Cyprus triggers contagion fears

It was almost like the good - or bad - old days in Europe today when an EU bailout plan for Cyprus sent shockwaves through the market.

The bailout itself wasn't a surprise - Cyprus has been in negotiations with its European partners for some months now. A specific component of the package, however, has reignited talk of contagion. Depositors will have to pay a tax of 6.7% on amounts below €100,000, and the rate will increase to 9.9% on amounts over €100,000. This measure is expected to raise €5.8 billion, a considerable portion of the bailout.

One could argue about the fairness of the tax. It seems inequitable that the smaller savers, who were under the reasonable impression that their deposits were guaranteed by the government, should have to share the burden. Uninsured depositors could have paid a higher rate to make up the shortfall, though it is thought the Cypriot government is still trying to salvage the remnants of the country's banking industry and was reluctant to implement a rate of more than 10%.

Issues of fairness aside, it is clear that depositors had to be bailed-in to some extent. Germany and several other eurozone members were never going to write a blank cheque, and a haircut of sovereign debt would only have damaged bank balance sheets and created a need for further recapitalisation. Depositors were the only remaining source of funds - Cypriot banks are mainly funded by deposits, rather than debt.

The decision to bail-in depositors means the Rubicon has been crossed. Will senior bank bondholders be next in line to share the burden of bailouts? That is the fear flowing through the markets today, with banks underperforming corporates and sovereigns. The Markit iTraxx Senior Financials index widened 10bps to 153bp, while the Markit iTraxx Europe was 4bps wider at 109bps. Both indices were significantly wider this morning but the afternoon saw some ground regained.

Cyprus itself was trading at 28.5 points upfront, about seven points wider than Friday. It was a considerable one-day move but it should be kept in perspective - the sovereign was trading more than 40 points upfront last June.

Other peripherals, such as Spain and Italy, were wider but the moves were relatively modest. This suggests that the fears of contagion are not as heightened as we saw in previous episodes of market turmoil. Nonetheless, all eyes will be on Cyprus over the next few days, and it has the potential to grow into a material negative catalyst. A vote in the Cypriot parliament on the bailout deal has been postponed until tomorrow evening, and the bank holiday has been extended until Thursday to prevent deposit flight. Activity in the market may be muted until we get a clearer picture of what is happening in the eastern Mediterranean.

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