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Tyndall Monthly Commentary: Does Cyprus Really Matter?

Cyprus is a small economy with a potentially huge footprint. How the European Union responds to its crisis provides an insight into its attitudes towards monetary policy.

Thursday, April 4th 2013, 10:31AM

by Andrew Hunt

As has no doubt been stated many times by many commentators, Cyprus is a small country with a pleasant climate in the East of the Mediterranean Sea that has a GDP that is, according to CNBC at least, probably only the equivalent of Boise, Idaho.  With no offence intended to the residents of Boise, the fact that this small economy has run into difficulties would not at first sight seem to be of particular significance to the outlook for the global economy.  Where Cyprus does matter, though, is that it is part of the Euro system and, were it to leave, it could cause systemic failures in the European and perhaps even global financial system, particularly if counterparty fears rose again (as they did in the wake of the Lehman crisis).  Fortunately, we do not suspect that the Cypriot economy or its banking system will be allowed to collapse; if the EU does not come to its aid (and hopefully it will do so without seizing deposits from Cypriot residents) then it is quite likely that Russia will rescue the country but this does not mean that investors should ignore what is going on in this small economy.  In fact, we believe that what is happening tells us much about what is happening within Euro policymaking circles.

It seems incredible even to us that it was only seven weeks ago that we visited Frankfurt and were told by a senior staffer at the ECB that the central bank needed to tighten its stance “soon” because the Euro region was facing the threat of higher inflation in 2015, or perhaps even earlier.  The analysis that he used to justify this seemingly strange assertion appeared to be based on what could only be described as a 1980s-era Bundesbank “manual” that postulated that somehow there was still too much money within the Euro region relative to the long-term demand for money (that is, that there were “excess money balances” as a result of the system’s overexpansion during the mid-2000s) and that this situation might one day trigger inflation in the Euro region.  We may have stated that this approach and its theoretical underpinning were based on some unrealistic assumptions about the likely stability of the demand for money within the Eurozone but, nevertheless, even under quite intense scrutiny, the ECB official “stuck to his guns” about the need to tighten and within a matter of weeks the markets were indeed beginning to discount the likelihood of an ECB tightening, despite the still-appalling economic weakness that the current data was – and still is – revealing in the region.  Consequently, at the time, we wondered whether the ECB, in reality, had some other agenda.
In fact, the analysis offered by the ECB seemed, at first sight, to be so strange to us that we were quite shocked by the views expressed (particularly given the large negative output gaps that much of the Eurozone are experiencing at present), but, with hindsight, we wonder whether what we were offered was, in fact, a glimpse of the divide that is opening up within the ECB itself and which seems to be “swallowing” Cyprus.

In some of our specific Euro area reviews over the last six months or so, we have opined that the ECB under Draghi has been presiding over what we have described as the Ruble-isation of the Euro system. For those readers that are not familiar with Russia’s monetary history in the 20th century (and, let’s be honest, not many people are...), during the early 1990s, as the USSR became the CIS, some rather strange forms of central banking protocols were adopted. Specifically, the central banks in the new countries within the CIS did not have the ability to create their own money to fund their own asset growth and, instead, they were obliged to fund their frequently aggressive rates of balance sheet growth by borrowing all that they needed from the Russian central bank in Moscow.  Unfortunately for the Russian central bank, the latter had absolutely no discretion over how much they lent to these “peripheral countries” – the Russian central bank had to meet the demand for credit from the other countries’ central banks elastically and the Russian central bank in turn had to fund its lending to these countries by issuing new money within Russia, which was, at that time, the core of the CIS. 

Within a year, this enforced rapid rate of central bank balance sheet growth in Russia had allowed a massive expansion of liquidity in the Russian economy (broad money growth hit a triple-digit rate) and the Russian population soon came to distrust this newly minted and rapidly expanding stock of money.  Consequently, the domestic demand for money began to fall relative to its surging supply and the resulting excess money balances were thereafter dumped in favour of either foreign exchange or goods.  The predictable results were a weak Ruble balance-of-payments position and domestic hyperinflation.

Unfortunately, although it is only whispered in academic and monetary economist circles, it does appear that ECB President Mario Draghi has, in effect through his explicit promises to do whatever is necessary to save the Euro, reduced the ECB to a facsimile of the Russian/CIS system a generation ago.  Because the individual members of the Euro are still sovereign states with their own electorates, forcing acute debt deflation and price deflation on these economies is potentially a fatal strategy for the authorities, as we have seen in Greece, Spain, Italy and, most recently, Cyprus.  In fact, we suspect that Draghi has reasoned, not unreasonably we suspect, that the tolerance for sustained deflation and depression in the peripheral countries is finite and indeed relatively modest and so the ECB has created a whole host of rescue vehicles such as the ECSB, the ELA, the OMT and  the lesser-known, but hugely important, TARGET2 system. 

Without going into their technicalities, this alphabet soup of emergency rescue vehicles have provided a number of routes through which funds from the stronger core can be channelled to the weaker countries within the periphery so that politically destabilising acute deflations can hope to be avoided in the latter group.  If the Euro were in fact a strict single-currency regime, as indeed the USA is under the FRB system or Hong Kong is under the Currency Board, then most of these vehicles would not exist but, in the Euro, their continued existence prevents the types of severe adjustment that countries experienced within the Gold Standard-era in the 1920s (or indeed individual states within the US do routinely experience even today), a situation that, in effect, allows European debtors to be debtors “forever” and hence this tends to lessen the deflationary pressures that they can experience, presumably for political reasons.

