Fitch says Cyprus Stalemate Shows Dangers of Ad Hoc Crisis Response

The crisis surrounding
Cyprus
 brings into focus the costs of policymakers’ “muddling through” approach to the eurozone crisis, said Fitch Ratings, as the European Central Bank (ECB) imposed a deadline of next Monday (25 March) on the island’s government to negotiate an alternative bail-out deal.

According to the credit ratings agency (CRA), without greater progress and clarity on the terms of financial and fiscal risk sharing between euro area member states, each sovereign and bank crisis prompts an ad hoc response that exacerbates uncertainty and undermines market confidence and financial stability. However, there are no immediate rating implications for other eurozone sovereigns.

The proposed Cyprus bail-out programme confirms the strong desire of European policymakers to minimise costs to other eurozone taxpayers but marked the first attempt to ‘bail-in’ bank depositors. But the necessary institutional framework and resolution mechanisms are not yet in place. To execute this strategy now, and critically to involve retail depositors, sets a potentially dangerous precedent for other eurozone countries, particularly those with weak banking sectors.

Fitch does not currently expect the instability in Cyprus to spread to other eurozone banking systems. But in our view any support package that includes a ‘stability levy’ is effectively ‘bailing in’ depositors and therefore inevitably increases the danger of contagion risks within the eurozone. Even if the stability levy is dropped the proposal sets a precedent that depositor bail-in mechanisms are now an acceptable policy tool. The CRA has placed the ratings of Cypriot banks on rating watch negative, reflecting the potential restricted default that would occur from a significant levy on deposits.

The loss of insured depositors’ savings would be an unprecedented step in the eurozone crisis and is likely to have longer-term implications for support-driven bank ratings. The Cypriot crisis demonstrates that there could be a more rapid removal of support than we had previously anticipated. This would create uncertainty for investors and have negative implications for bank ratings.

The situation underlines the necessity of banking union within the eurozone to provide an effective framework for the management of the financial crisis. As Cyprus has also demonstrated, deposit insurance, a key part of the sovereign-bank nexus, is compromised when the sovereign is financially distressed and the size of the banks and deposits is overwhelming.

Progress on banking union, including a clear resolution regime and some form of common deposit insurance, and an effective single supervisory mechanism, is essential for securing the long-term financial and economic stability of European economic and monetary union.

The deposit freeze imposed in Cyprus this week is a de facto restriction on the free flow of capital. If other forms of capital controls are introduced as part of a programme agreed between the Cypriot authorities and the EU-IMF, Fitch would review the AAA country ceiling assigned to all eurozone countries (other than Greece, whose country ceiling of B- reflects the risk of a euro exit), which is premised on the free movement of capital across the eurozone.

Limited debt service relief and legal constraints, and fears of the contagion from imposing losses on sovereign debt continue to be factored into Fitch’s Cyprus sovereign rating of B/negative. But without a quick resolution to an evidently unsustainable situation, the risk of a disorderly sovereign and bank default will increase.

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