Risk of euro break-up now higher than ever before

Occasionally tuning in to the unfolding of the Cyprus fiasco on holiday over the past few weeks was a somewhat surreal experience. The conditions of the original bailout proposal were so unexpected and so different from everything that had gone before that it appeared as if initial reports of its terms had got it wrong.

A bailout for Cyprus had been inevitable since Greece's sovereign default a year ago blew huge holes in the balance sheets of the island state's banks. At a conference in Nicosia last May, participants had fully accepted that inevitability. That was reflected in a leading article in the Cyprus Mail at the time which urged the then president to get on with making a formal application for aid to end the uncertainty.

But if there was profound gloom over the island’s banks, there was something approaching euphoria about the recently discovered gas fields in the eastern Mediterranean, a decent chunk of which are in Cypriot territorial waters. My assumption had been that the rights to some of the energy would be sold off to fund the recapitalisation of the banks. That assumption proved very wrong.

Instead, under the terms of the bailout, positions long held in the euro zone were turned on their head, including the imposition of haricuts of senior bank bondholders. The long-feared spectre of queues outside banks materialised. The previously unthinkable imposition of capital controls took place.

Most astoundingly, insured depositers were to have a significant chunk of their savings effectively expropriated, although this was reversed when the full implications of the move became clear to the European and Cypriot authorities which thought up the idea.

It is always easy for those of us who comment from high perches to criticise those who make difficult policy choices and, given the scale of the bank losses – considerably bigger even than those of Irish banks relative to the size of the economy – there were always going to be some hard choices for Cyprus once the decision was taken to topple the Greek sovereign debt domino.

But that said, and even by the standards of the euro crisis over the past three years, the Cyprus bailout saga has been scarcely believable in its ineptitude.

Whatever (limited) crisis-management credibility the eurogroup finance ministers, the European Commission and the European Central Bank had left has been severely depleted.

The most significant implication of this, and the precedents set in the Cyprus case, is that the probability of a break-up of the euro as it is currently constituted has risen significantly.

At various stock-taking momentsin recent years, this column has attempted to put a figure on that probability. Any such assessment is a judgment call, but to recap: at the end of 2010 (the first year of the crisis), it appeared to me that the probability of a euro break-up stood at 15 per cent over the medium term; by the end of 2011 it had risen sharply to close to 50 per cent; and by the middle of last year it had passed the 50 per cent threshold (in other words, break-up appeared more likely than all 17 members remaining part of the single currency).

As of the middle of last year, the most immediate trigger for the situation to spin out of control was the prospect of Italy and/or Spain being unable to raise money for public debt repayments as they fell due. By September, as the ECB put in place its new bond purchase mechanism to deal with such an eventuality, the risk of break-up as a result of liquidity crisis receded. This pushed the probability of break-up back below the 50 per cent threshold.

But even before the Cyprus debacle, the risk had gradually started rising again, in direct correlation with the deterioration of the Mediterranean economies of Italy, Portugal and Spain and the continuing power vacuum in Rome.

With new precedents set regarding bank creditor bail-ins and the imposition of capital controls, the speed with which things will spin out of control in countries on the slide will now be much more rapid and much more difficult to control.

As Ireland experienced in 2010, an outflow of deposits can happen very quickly. In September of that year (mostly foreign) depositors took fright and withdrew €31 billion from Ireland-based banks. In October the figure reached€67 billion. In November the troika arrived.

After Cyprus, depositors in fragile countries will pull out more money more quickly at the first sign of trouble. The probability of euro break-up has never been higher.