Cypriot Banks to Open, Can Euro Hold?

By Renee Mu  and  Jason Shemtob 27 March 2013 23:33 GMT The Dow Jones FXCM US Dollar Index rallied on the euro weakness in the past session. Tomorrow Cypriot banks will reopen after nearly two-week lockdown. The country’s government decides to put tight capital controls on bank accounts in order to prevent a mass flight of deposits. Yet, when the withdraw restriction is lifted in a week or longer, the money is going to leave anyway as depositors seek to reduce their holdings in banks amid fear of further loss.

Increased money demand and fixed monetary supply (Unfortunately Cyprus can’t issue more euro) will push interest rates higher to reach a new equilibrium. However, real interest rates to depositors especially who hold large accounts have been cut sharply and even turn negative because of the bail-in program. The economic imbalance will lead to a jump in inflation and decline in output, which means the sovereign debt crisis is far from over, and the euro still faces downside pressure. A good lesson to investors is to think cautiously before make any investment in such lightly-regulated countries. It is easy to lend money but it might take forever to get it back like the struggling Cypriot creditors.

On Monday, the leading Eurozone Finance Minister Dijsselbloem suggested that the Cyprus deal could be a future template in dealing with troubled banks. European officials later backtracked his comments, but also said preferred bank restructuring than using taxpayer’s fund to save banks. It therefore raises concerns in Italy, Greece and other Euro-area countries with financial problems – will their depositors suffer a similar loss one day? One possible reaction of creditors is to withdraw money from local banks and transfer to countries with more stable banking system either inside or outside the euro-zone. An increasing capital outflow will dampen the existing crisis and reduce demand for the euro.

The downside pressure for euro not only comes from Cyprus but also from the third largest economy in region. Italian Democratic Party leader Bersani said that Italy was in a “dramatic situation” and needed “a government which performs miracles”, as he had few options left after ruled out an alliance with People of Freedom. If he failed to form a functioning government, the president can tap someone else to try to create a coalition or he can call for a new election. Yet both will add more uncertainties to the market and may further drag down the euro.

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27 March 2013 23:33 GMT

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