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Mounting concern that Cyprus will need bail out PDF Print E-mail
News - Latest
Monday, 01 August 2011 10:33

Concern is mounting that Cyprus may join Greece, Ireland and Portugal as the next country in the euro zone needing a bail out form the European Union.

Last week Moody’s Investors Service cut the rating for Cyprus two levels to Baa1from A2. Although still an investment grade, it assigned a negative outlook, signalling that the next move may be another downgrade.

An explosion at a naval base last month badly damaged the Vasilikos power plant in Cyprus. That has caused blackouts, and Moody’s said that the power shortage was likely to hurt the economy, which it now expects to stagnate this year and expand only 1% next year.
 
Moody’s also cited the ‘increasingly fractious domestic political climate’ and ‘the material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece’.

Banks in Cyprus continue to hold substantial Greek debt and will be affected in the case of a sovereign debt default, Moody’s said, adding that it was also concerned about the large role the banking sector plays in the Cypriot economy. Bank assets amount to about 600% of gross domestic product in Cyprus, excluding foreign bank subsidiaries, it said.
 
Also political friction might make it harder for the centre left government, which does not have an absolute majority in Parliament, to push through spending cuts and privatizations that were announced a month ago.

‘This adverse development increases implementation risk to the government’s plans, many of which will require not just cross party support but also acceptance by the trade unions,' Moody’s said.
 
There are also concerns about the banking sector in Cyprus expanding too fast. There has been an explosion in foreign money, much from Russia and the Middle East and Cyprus is seen as a safe haven for cash from these regions.

‘The Cypriot banks have been considered safer than the Greek banks and have received a lot of the deposit outflow from Greece,’ said Panicos Demetriades, a professor at the University of Leicester in England.

‘However, the problem is that a small country like Cyprus cannot afford to support such a large banking system if it gets into trouble,’ he added.

According to Stuart Thomson, chief economist at Ignis Asset Management, it is highly likely that Cyprus will default within 12 months. ‘Moody's downgrade from A2 to Baa1 still leaves the island with an investment grade rating. This is too kind, we believe that Cyprus will be downgraded to junk over the next few months and will follow Greece into default over the next twelve months,’ he said.

‘As the recent stress tests highlighted Cypriot banks are highly exposed to the Greek crisis. They have benefitted from the deposit outflow from Greek banks over the past eighteen months, but these funds are likely to seek safer homes now that Cyprus's problems have been brought into sharp relief,’ he explained.

‘According to the Central Bank of Cyprus, deposits held by other financial intermediaries fell from €7.5 billion in May to €6.1 billion in June, showing the start of this process. This leaves domestic banks highly vulnerable,’ he added.

He pointed out that the build up of financial assets in Cyprus has created an unsustainable Ponzi scheme similar to Ireland. ‘The Cypriot ratio is unsustainable and as Moody's noted with masterful understatement that there is a material risk that at least some Cypriot banks will require state support over the medium term as a result of their exposure to Greece,’ said Thomson.
 
He also explained that last week's proposed changes to the European Financial Stability Fund will allow the organisation to provide funds to countries to recapitalise their banking system. ‘Cyprus could become the first protectorate of the fund. Much more likely will be a small bailout from the EFSF. More importantly, will be the likely imposition of economic governance from Brussels. This would be consistent with German Finance Minister's recent comments that countries that seek funding from other Eurozone members will need to surrender some sovereignty,’ explained Thomson.

‘Cyprus will be an obvious test case of this new hard line policy. It will be the first sign that volatility is being transferred from interest rates to politics. We believe that this will ultimately be bearish for the Euro,’ he added.

 

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