In one of a few early hints that Europe might surprise the world with its Cyprus bailout, on February 10th the Financial Times leaked the content of a secret EU memo. It reported that bank depositor haircuts were among three options being considered to reduce bailout costs. And the memo also warned ominously that “such drastic action could restart contagion in eurozone financial markets.”
Clearly, policymakers decided to take their chances. And now we’re living through the contagion that the memo’s authors predicted. But what exactly does that mean? Sure, we can see volatility in asset prices, but how long will it last? Some pundits say it’ll blow over like a late afternoon shower on an otherwise sunny day. I disagree.
I’ll suggest there’s more to it than rising market volatility and that we should take a closer look at the meaning of contagion. I’ll argue there are three different types at work today: vanilla contagion, latent contagion and stealth contagion. And when you add up the three effects, Cyprus will have a bigger global impact than many expect.
This is the term I’ll use for a rapid transmission of volatility from one region to another – what most people simply call contagion. We’ve seen vanilla contagion in financial markets since the announcement of the first bailout agreement on March 16th. We’ve also seen it in reports of bank customers in the European periphery rethinking their loyalties. Both effects should continue for awhile, especially as EU officials have warned uninsured depositors that their assets aren’t protected in government bailouts. This is by far the most significant development of the past two weeks. And it’ll play out slowly, since it takes depositors time to find a new home for their assets once they’ve decided their banks are too risky.
On the other hand, the optimistic case is that flight capital in the periphery has already “flown” during the past several years of repeated crises. Remaining bank deposits should be stickier than they were before Europe realized the euro isn’t such a huge success. Moreover, most people take a wait-and-see attitude to events that aren’t happening right on their doorsteps. And as long as the news doesn’t get worse, they just keep waiting. That’s not to say things won’t get worse for those with the misfortune of living in Cyprus – they’ll get much worse. But the bad news for Cypriots should gradually lose its shock value for those living elsewhere.
This is the contagion that occurs because people who are waiting-and-seeing aren’t quite forgetting. When the next crisis does come to their doorsteps, they’ll quickly remember what happened to the Cypriots. And the flight to safety will occur much faster than it would have without the new precedent set by the latest bailout. Think of it this way: If vanilla contagion is the extra lock you purchased after learning of a rash of burglaries in your neighborhood, latent contagion is the fact that you’re now jumping out of bed much more quickly when you hear a noise in the middle of the night.
In my opinion, latent contagion will prove more damaging in this instance than vanilla contagion. After all, Cyprus is pretty tiny. If the various crises in the rest of Europe were fully resolved, then it wouldn’t receive much attention. It’s because the crises in Europe are alive and kicking that Cyprus has so much meaning. The bailout gives us information about what could happen when banks (or governments) in other countries are once again short of cash.
Latent contagion is already appearing this week with the Italians’ continued failure to form a new government. It’s not especially comforting that Italy is in the middle of a political crisis just as the EU rewrites its rules of engagement in the aftermath of Cyprus.
The third type of contagion is one that no-one seems to be talking about. To understand it, imagine that people waiting-and-seeing just keep on waiting and never take action. Then there’s no contagion, right? Well, actually that’s wrong. It’s wrong because contagion doesn’t just work by causing people to take certain actions; it also works by causing them to refrain from certain actions. Like lending, for example. Tightening lending standards are a key piece of the vicious circle that’s currently in place in Europe. Have a look at the chart below, which shows past results of the ECB’s bank lending standards survey, and then I’ll come back to stealth contagion in just a moment.
In a recession, this survey is like a quarterly and economic version of Groundhog’s Day. If it shows lending standards are still tightening, then expect “winter” to continue, because it’s folly to think economies will recover. Economies rise and fall with the rise and fall of credit, and if bankers tell you credit expansion isn’t happening, then economic expansion isn’t happening either. It’s really that simple. This is arguably the best leading indicator of all, even though it’s rarely noticed. For those optimistic forecasters who keep expecting a recovery and getting it wrong, their errors are probably best explained by not giving enough weight to lending standards.
Getting back to stealth contagion, this occurs when people reduce their risk-taking activities. It has nothing to do with either buying an extra lock or being jumpy at night after learning of those burglaries I mentioned earlier. Think of it as a developer shelving his plans to build a high-end apartment complex because of the increase in local crime. And in the case of stealth contagion from Cyprus, bankers are the ones to watch. Bankers in the peripheral economies realize their deposit base is becoming less secure, even if they haven’t seen a significant rise in withdrawals. They’re doing the same calculations as the rest of us and concluding that risks are higher than they were before.
So how significant is the stealth contagion effect? We’ll have a pretty good answer to that on April 24th. That’s the next release date for the lending standards survey. The ECB began to solicit responses in mid-March and will continue to do this through the early part of April, which means the survey should partly reflect the public mood as the Cyprus bailout has unfolded. And I predict it’ll tell us to expect more winter, but don’t just take my word for it. Mark your calendar for April 24th and plan to go straight to the ECB’s website. We may learn that the least talked about of the three contagion types is also the most significant.
Lastly, here’s an article posted by Zerohedge and sourced from JP Morgan that lists other indicators that might foreshadow a change in lending standards. In a nutshell, other indicators to watch include excess cash in the Euro banking system (available daily), peripheral bank debt issuance (available weekly), TARGET2 balances (monthly) and balance sheets of monetary financial institutions (also monthly).