For example, had Spain been left with an unfunded balance-of-payments deficit equivalent to almost 30% of its GDP last year (as would have happened without the operation of the ECB’s rescue systems), then the implied monetary deflation would have been massive and probably somewhat worse than any that has been experienced by any country in the post-war period.  Had this level of deflation been allowed, then we have no doubt that Spain’s population would have exercised their rights as a sovereign state and departed the Euro with all possible haste.  Hence, we can argue that the massive expansion in the ECB’s rescue efforts last year effectively saved the currency union.

By allowing these rescue vehicles to lessen or, at times, even prevent deflation in the uncompetitive periphery, though, Draghi has implicitly created a system in which the periphery can, in effect, borrow on demand funds from the ECB (thereby implying a rise in the ECB’s “assets”) in a way that would seem familiar to any Russian central banker 20 years ago.  Moreover, the ECB has itself then been obliged to fund its acquisition of claims on the periphery by obliging the core countries’ central banks to lend to it, thereby creating assets for the core countries’ central banks, which they, in turn, have to fund by issuing liabilities drawn on their central banks that constitute liquidity in their domestic financial systems.  Hence, the ability of the peripheral central banks to borrow “at will” from the ECB has resulted in bank liquidity growth in the once financially conservative German central banking system to hit unprecedented levels.

Admittedly, the Bundesbank’s balance sheet has been shrinking of late as the return of foreign private sector capital inflows into the periphery have allowed some of the rescue vehicles to shrink but, nevertheless, the Bundesbank’s balance sheet – and hence the implied level of liquidity in the German banking system – is likely to be somewhat higher than the Bundesbank itself would probably like it to be at present.

At this point, the fear for the Bundesbank must be that, like their Russian counterparts 20 years ago, the German banks or even the wider population might quite rationally decide that with the “potential money supply” having increased so dramatically over recent years, it is “worth less” and that they should dump it either in exchange for foreign assets that might well cause an inflationary decline in the external value of the Euro (just as a similar event has done in Japan over recent months) or even cause the domestic population to move into real goods with direct inflationary consequences for the domestic economy.  For a country with Germany’s aging demographics, let alone its history, the thought of residents dumping the “excess money” that it has been obliged to create by the ECB must be the stuff of nightmares for the Bundesbank. 

Hence, we wonder whether the real monetary overhang that our ECB staff member was referring to in our interview was not in the Euro system as a whole but rather in the core countries specifically.  This would explain the rather Germanic theoretical standpoint that he used in his presentation.  If this is indeed the case, then we could easily imagine that the German, Lux and Finnish central banks (which, rumour has it, were initially very opposed to Draghi’s OMT in the first place) will, at present, want to achieve two things: they will want, at all costs, to prevent their domestic residents and banks from losing confidence in the Euro’s value so that they don’t “dump” it in the way that the Japanese banks and others have done to the Yen; and they will also want Draghi to renege on his promise to do whatever is necessary so that the supply of Euro liquidity is no longer simply a function of what the periphery demands.

In short, what we suspect we witnessed at our meeting back in January and what may have framed the Euro authorities’ response to the Cyprus event was the result of the divide that has opened up between the monetary conservatives who oppose the Ruble-isation of the Euro and those that want to transfer Europe’s monetary policy-making to the periphery at the core’s “expense”.

Last weekend, in what was clearly a reversal of Draghi’s “at all costs” strategy, we suspect that the conservatives were allowed to prevail over the softer Draghi camp simply because Cyprus was perceived as only being a small economy with lots of non-resident depositors.  In effect, Cyprus was to be sacrificed to underline to the periphery that there was, in fact, no blank cheque available from the core and to emphasise to the core that the Euro was not going to follow the path of the Ruble.  Unfortunately, if not unsurprisingly, Cyprus’ voters and depositors were not prepared to be sacrificed in this way and we suspect that Cyprus is therefore becoming less of a martyr for the core’s perceived optimal version of the Euro and more of a cause célèbre or poster-child for the embattled periphery (the economic data for which still seems to be deteriorating aggressively, as we noted above).

Therefore, while we suspect that ultimately Cyprus will be bailed out by its Russian friends, the whole incident probably tells us that there is a significant chasm opening up between the core and the periphery within the Euro over the future and character of the system and that this is a chasm that is being brought into sharper focus by the proximity of the German elections that are giving the anti-ECB camp in Germany some “air time”. 

In practice, we suspect that the system will not survive if the conservatives prevail, since the periphery will not be able abide the deflation, but if the periphery wins, we suspect that the Euro will finally morph into a weak currency/higher background inflation area that the core may not like very much at all...  Nevertheless, in the near term, we can only expect that the battle for the heart and soul of the ECB will create more periods of political and policy uncertainty, particularly given Germany’s current low-growth environment and the depression that is unfolding in the periphery.

Andrew Hunt
International Economist, London


Andrew Hunt International Economist London

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