‘Very real danger’ that the eurozone crisis about to flare up again

An agreement between Cyprus and its EU lenders that would tax the country’s bank deposits in exchange for a bailout is igniting fears of a resurgent European debt crisis.

IHS economist Chuck Movit said the bank levy, which would tax even average savers to help pay for the bailout, could open up a “nasty can of worms.” The biggest concern is that savers in other struggling eurozone countries could start to fear they’re next, triggering a run on banks.

“[The risk is] depositors will feel increasingly uncomfortable about leaving their money in banks in these countries,” IHS economists wrote. “This could then lead to a destabilizing withdrawal of credit from banks that exacerbates the problems and further escalates the problem.”

That means the sovereign debt crisis, which has practically vanished from investor minds since last September, could return to be the main market driver over the next few months.

“A mass of withdrawals from eurozone periphery banks could heat up the debt crisis once again after the international financial community had decided that lending to countries such as Spain and Italy would not require the extremely high risk premia it had earlier demanded,” Mr. Movit said.

Cyprus shocked markets over the weekend when it announced it would tax the country’s bank deposits to secure a 10-billion euro bailout package. Under the terms proposed, Cypriot depositors with funds under 100,000 euros would be on the hook for a 6.7% tax, while those over 100,000 euros would pay a 9.9% tax.

This is the first time that a bailout package in the eurozone has directly involved taxing bank deposits.

“The very nature of banking has been shaken to its roots with this decision, for banking depends upon trust,” said market commentator Dennis Gartman. “Trust that has now been shattered; torn asunder, broken and destroyed.”

Analysts are now worried that any future bailouts involving other struggling periphery countries could also involve bank taxes.

“The problem is [the Cyprus bailout] might have just set a precedent for the larger crisis-economies such as Spain and Italy,” said Mark Chandler, head of fixed income and currency at RBC Capital Markets.

In the past, EU officials had said that bank deposits would not be touched in an effort to calm savers and prevent a run on banks. Many savers in Greece, for instance, pulled their savings out of banks during that country’s bailout negotiations.

Already, there are reports in Cyprus that long lines have formed outside many bank branches as people rush to pull their money out from banks.

Not everyone is afraid what happened in Cyprus will spread to other eurozone countries, however. Willem Buiter, economist at Citi, said that despite the initial fury, the program is good news for the euro area.

“Contagion risks are overrated, in our view,” he said. “The risk of bank runs in other euro area countries has clearly risen, but the unique features of the Cypriot situation should limit the ‘read through’ to other cases in the euro area. Even when bank runs occur, the European Central Bank has the means to substitute for the funding lost from departed deposits.”

Stock markets around the world were also taking the news in stride. While North American markets were down on Monday, the Dow and the S&P 500 saw marginal dips of only 0.07% and 0.25%, respectively.

Cyprus officials are expected to vote Tuesday on whether to approve the bailout terms. Early indications suggest there is an effort to soften the blow on smaller depositors, including removing the tax on deposits under 20,000 euros altogether. However, nothing is confirmed, yet.

And while markets were relatively muted on the news on Monday, John Higgins, economist at Capital Economics, warned that a rejection of the deal during tomorrow’s vote could set off stock market volatility this week.

“The return of fears that Cyprus (and other countries) may actually leave the euro-zone altogether – if say the latest deal is rejected by the Cypriot parliament – could lead to a sustained correction in the prices of equities more generally, as well as other risky assets,” he said.  OttawaCitizen