are rational and understandable. Policymakers' conclusion that the Cypriot government' s debt burden would be unsustainable without some form of burden-sharing is reasonable. The refusal to lend to sovereigns that are clearly insolvent is consistent with past actions.However, the hard line adopted by euro area governments during negotiations suggests it is more willing than in earlier stages of the crisis to tolerate a risk of inducing financial market disruption when imposing conditions - a willingness designed in part to appease domestic political pressures, particularly in Germany. The proposal to impose a haircut on bank depositors is precedent-setting, irrespective of the system-specific circumstances in Cyprus. The strict interpretation of preconditions for assistance, including the strong emphasis on burden-sharing to support debt sustainability, illustrates the pressures that euro area policymakers are under to protect domestic taxpayers and impose losses on creditors of stressed sovereigns and stressed banks. Depositors, sovereign bondholders and holders of senior bank debt instruments in other fiscally constrained euro area sovereigns now face an increased risk of burden-sharing where policymakers believe it is appropriate.The dilemma euro area policymakers face is that, as they increase the pressure on peripheral countries to stay the course of structural reforms and fiscal consolidation, they inevitably increase the risk of political backlash and damage to market confidence in their ability to deal with shocks. Policymakers also risk market confidencein the irreversibility of euro area membership.Policymakers' ability to contain contagion is not assured. The stance of euro area governments suggests that policymakers are confident that market conditions are sufficiently benign and/or that they have sufficient tools to avoid contagion spreading to other peripheral sovereigns and their banks. Policymakers' willingness to take a hard-line negotiating position that could lead to a member exiting the euro area contrasts with previous negotiations with other member states on the conditions for financial assistance.Policymakers' confidence may be misplaced. To date, the course of the euro area sovereign and banking crisis offers no assurance that fallout from events in Cyprus would be easily contained, such as deposit or capital outflows from periphery banking systems. A Cyprus exit would prove that the currency union is divisible and that policymakers' commitment to doing "whatever it takes to preserve the euro," as European Central Bank President Mario Draghi said, does not extend to preserving the union in its current form. It would also confirm our view that support for other struggling euro area sovereigns may not be forthcoming if they fail to adhere to the requirements set forth by the creditor nations of the currency union. Policymakers would struggle to contain the disruption it would cause to the financial markets.Even if Cyprus ultimately remains within the union, the handling of the negotiations sends messages to depositors and investors that will undermine the resilience of the euro area financial system to future shocks.As euro area policymakers discovered at the time of the second Greek bailout, when they decided to make financial assistance contingent on private-sector creditors accepting losses on sovereign bond holdings, precedents are difficult to expunge from investors' memories, even when policymakers later try to assure the markets that they will not repeat such moves.Policy formulation remains unpredictable and prone to missteps and unintended credit negative consequencesPolicymakers' harder negotiating stance and apparent willingness to tolerate high-severity outcomes increases the probability of events that would be credit negative for all euro area sovereigns. The visceral reaction in Cyprus and elsewhere to the Eurogroup' s willingness to endorse depositor losses under the deposit guarantee threshold of E100,000 and the public brinkmanship between Cypriot policymakers and their euro area counterparts illustrate the potential for policy missteps inherent in policymakers' "muddle through" approach to providing assistance to member nations suffering financial stress.Source: bne
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Publication:Balkan Business News
Geographic Code:4EXCY
Date:Mar 25, 2013
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