Cyprus Collapse Triggers Unintended Consequences

Some people believe that by imposing losses on investors and reducing the Cyprus banking system liabilities, the European powers have addressed the problems in Cyprus (if harshly). Others think that it was just an unjust tax on depositors. I have written about the sequence of events. Cyprus banks borrowed money and bought Greek government bonds. Greece defaulted, imposing big losses on bondholders.  Cyprus banks postponed marking down their losses. Now, they have to mark those losses and admit that they are insolvent. This triggered a run on the banks. Now, finally, shareholders, bondholders, and depositors are taking their losses. The government of Cyprus and the “Troika” did not provide enough money to pay everyone.

Within Cyprus, there is now uncertainty about remaining deposits, capital controls, and the solvency of the Cyprus government itself. Elsewhere, the focus turns to other countries (e.g. Slovenia) where markets are becoming jittery that the same thing could happen.

The first question is, can one still buy gold in Cyprus? I predict that if it’s still possible to buy gold right now, it may not be for long. I corresponded with Panos Kostopoulos of AMP Gold Bullion Merchants Ltd. in Nicosia. First, he said:

“Immediately after the Cyprus presidential elections [Feb 24], I strongly recommended to Cypriots to buy gold, in order to protect their hard-earned money (taking in consideration wide spreading rumors for the deposits “haircut”, already at the time). Unfortunately, not a single person was convinced to do so. It is obviously needless to mention that I received orders for over 15kg within one day after the haircut was officially announced.”

It is interesting that Cypriots were not proactive, either in buying gold or in transferring Euros to banks outside Cyprus. It’s hard to believe that people will continue to be so naive in the next flare-up of the ongoing crisis.

Regarding whether they sell gold in Cyprus, Mr. Kostopoulos said:

“Our bullion is always kept OUT of Cyprus. We can either import it to Cyprus and sell it, or we can sell to our potential clients Gold warehouse receipts, with which they can go and collect their gold from our collaborators-dealers in Germany, Holland or Belgium. So, the answer to your question if we can sell gold in Cyprus at the moment is YES. However, nowadays, who will pay us in cash (daily withdrawal limit is 300 Euros per person)? Should we receive payment in our Bank account, we would need to apply to the Central Bank for permission to transfer funds out of the country, in order to pay for our scrap suppliers in Greece, so that we would replace our stock and keep our cycle of business going. The approval would take some bureaucracy hassle and at least 48hours, so, since our normal cycle of business is delayed, we are concluding transactions only with selected existing clients, for amounts not exceeding 20,000 Euros, and at a substantially higher premium than before, or than in the rest of the world [3.5% vs. 0.5%].”

Mr. Kostopoulos confirms that gold is not typically being brought into Cyprus. It is also important to note that Cypriots must pay using Euros outside the country, or cash. If they don’t have either, then most cannot get gold (those few who can will only get a limited quantity, and are subject to permission and delays at the central bank, and higher costs).

He was not optimistic that capital controls will be lifted soon.

Shareholders in the banks have taken total losses, though stock market losses do not generally cause a systemic crisis. Bondholders were also wiped out, and this is more serious because bonds are held in the portfolios of insurers, pension funds, and annuities. The Cyprus bond default could also bring down banks in other countries, if they used leverage to buy Cypriot bonds. The most serious impact is that depositors lost deposits over €100,000.

In sharing my thoughts, I take the risk of being wrong. It is not possible to predict the market reaction even in calm times, much less a sea change in volatile and dangerous times such as now. Below is my analysis, logic, and educated guesses about how events may play out over the short to intermediate term.

Cypriots who were formerly wealthy are now impoverished. Businesses may be unable to pay their landlords, suppliers, and payroll. Consumers, who now feel less wealthy, will cut back their spending. Unemployment is likely to spike (it was 14.7% in January).

