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Prospects Weekly: Cyprus bailout deal, ECB funding, Mutual fund (bond and equity) flows to developing countries

Global Macroeconomics Team's picture
While attracting a great deal of market attention, the Cyprus bailout deal – which has yet to be approved – has so far had limited impacts on financial markets. The limited increase in risk indicators follows several months of improving conditions, which have allowed Euro Area banks to pay back ahead of schedule more than 23% of the emergency lending provided by the ECB in its Long Term Refinancing Operation (LTRO).  Nevertheless, banking-sector challenges remain. Overall bank lending in the Euro Area continues to decline, with sharp declines in high-spread economies and broad stability in the rest of the Euro Area.  After a record start to the year, developing-country bond and equity fund flows have significantly weakened in March.

Immediate  market response to the rejection of the Cyprus bailout proposal has been mute. The Cyprus bailout proposed this past weekend sparked controversy because of concerns that requirements forcing depositors in affected banks to participate in the bailout (“bail in provisions”), could be perceived as violating deposit guarantees and spur a run on banks elsewhere in the Euro Area. The proposal was rejected by the Cypriot Parliament late Tuesday March 19. Thus far, market reaction has been mute. The benchmark Stoxx Europe 600 index has retreated by about 1.0% since Monday (though 18% higher than end-June 2012 levels). Yields on Italian, Portuguese and Spanish bonds went up modestly (13, 30, 12 basis points respectively) earlier in the week, but declined on Thursday. Yields remain between 136 and 494 basis points below their July 2012 levels.
European Banks have significantly reduced their reliance on ECB funding. Euro Area banks are gradually becoming less dependent on crisis loans as their access to market funding has improved in recent months. Some 23% of the €1 trillion in ECB loans provided under the first and second Long Term Refinancing Operation  (LTRO1 & LTRO2) to Euro Area banks have been repaid well in advance of their coming due at the end of December 2014 and February 2015 respectively. Nonetheless, Euro Area bank lending to the private sector still remains weak, contracting in high-spread Euro Area economies at a 15.3% (3m/3m saar) annualized pace during the three months ending January 2013, and remaining broadly stagnant in  the rest of the Euro Area.
After growing extremely rapidly in January, mutual fund (bond and equity) flows to developing countries weakened in early March. After reaching a record-high of $23.5 billion in January, equity inflows to developing countries declined sharply in in March. The four week moving average fell to $306 million in the week ended March 15th, about 40% less than the average monthly inflows over the preceding 5-years.  Bond flows, though less volatile, also eased from an average weekly inflow of $1.4 billion for the first two months of 2013 to less than half that rate ($634 million) during the first two weeks of March. The pull back in developing country mutual fund (bond and equity) flows in part reflects pay-back from the solid January-February flows (the strongest flows since 2008), but could also reflect  nervousness in the run up to the Cypriot debt restructuring deal. Overall and for the year-to-date, equity and bond flows are almost 50% higher than in 2012 ($44.3 billion versus $30.4 billion in 2012).

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