Tuesday, March 26, 2013

Economic complications of a Cyexit

Over the past few days, the Cyexite scenario has been communicated several times, either via journalists or bloggers and some other times as a leverage for negotiations... I shall  examine some implications of this undesired though improbable- if you ask me- scenario

First of all, Cypriot firms, both financial and non-financial, and households have issued debt denominated in Euro, such as loans, bonds, commercial credit, cheques etc. Then, in case Cypriot pound (CP) substitutes for euro a practical question arises: the just mentioned debt will be repaid in what currency? If some of you see an obvious answer, please take some time to reconsider your thoughts. First of all, the debt holder will have to agree to be paid back in an other that the agreed currency and then he will have to negotiate the exchange rate this will happen (for now let us ignore the exchange rate related problems). On the other hand, the debt issuers, will have to find adequate funds to pay back its borrowers both Cypriots and foreigners, alternatively adequate and suitable collateral should be provided (e.g real estate located in Cyprus that will yield periodical income denominated in CP is not suitable at all, and cannot be sold either in a foreign currency nor in CP). Moreover, the will have to be an agreement as far as the interest rate is concerned; significantly higher rate is needed in order for the holder to be compensated for the additional risk that he undertakes but in that case the debt will turn out to be unbearable for the issuer. In case a sustainable for the issuer rate is agreed it will not compensate for the risk and hence it will be similar to default.

Secondly, some attention must be paid to the credit default swaps (CDS). Under such circumstances, the conditions, that determine whether the debtor has failed to meet his/her obligations, cannot be easily specified. The CDS seller will have reasons to avoid paying for a not so strictly defined credit event while the buyer has reasons to claim compensation.

Now, let us consider the exchange rate risk that we overlooked previously. Following the Cyexit, foreigner holders of assets now denominated in CP will start selling their assets, most probably, at any price. In that way, demand for foreign currencies will be increased accompanied by increased supply of CP all that leading to CP denomination. Thereafter, holders of debt now denominated in CP will lose a large fraction of their savings and debt issuers will fail to meet their obligations in coupon rates and capital if the debt is now denominated in a foreign currency instead. In addition, international trade transactions with Cyprus will be subject to high daily variations of exchange rate threatening the activities of both importer and exporters, c.

Please note that in all the cases mentioned above, restrictions on capital movements that are likely to be imposed will only make things worse for the debt holders.

Thirdly, deposits in Cypriot banking system will be converted to CP and they will also be subjected to the currency devaluation, shrinking purchasing power and assets value of the holders. Mutual funds, banks and many other financial entities who keep their deposits there will record significant losses additionally amplified by the capital movement restrictions (remember that deposits had already been heavily taxed). At this point, the risk of dissemination throughout the Euro-zone and the rest of the globe begins to rise notably (I have previously expressed myself with respect to the broader contamination risk) causing further unrest. 

There is also another question that calls for an answer; what will happen with the Euro banknotes already in circulation which are either held by households or banks. The most probable outcome is the parallel circulation of both currencies, CP and Euro, and the everyday transactions will become difficult, because agents would prefer to receive payments in the hardest currency of the two, i.e the euro. Eventually, the avoidance of CP and the preference of Euro will make the former lose even more value.

Furthermore, since the road of exiting the EMU has now opened there is no institutional entity that can guarantee the cohesion and the preservation of the Euro-zone. A suspicion as such, would increase the risk of a wider systemic crash added to the already stressed banking system.

All of the above mentioned features of Cyexit will most likely call for a large monetary actions from both Cypriot and foreign monetary authorities. As a result, the credibility of ECB to sustain and stabilize the Euro currency may irreversibly be damaged and European authorities will have failed to successfully complete the integration that has been persistently and carefully pursued over the last decades.

In conclusion, if you have thought several reactions to the above mentioned threats please keep in mind that these measures may require a lot of time to be agreed. It would be a really painful- if not impossible- task to mitigate the threats of the Cyexit and the stakes for all member states are high. In any case, there are plenty of other solutions that are much smoother,  much less violent and much more viable in order to prevent... an angel from falling.

If you wish, you may try and think of any other EMU member state adopting its own currency. The above described results apply.

I sincerely hope that I have convinced you that the exit of any country is not probable at all. If not, comments are welcome. At the end of the day balance is always reached.