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Forex Flash: Muddling through emerges as the central scenario for Cyprus – Merrill Lynch

FXstreet.com (Barcelona) - After difficult negotiations in Cyprus talks of a euro exit have resurfaced, but Merrill Lynch analysts see it as much less likely than a muddling through scenario: “Our central scenario is that of muddling through, with a painful deal being reached by the Troika, Cyprus and the possible participation of Russia”, wrote analyst Laurence Boone, adding that this would include some private sector participation as well as indirect but lasting consequences for other periphery countries, “because the discussions would be likely to increase fragmentation again”. “Under that scenario, we would expect policy makers to focus on options to support credit in the South to overcome the renewed fragmentation impact”, he added.

Less likely is the alternative scenario of a default on private and/or public debt in Cyprus. “In that scenario, when banks reopened, deposit flights would likely trigger bank insolvency, and the ECB would veto ELA”, Boone wrote, pointing to bank defaults since the sovereign is not in a position to nationalize the banks and cover the deposit insurance. “The shock would be significant and the policy response would need to be commensurate” and it would lead to talks of a Cyprus exit.

Merrill Lynch analysts’ central scenario is a muddling through, with negotiations to drag on as an acceptable compromise must be found between Cyprus, the European authorities (including the Parliaments of North-ern economies) and possibly Russia. “A deal would probably involve some private sector participation as a condition from Northern European parliaments – which would not understand why their taxpayers must lend money while Cyprus depositors are left untouched”, said Boone, also assuming that the ECB will keep providing liquidity to banks either directly (through repo operations) or indirectly (through the Emergency Liquidity Assistance), as long as they are solvent.

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