The Cyprus financial crisis has had a surprising impact on the outlook for the euro zone, according to QNB Group.
The deteriorating situation in Cyprus could mark a turning point as it raises concerns about the implications for other crisis-stricken countries, says the QNB report.
The downside risks to the euro and sovereign debt in the euro zone may be rising again, it said.
Even though the country only accounts for 0.2 percent of euro zone GDP, Cyprus' bailout has illustrated the need for further reform and has set dangerous precedents for future Eurozone bailouts.
While optimism has prevailed so far in 2013, the escalation of the Cyprus situation could mark another turning point in the euro zone crisis and the beginning of the re-emergence of systemic tensions.
The two largest banks in Cyprus, the Bank of Cyprus (BOC) and the Cyprus Popular Bank (Laiki Bank) were both heavily impacted by the Greek financial crisis through exposures to their own operations in Greece and to Greek sovereign debt.
Following the second Greek bailout in 2012, both banks needed to be recapitalized by the Cypriot government.
They also tapped funds from the ECB's Emergency Liquidity Assistance (ELA) to support increasing liquidity demands from operations in Greece. Laiki has drawn almost 10 bn euros from the ELA.
In order to solve the critical situation of the country, the Troika (the European Commission, ECB and IMF) entered into negotiations with Cyprus to address the shortfall in funding of the Cyprus government and banks, estimated to be 17 bn euros.
Negotiations initially concluded on March 18 but the troika was only prepared to provide 10 billion of emergency funding.
Cyprus would raise the remainder itself with 6 billion euros coming from a levy on deposits above and below the insurance ceiling of 100,000 euros.
In exchange for lost deposits, savers would receive equity stakes in their banks. However, this deal was rejected by the Cypriot Parliament on March 19.
In the final agreement reached on March 25, it was decided that Laiki Bank should be restructured with its good assets and insured deposits below 100,000 euros being transferred to BOC.
Whether uninsured deposits over 100,000 euros from Laiki Bank will be repaid will depend on the receivership process and the liquidation of bad assets.
Meanwhile, large deposits of over 100,000 euros in BOC have been frozen and may be subject to a haircut at a later date if it is deemed necessary to meet capital adequacy requirements.
A significant portion of secured debt in BOC is also expected to be written off.
However, this package looks threatened following the news on April 11 that 23 bn euros in rescue funds are needed, meaning that Cyprus needs to find 13 billion euros rather than 7 billion euros in addition to the EU/IMF bailout of 10 billion euros.
It is now thought that the emergency measures put in place could raise around 11 billion euros, leaving a shortfall of 2 billion euros.
The Cyprus bailout has raised concerns about the euro.
Although euro zone officials, including the president of the ECB, have clearly stated that Cyprus is a special case and does not provide a template for future bailouts, investors and savers remain acutely concerned that future bailouts could also involve a haircut for depositors in banks.
In savers minds, Cyprus may have set a precedent.
It could encourage the removal of savings and deposits from banks in larger economies that look like they may require a bailout in the future.
It could encourage capital flight from the Eurozone and undermine the value of the single currency.
Following the bailout, Cyprus became the first ever euro zone country to apply capital controls with limits on credit card transactions, daily cash withdrawals, foreign money transfers and cashing cheques.
This is a clear indication of the severity of the situation and, effectively, at least temporarily devalues Euros located in Cyprus as they are now less easy to transfer.
The Cyprus crisis has already helped drive the value of the euro down from $ 1.36 at the beginning of February to $ 1.28 at the end of March.
This is partly owing to a general strengthening of the dollar, but the euro has depreciated against most major currencies and Bloomberg's euro index has dropped 3.5 percent over the same time period.
Furthermore, the botched initial bailout package has raised concern about the management of Europe's financial crisis.
The issues faced in the Cyprus crisis are the same as those faced in previous bailouts.
Over-indebted banks have been supported by the government until the sovereign itself has run out of funds to recapitalize the banks and becomes insolvent.
It also illustrates how financial contagion is still occurring as Cypriot banks were negatively impacted by their exposure to the Greek crisis.
The reoccurrence of these issues suggests that Europe has failed to stem the spread of the crisis.
The re-emergence of tensions could come from a number of countries.
Spain and Greece remain concerns with high unemployment and weak growth; Portugal's constitutional court recently blocked austerity measures threatening its bailout package; Italy has reached a state of political paralysis; and Slovenian banks are expected to require recapitalization.
In sovereign credit default swap (CDS) markets, the cost of insuring Portuguese and Slovenian debt has increased noticeably in the last month.
Portuguese CDS prices have risen from 364 basis points (3.64 percent) to 415 basis points per year to insure 5-year sovereign debt while Slovenian the same CDS prices have risen from 250 basis points to 378 basis points.
Over the last year, financial markets in the euro zone have had a good run as concerns about the debt crisis have been alleviated by ECB measures to support banks and sovereigns and by some positive economic data from the US and China.
The EuroStoxx 50 index rose 33 percent from a low of 2,069 in June 2012 to a 2013 high of 2,745 in mid-March and was at 2,625 on April 16.
However, the deteriorating situation in Cyprus could mark a turning point as it raises concerns about the implications for other crisis-stricken countries.
The downside risks to the euro and sovereign debt in the eurozone may be rising again.
Reproduced with permission from Arab News