It is questionable if Cyprus can fund its existing welfare state, much less grow the rolls—especially with a declining tax base. The Cyprus government bond itself currently has a Caa3 rating by Moodys (i.e. speculative, high risk). Can the Cyprus government now sell more bonds to pay maturing bonds plus fund its operations? If not, then many people, including the newly jobless, could be forced to leave the island.

A mass exodus would put downward pressure on real estate prices and on rents. This will impact much of the remaining banking system asset base, leading to further losses for depositors. The system based on borrow-to-consume has probably reached its terminus in Cyprus.

Cypriots face a dilemma. Without capital controls, people would quickly drain the banks of whatever remaining liquid assets they have, and then the banks would collapse utterly. With capital controls, they cause a whole new set of problems (if they can even successfully keep the capital in the country).

Will they offer a special exception to businesses that import products? Cyprus imports food, fuel, raw materials, and machinery[1]. If they don’t allow importers to send money offshore, it is hard to imagine how these businesses could continue to buy the products that Cypriots need, leading to immediate and desperate shortages. If they do, then it would seem to be a great hole through which massive capital outflows could pour, circumventing the capital controls.

Let’s assume that Cyprus somehow manages to enact rules that differentiate between permissible importing and illicit attempts to send Euros out of the country. There is still their trade deficit, which means capital is leaving unless it is offset by either foreign investment in Cyprus or additional bond selling by the government. Is either of these likely? Can the Cyprus government sustain borrowing at the current market rate, even if the market would bid on its bonds at all?

Capital controls are “necessary” if one accepts that any part of the coercive regime of irredeemable paper money with a government bond as “risk free” asset. But there is a profound and subtle (for now) unintended consequence. Euros in Cyprus are not the same as Euros out of Cyprus. A spread is forced open between what I shall dub “Cypros” and Euros.

To see this, imagine that you had a bank account at a bank in Germany. Someone in Cyprus says he would like to trade Cypros for Euros. He invites you to open an account in Bank of Cyprus and he has opened an account in Germany. He will transfer 10,000 Cypros to your account in Cyprus and in return you will transfer Euros to him in Germany. How many Euros would you bid to buy his 10,000 Cypros?

Less than €10,000.

Why? Unless you planned to go to Cyprus on holiday, holding a balance at Bank of Cyprus does you no good. This is the least of your problems. There are two other risks to your Cypro deposit.

One is that the Bank of Cyprus could collapse. Especially if Cypriots find ways to bypass capital controls, and probably even if not, the bank could default on its deposits. The Cyprus government does not appear to be in a position to provide bailouts—not even the “deposit insurance” promised up to 100,000 Cypros. The European Central Bank and the IMF may have made their best and final offer and could very well leave the depositors of Bank of Cyprus to their fate. There is no way to know today.

The second risk is that Cyprus could formally abandon the Euro. It would be the logical next step, after implicitly switching to Cypros. There is little question that the value of the Cypro would plummet following such an announcement.

Now consider the Cypriot with the 10,000 Cypros. Does he have any reason not to want to trade them for Euros in a German bank? When one side has many good reasons to be reluctant to buy, and the other side has a clear and compelling reason to sell, the price is bound to fall. I would bet an ounce of fine gold against a soggy dollar bill that this spread has already opened up, even if it is not yet reported in the news. Once this genie is out of the bottle, it will be impossible to put it back in, short of a blank check from the European powers.

Let’s look at something else, another unintended consequence, that is probably not well understood. Each cash note circulating in Europe was created by one or another national central bank. I understand from my German friends that paper Euros have a series designation imprinted on them. For instance, “X” means Germany and “G” means Cyprus. It would seem to be the basic operation of Gresham’s Law that people would prefer to hold “X” notes and spend or trade “G” notes away. This is because a bank note is the liability of the issuing bank. With the risk that a Euro note, even if it is currently circulating in France, could be defaulted by the Cyprus central bank or officially redenominated in Cypros, why should people prefer to keep it? Just as the silver coins in widespread circulation in the U.S. in 1965 were pulled for private hoards and only base metal coins were in circulation thereafter, the same phenomenon could occur in reverse with “G” euro bills.

