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Installation of a new government in Italy and the first effects of the newly approved bailout in Cyprus provide some modestly optimistic data points for an otherwise weak euro area outlook.
For Italy, a Fresh Start, a Youthful Team, but No Guarantees of Success
In Italy, Enrico Letta has taken office as the prime minister, heading a coalition of his own center-left Democratic Party, former Prime Minister Silvio Berlusconi's People of Freedom Party, and the centrist Civic Choice bloc of former Prime Minister Mario Monti.1 Some see this new grouping as another "technocratic" regime, a Monti 2.0, but with a few more politicians in key positions. But that is a matter of debate.
Letta himself is a centrist. A nephew of Berlusconi's chief of staff, he started his career in the disgraced Christian Democratic Party, which collapsed in the "Clean Hands" corruption scandals in 1992–94. At the age of 25, he became president of the center-right European People's Party's youth wing, before joining the center-left predecessor of the Democratic Party in 1994. He was the youngest ever government minister (for European affairs) in the late 1990s and has been his party's deputy secretary since 2009. Letta is decisively a Europhile, a former member of the European Parliament and author of wonkish books with titles like Dying for Maastricht and Dialogue around Europe. In a party long dominated by elderly former Italian communists, including Italy's president, Giorgio Napolitano (once described as Henry Kissinger's favorite communist), Letta's ascension shifts the left toward the center, potentially turning the party into a more modern collection of European social democrats.
The new cabinet, moreover, is dominated by seasoned and safe veterans as well as technocrats. The minister for the economy and finance is 70-year-old Fabrizio Saccomanni, director general of the Bank of Italy and a former close associate of Mario Draghi, president of the European Central Bank (ECB). The new foreign minister is a 65-year-old old former European commissioner, Emma Bonino, the first woman in this post. The head of the government statistical office and a former chief statistician of the Organization for Economic Cooperation and Development (OECD), Enrico Giovannini, is labor and welfare minister. The career bureaucrat Anna Maria Cancellieri shifts from interior minister under Monti to justice minister. Angelino Alfano, a 42-year-old ally of Berlusconi (and another former Christian Democrat), is deputy prime minister and interior minister.
But whether this generally capable, pro-European government, which enjoys a broad majority in Parliament, can pursue needed structural reforms is a difficult question to answer. Italy's problems are deep and have been festering for decades, and it seems unlikely that they can be solved during a single parliamentary term.
One factor to watch is the extent to which Letta and his relatively youthful team can compete against Bepe Grillo, the volatile comedian and leader of the Five Star Movement, which has chosen to remain outside the government. Letta himself is nearly 20 years younger than Grillo, who may be able to seize the mantle of "agent of change" with that generational advantage alone.
Grillo's decision to remain outside the government, despite his movement's success in getting more than a quarter of the votes in the election, could mean that his influence has peaked. Grillo will probably need to share the political limelight with younger members in order to duplicate his success in the next election, even if Letta's government fails to restore economic growth and reform momentum. In this bleak scenario, fear for the future is likely to outweigh anger at the establishment as the main political concern for many still affluent Italian households,2 and they are likely not to forget that Grillo refused to capitalize on his political success to make a difference in the Italian crisis.
For Cyprus, a Risk of Delay in Lifting Capital Controls
On April 30, the Cypriot parliament voted narrowly (29-to-27) to approve the financial assistance deal reached last month with the Troika of the European Commission, the European Central Bank and the International Monetary Fund. This action clears the way for the bailout to proceed and for a more substantive discussion of when Cyprus's capital controls can be lifted. Had the vote failed, the controls would likely have had to remain in place for the foreseeable future. Meanwhile, new data from the Cypriot central bank show that the country's capital controls have been reasonably effective. Deposits declined 5.5 percent in March to €63.7 billion, reaching the level they had been before the crisis in Greece in early 2010. Domestic resident deposits dropped 3 percent, while other euro area resident deposits dropped 13 percent, and residents of the rest of the world took out €1.9 billion, or 9 percent of their deposits.
