25/03/2013 09:47:00

Relief In Markets, But No Enthusiasm As Cyprus Signs Its Deal

By Katie Martin

Europe's financial markets reflected relief Monday that a deal to bail out Cyprus had been struck, helping the country to dodge a potentially catastrophic exit from the euro.

Enthusiasm was tempered however by the sour taste left by the region's troubled crisis response, the possibility of long-lasting capital controls, and the damage inflicted on the Cypriot economy.

The deal lines up 10 billion euros ($13 billion) in financing for the government and shuts Cyprus's second-largest bank, Cyprus Popular Bank PCL, imposing steep losses on deposits of more than EUR100,000, European officials said. The country's largest bank, Bank of Cyprus PCL, will also be downsized aggressively, with large depositors there taking a hit. Restrictions on the flow of capital from the island, described as "administrative measures" in the overnight statement from euro-zone finance ministers, look set to remain in place for some time.

But the deal doesn't include any losses for smaller depositors or depositors in other Cypriot banks, a proposal that derailed an initial attempt to reach a pact last week.

"The agreement has been structured in a way that does not require the approval of the Cypriot parliament," said Reinhard Cluse, an economist at UBS. "This removes the major risk of a renewed rejection by the Cypriot parliament, which would arguably have led to an uncontrolled collapse of the Cypriot banking system and potentially Cyprus's exit from the euro zone."

Relief that the worst-case scenario had been avoided gave some scope for markets to rally, but that rally proved shaky.

The euro pushed higher in Asian trading hours as news emerged that a deal had been reached between the island and international creditors. But the climb had largely unravelled within an hour of European traders getting to their desks, leaving the euro trading at around $1.30. Steve Englander, an analyst at Citigroup, said he expected the currency to be trading lower by the end of the global day.

Cypriot bonds, as well as those of other fiscally-frail euro-zone countries, rallied in early trading. Yields on Italian 10-year bonds sank to the lowest level since that country's inconclusive elections a month ago, at 4.43%. Meanwhile, ultra-safe German Bunds slipped at the open as risk appetite recovered. Still, the relatively modest moves seen reflected market optimism heading into the weekend that a deal would be done, while also highlighting some lingering concerns over euro-zone leaders' handling of the Cypriot situation.

The price of Cyprus' bond maturing in 2020 climbed to EUR71.25 in early trading from EUR63.25 on Friday, though volumes remained extremely light with banks in the country still shut.

European bank stocks were among the biggest gainers in early trading, but gains looked tentative as some enthusiasm in the sector began to wane.

"We see a risk that Cyprus's sovereign debt burden post-bailout might not be sustainable, as the country is likely to enter a deep recession caused by the shrinkage of the banking sector and severe deleveraging," Mr. Cluse at UBS said.

Underscoring the risks left behind by this bailout, Moody's Investors Service said Monday that Cyprus will remain at risk of default and a euro-zone exit for a "prolonged period."

"The system's profile as an offshore financial center is unlikely to survive this crisis," said senior credit officer Sarah Carlson.

"The potentially irreparable damage to the country's current drivers of economic growth leaves its ability to sustain its current debt highly in doubt."

Fitch Ratings also said last week that capital controls could dent bank ratings across Europe.

Holders of Banco Popular bonds will incur steep losses under the terms of the new deal for Cyprus. Still, the cost of protecting European bank debt against default fell after suffering last week from uncertainty and low trading volumes amid the wait for a definitive outcome.

"The risk of a disorderly collapse has been taken off the table and financial markets look set to express their relief," said Mizuho International credit strategist Michael Ridley in a note.

The iTraxx Europe index was five basis points tighter at 170 basis points, according to Markit data. This means it now costs an average of $170,000 a year to insure $10 million of the debt in the basket of 25 financial companies. The Sub Financials index was seven basis points tighter at 288 basis points.

(Nina Bains, Art Patnaude, Tommy Stubbington, Natasha Brereton-Fukui and Gabriele Steinhauser contributed to this article.)

Write to Katie Martin at katie.martin@dowjones.com

(END) Dow Jones Newswires

March 25, 2013 05:47 ET (09:47 GMT)

Copyright (c) 2013 Dow Jones & Company, Inc.

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