This is a very dangerous development.  Let’s go back to my first question. Is gold still bidding on the Cypro? Aside from some possible inertia, desire to satisfy loyal customers, and remaining inventory, the big picture is that there is an irreparable fissure in the Euro. Due to national and banking system insolvency, the Cypro has split off. While the Euro is irredeemable, the debtors supporting it are still paying the interest.

Will anyone be willing to exchange gold for a Cypro bank deposit locked under capital controls, with risk of default, and no near-term prospect to get it off the island? There is no rational reason why they should. Only so long as the central bank allows bullion dealers to export Cypros at par can gold be imported for sale in Cyprus.

The government may not have realized it yet, but once Cypriots have gold, then they have escaped the prison of the Cypro. They can find ways to get the gold off the island, perhaps by boarding a boat and carrying it in their pockets. The flows out of their banks will, sooner or later, lead them to prohibit buying gold as a way around capital controls.

However, once gold is no longer available, then the final coup de grâce will come quickly. There is an interesting asymmetry. While gold owners no longer desire to get Cypros, holders of Cypros will still desire to get gold. When they cannot buy gold in a direct exchange, what will they do?

They will buy anything that can be readily exchanged for gold. Will Cyprus ban the export of commodities? If not, then holders of Cypros will buy oil, petrol, wheat, and other liquid commodities. They will sell it to those who can pay gold. This constant buying pressure on commodities and other goods will drive up their prices in terms of Cypros. It will send the goods offshore, depriving Cypriots of the ability to consume them.

Mechanically this is simpler than it sounds. Off the island, there is a Euro price for gold and a Euro price for crude oil, say €1244 per ounce and €82 per barrel. If one could exchange an ounce of gold for 16 barrels of crude, it would be a good deal (not including costs such as shipping, and taxes). While this window remains open, it will provide a way for foresighted Cypriots to exchange their Cypros for good gold. Under these market conditions, any Cypriot who can exchange Cypros for 16 barrels of crude can get an ounce of gold.

The window will not remain open for long. This is because the Cypro prices of commodities will rise relentlessly and exponentially. As they are becoming scarcer, and thus Cypriots will be watching the purchasing power of their Cypros falling, the Cypro-to-commodity-to-gold trade will be fueled even more, driving up the prices of commodities further. In the end, the Cypro will be repudiated.

People will call this “hyperinflation”. It will have nothing to do with the quantity of money. Cyprus may or may not be printing Cypros. We would guess they will not, as this is not allowed. While they still pretend that they are still using the Euro, and still deny that they have transitioned to the Cypro, they will have to obey the European rules.

In this scenario, I do not see how Cyprus can fix the problem simply by declaring a new currency. The root of the problem is that the assets backing the bank deposits, and ultimately the Cypro, were proven to be worthless. Bank deposits are the liability of the banks; if the banks’ assets are worthless, then so are their liabilities—i.e. the deposits. As the Cyprus central bank is also insolvent, its liabilities such as the Cyprus “G” Euros are worthless.

Cyprus could try to move to a new currency, and start from scratch. The bad liabilities would be written off, and thus there would be few assets. I assume that this would not be acceptable to the voters who would be rendered penniless. Voters today seem to prefer to have something from nothing, like a cargo cult. They want new paper currency and new bank deposits that “work”. Cyprus can issue such new liabilities. What they cannot do is declare by fiat that the banks’ worthless assets (such as Greek government bonds) shall have market value again.

Cyprus is caught between a rock and a hard place. Cypriot voters would not agree to be 100% wiped out in the name of moving to a better currency. The reality is that the Cypriot banks are nearly 100% wiped out.

Meanwhile, outside Cyprus, pressures are building on other marginal countries and their insolvent banking systems.

The best way to understand what’s happening in the dollar and euro credit markets is to watch the gold basis. Monetary Metals publishes The Last Contango: Gold Basis Report weekly (free registration required).