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With the ECB warning that in the absence of a deal with Troika, ELA funding for the troubled Cypriot banks will cease by Monday, the probability of Cyprus leaving the euro zone is far from negligible. Looking at the credit markets, Cyprus sovereign bonds are pricing a 15-20% probability of default.
Although Cyprus does not want to leave the euro zone, for both political as well as economic reasons, its financial situation is so complex and time to sort the mess out so short, that all scenarios are possible.
Even though Cyprus's economy is too small to be relevant, an exit from the euro zone will set a precedent that will shake markets. What will happen if indeed Cyprus does exit the Euro?
Under the Cyprus exit scenario, we would expect a global risk-off, with a likely reversal of flows from EM bonds and equities. We could also see deposit flight from weak European periphery banks and a general flight to quality - this would lead to the sale of the most crowded trades.
CEEMEA currencies: We would expect significant sell-offs in the currencies where non-resident EM funds have their biggest allocations (TRY, ZAR, PLN, RUB). Sell-offs would be triggered from both FX hedging as well as from the sale of local bonds and equities. Likewise, we would expect a spike in volatility in these currencies, which currently hovers at very low levels.
Local bonds: We would expect local bond curves to get much steeper, with the change in steepness linked to the share of non-resident EM funds of the local market (HUF, ZAR, PLN are most owned). We would also expect widening of the local bond-swap basis.
Credit: In line with the other asset classes, we would expect credit spreads to move wider, shifting in line with the market betas.
Who could intervene in FX markets?
The central banks of PLN, RUB, RON and HUF have the FX reserves and the willingness to intervene to lower FX volatility, and to stabilise the market but only after substantial currency weakness. We think that central banks of ZAR and TRY have the least ability to intervene in FX markets. For these, hiking rates may be the only form of intervention as both ZAR and TRY have vulnerabilities - twin deficits in the case of ZAR, and a high current account deficit in the case of TRY.
What does it mean for fiscal policies?
We see little room or appetite for further fiscal tightening. Fiscal policies across the region have been tightening since the crisis. The countries that could actually tighten fiscal policies are South Africa that has been running a counter-cyclical fiscal policy, and Turkey that has started loosening its fiscal policy to bolster growth.
Who could cut rates further if recession bites again?
We think that the rates in PLN and RUB could come down further. We would not foresee any rate cuts in TRY and ZAR because of likely currency weakness. We would also expect a continuation of HUF rate cuts, especially after the recent change at the helm of the central bank.
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