Thus only a modest amount of money has left the banking system, much of it withdrawn immediately by hard hit Cypriot retail depositors. The Central Bank of Cyprus balance sheet shows, however, that a sizable part of the total €3.75 billion monthly deposit outflows was replaced by an increase from by €1.2 billion to a record €11.4 billion in emergency liquidity assistance (ELA) from the European System of Central Banks (ESCB), which comprises the European Central Banks and the central banks of other members of the European Union. (The Central Bank of Cyprus identifies this lending on its balance sheet as other claims on euro area credit institutions denominated in euro.) Such assistance now equals 64 percent of Cypriot 2012 GDP. Deposit levels and ELA provision since Cyprus adopted the euro in 2008 in Cyprus are in figure 1.
MFI = monetary financial institutions
CBC = Central Bank of Cyprus
Source: Central Bank of Cyprus; Eurostat.
Figure 1 also reflects the remarkable stability of deposit levels in the Cypriot banks, despite the crisis, while illustrating the rapid ELA increase for Cypriot banks after they lost access to the wholesale funding market following the Greek debt restructuring in March 2012. Figure 1 shows further how, only after the March 2013 bailout did the ECB's ELA provision directly replace the withdrawn deposits of some of Cyprus's banks, notably the doomed Laiki Bank. Initially ELA only replaced lost access to wholesale funding for such banks.
The issue of potential ECB exposure from the ELA will help determine the timetable for lifting Cypriot capital controls. Some commentators assert that Cyprus's capital controls have created a de facto dual currency in the euro area, where capital controls are not allowed except in the direst emergencies. The euro area will have to lift its capital controls as soon as possible, and avoid the Icelandic scenario of having them linger on for years. Being part of a common currency area must make a difference in this matter.
Reports that the Cypriot government may wait until September 2013 to lift the controls, after the restructuring of the Bank of Cyprus and Laiki Bank is completed, are disheartening. It is difficult to see the rationale for keeping capital controls in place for all Cypriot banks, while awaiting the completion of the restructuring of just the two big banks. The Bank of Cyprus has already begun its swap-to-equity arrangement for uninsured deposits in excess of €100,000, converting 37.5 percent of them into A shares, while holding another 22.5 percent as an additional buffer for potential future conversion. The Bank of Cyprus's recapitalization needs and the size of losses inflicted on uninsured depositors should be known by June. The acknowledged liquidation of Laiki Bank, most likely with a complete wipe-out of creditors, including uninsured depositors, should also hasten the lifting of capital controls.
Unless of course, the ECB thinks that lifting them is too risky.
Following the transfer of Laiki's emergency liquidity liability to the Bank of Cyprus, the European central bank system will have the dubious distinction of being the largest single counterparty in the new combined legacy bank entity in Cyprus. Yet the riskiness of the ESCB's ELA provision is alleviated by the liquidation of Laiki and the Bank of Cyprus's restructuring, enhancing its ability to sustain itself without the need for more emergency lending. But the market consequences of lifting capital controls in Cyprus are inherently unpredictable. While March data are somewhat reassuring, no one knows if everyone will simply take the money and run when they can, exposing the ECB to at least some risk. The ECB is obliged to provide liquidity to any solvent bank, and the Troika program assumes that all other Cypriot banks except for the two biggest are solvent). But no bank is solvent if it suffers a bank run as part of a general panic in a country's banking system. As a result, the ECB might in extremis have to replace all the remaining €63.7 billion in deposits in the system. Such an extreme outcome is not likely. But if a run starts, would the ECB be willing to provide another €20 billion to €25 billion to Cypriot banks, bringing its lending to nearly 200 percent of GDP?3 Perhaps the ECB would rather wait a little longer to make sure.
