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<p style="text-align: center;"><strong><em>An Independent Strategy report on Cyprus</em></strong></p>

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INVESTMENT CONCLUSION

The Cyprus deal is still a bad one. But it will allow the markets to forget Cyprus for a while. We had insurance against a “no deal” in terms of short peripheral bonds (net) and the euro plus long US Treasury bonds. We are removing those. But its worth noting that we are staying short Italy sovereigns and banks. We remain long Spain, Portugal and Ireland. We expect the sigh of relief to be short-lived. Indeed, our shorts lost us very little money as the markets priced in a Cyprus deal.

ANALYSIS

Much of the detail is undefined as yet. But the elements are clear: budget cuts (4% of GDP); big haircuts on uninsured deposits (above €100k); closing the second-biggest bank (about 30% of loans and deposits) and ‘bailing in’ uninsured depositors (with losses of up to 40%!), senior and junior debt holders and, of course, equity; and restricting savers’ access to their money in all banks through capital controls. The levy on small depositors has been dropped and senior bank debt is being bailed-in with the closure of Laiki and the recapitalisation of the Cyprus banks. Addi- tionally, corporation tax will be increased from 10% to 12.5%.
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This deal is a bad deal for these reasons:

<img class="alignleft size-full wp-image-1053" alt="" src="http://www.thoughtforaction.org/wp-content/uploads/2013/04/Screen-Shot-2013-04-03-at-09.46.34.png" width="394" height="307" />• Bailing in depositors (Figure 1) is a very bad idea and will make future bailouts, such as Italy, subject to deposit flight. The fact that the initial deal bailed in depositors but not senior bondholders was a piece of scandalous inequity, which fosters suspicion of the leadership of the Eurogroup and ECB. The news is that the Spanish government is considering “taxing” depositors too.

• Suspendingcapitalconvertibilitywithinasingle currency area means a single currency doesn’t exist anymore, de facto. Clearly a German euro is worth more than a Cypriot one today. Again, this will promote capital flight and make future bailouts very difficult.
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• These two former measures are intended to keep the Troika bailout package to €10bn and use depositors’ money to recapitalise the banks by €6bn — instead of the Troika’s. The justification for this was that to do the opposite would raise sovereign debt to GDP to unsustainable levels (150%-plus). We find debt sustainability to be better (but not good) if long term (30yr) loans at ESM cost of borrowing +100bp (the Greek model) are used rather then the current package.
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<img class="alignleft size-full wp-image-1054" alt="" src="http://www.thoughtforaction.org/wp-content/uploads/2013/04/Screen-Shot-2013-04-03-at-09.46.54.png" width="402" height="303" />• The current €10bn troika package is destined primarily to fund budget deficits and sovereign rollovers over the next three years. It will not be enough because: a) freezing people’s money and the loss of confidence in

the government measures will cause consumption to collapse; b) the deleveraging of the banks, including the closure of Laiki and the bail-in recapitalisation of Bank of Cyprus and other banks, will be draconian with massive knock-on effects on credit availability; c) the financial sector will shrink by two-thirds and this accounts for 8.5% of annual economic output (Figure 2). This doesn’t factor in the large support and serv- ices industries that have grown up around banking, so the economic impact will be even more substantial. Finally, this austerity programme will have zero support among the citizenry, which makes compliance impossi- ble.

There are two over-arching impacts of this. First, the acceptability of future austerity packs based on German 'austerity' and diktat is zero. This is particularly relevant to Italy, whose election result already signalled that the German reform model was reaching its use-by date. Italy, moreover, is sliding towards ungovernability and a bailout without being able to do much about either.

Second, the ECB objective of ending financial fragmentation will be made more difficult by its acquiescence to this deal. Worse, its pledge ‘to do what it takes’ to save the single currency must seem a trifle empty in Nicosia this morning. The OMT remains inoperative; with the latest excuse being that the legal paperwork is not ready.

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<img alt="Screen Shot 2013-04-03 at 09.50.11" src="http://www.thoughtforaction.org/wp-content/uploads/2013/04/Screen-Shot-2013-04-03-at-09.50.11.png" width="354" height="142" />
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<h6 style="text-align: left;"><strong><em>INDEPENDENT STRATEGY</em></strong>
1 QUERIPEL HOUSE, 1 DUKE OF YORK SQUARE, LONDON SW3 4LY, TELEPHONE: +44-20-7730 4965 FAX: +44-20-7730 7963, E-MAIL: main@instrategy.com, WEBSITE: www.instrategy.com, <em id="__mceDel" style="font-size: 0.75em;">AUTHORISED AND REGULATED BY THE FINANCIAL SERVICES AUTHORITY </em></h6>
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