A more pertinent question is whether the German government would take such a risk before elections on September 22,4 if another round of ECB emergency loans fans anti-euro sentiments. For the junior German coalition partner, the Free Democratic Party, which is polling close to the 5 percent threshold for parliamentary entry, this is a very serious risk. The political dynamics in Europe are such that it is impossible to ignore the electoral calendar of the regional hegemon, Germany.
But there are also risks entailed by delay. Cyprus's recovery is likely to be impeded by shackling the country's working capital inside its banks. If all Cypriot banks end up affected by most of the capital controls in force today until September, no doubt the 2013 economic contraction will be massive, exceeding current official assumptions. If that happens, Cyprus's future financing needs from the Troika would surpass the allocated €10 billion (equal to 60 percent of GDP). Of course, Germany and the ECB may accept the risk of delay, especially because the amount of money is small in the larger scheme of things in Europe. Even if, like Greece, Cyprus needs euro area debt write-downs to help meet its future financing needs, euro area leaders may accept this possibility to protect the ECB today and help smooth the German election campaign. Such an approach, however, would show little care for the short-run plight of Cypriots. It would also render the coming IMF debt sustainability analysis (DSA) irrelevant.
Then there is the issue of whether a dual currency—"the Cypriot bank euro"—would actually develop and trade at a lower rate than the regular euro during prolonged capital controls. The prospects for such a dual market are currently low, provided the consensus holds that controls are lifted by the end of 2013. Cypriot bank depositors would have to place a high value on immediate access to their bank deposits—for example, a 10 percent discount for each euro in a Cypriot bank that is blocked another 6 to 9 months. Such "Cypriot bank euros" might theoretically then be traded in their own market, but it is unlikely that anyone would be willing to take as much as a 10 percent haircut on them. And since the AAA euro yield curve is essentially zero out to 18 months,5 a "Cypriot bank euro" frozen in accounts under capital controls seems unlikely to lose much value or trade lower than the regular euro. Exceptions to this would occur if foreign depositors need access to their cash for pressing overseas purposes, or Cypriot retail depositors in desperate need of cash to sustain consumption during the crisis are willing to take a bigger upfront loss to get access to their euros.6
Were "Cypriot bank euros" nonetheless to be offered at a sizable discount to regular euros, the headline risk for the euro area would be serious. But any risk is unlikely to be widespread. The fears by some of a thriving market for discounted "Cypriot bank euros" thus seem excessive.
The timetable for lifting Cyprus' capital controls seems mostly dependent on how deep a recession in Cyprus the euro area and the ECB are willing to contemplate in 2013. The close vote in the Cypriot parliament in favor of the bailout suggests, however, that a euro area strategy aimed at minimizing the financial risks to the ECB and German electoral politics by keeping capital controls in place for too long—and thereby deepening the recession in Cyprus—could produce a political backlash in Nicosia. The Cypriot Troika thus faces tough choices between its own needs and what is best for Cyprus.
Notes
1. SC is he Italian acronym for civic choice, or Scelta Civica.
2. Recall that the median household wealth in Italy is a hefty €173,000, according to the new ECB Household Finance and Consumption Survey discussed here on RealTime last week.
3. Since it would be hard to imagine that the Cypriot banks would have sufficient ECB-eligible collateral to replace large amounts of lost deposits, ELA against uncertain collateral would seem the only way the ESCB could keep the Cypriot banks afloat.
4. I am indebted to my colleague Nicolas Véron for pointing out the similarity between the Cypriot government's September deadline and the German election date.
5. Since Cypriot bank deposits are either insured deposits, or deposits in banks that have not been affected by the recent Troika banking sector restructuring and hence must be assumed to be solvent, they are essentially locked-up cash with no realistic further credit risk. Hence using the AAA euro yield curve is appropriate.
6. I am indebted to my colleagues Doug Rediker, Anders Åslund, and Nicolas Véron for fruitful debate of this issue.
