How to profit from Cyprus contagion fears

Up until a fortnight ago, most British people thought of Cyprus as a nice place to go on holiday. In the City, very few bankers or traders paid any attention to it. But true to form, politicians in Brussels managed to turn the future of the tiny island into headline news.

The EU now wants savers with over €100,000 on deposit to sacrifice a big chunk of their money as part of a bail-out deal. And to prevent money fleeing the country, capital controls have been imposed. These stop people cashing cheques and limit the amount of money that can be taken out of the country (to €1,000) or spend abroad (to €5,000 a month).

Right on cue, stock markets in Italy, Greece and Spain dived as fears spread that they could be next.

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But as others panic, we see opportunities for investors.

Cyprus isn't unique

Up until now, the consensus has been that you shouldn't expect large depositors to take a hit. However there's no real reason why this should be the case. After all, people knew when they put money in that deposits in Cypriot banks were only protected up to the level of the EU guarantee of €100,000. And it's debateable whether the state should offer any guarantee at all when it's private sector money that's at risk for more on this, subscribers can read Merryn Somerset Webb's editor's letter: A useful lesson from Cyprus. (If you're not already a subscriber, subscribe to MoneyWeek magazine.)

Besides, during all the recent furore over Cyprus, people seem to be forgetting that we've been here before. When Iceland crashed, only selected domestic depositors were bailed out, with others pushed into a bad bank'. It also refused to cover deposits made in foreign branches of Icelandic banks. It then imposed capital controls to prevent people pulling their cash out. These measures have had some success - debt is now less than 90% of GDP. And unemployment is only 4.7%.

It will be tougher for Cyprus

To a large extent Cyprus is following Iceland's path. But thanks to EU rules, it hasn't been allowed to treat citizens and non-citizens differently. However, the minimum limit of €100,000 on deposits that can be raided arguably achieves much the same thing, since many of the big depositors are Russian, while virtually all the small depositors are Cypriots. Meanwhile, its capital controls are less draconian than Iceland's.

Sure, Cyprus isn't Iceland in at least two ways. For starters has a lot more debt even after the depositor haircut, the debt-to-GDP ratio will still be very high.

More importantly, following its banking crisis Iceland was able to devalue its currency, making its exports cheaper. While Cyprus is still in the euro, that is clearly not an option.

What will happen next?

As we've said before, the crisis in Cyprus takes us just one more step towards the death of the euro. However, Brussels can easily spin this out and make it a death by a thousand cuts.

The quick route would be for the high-debt countries to quit the euro and use inflation and default to bring their debts to sustainable levels. The longer route is for Brussels to agree, country by country, to a combination of bail-outs and write-downs while printing money to stimulate growth.

As Brussels procrastinates, it's hardly surprising that banks shares around Europe are plunging while the yield on Italian, Portuguese and Spanish sovereign debts have gone up. The fact that German yields are falling suggests, as Marshall Glitter of IronFX points out, that euros are shifting from the peripheral countries into safer Germany.

It's time to buy into Italy and Greece

The good news for investors is that all this uncertainty is creating opportunities in shares in the crisis-hit countries.

Italy should do well as the euro weakens, since it has many world-quality manufacturing firms. And as my colleague John Stepek points out, the Italian banking sector is more solvent than people think.

However, if you have an appetite for a bit of risk you might think about Greece. A cheaper currency will give the tourist sector a real shot in the arm. As we've pointed out, it's also very cheap, trading on a cyclically-adjusted price/earnings ratio (Cape) of 2.5. In contrast, the UK has a Cape of 13.

In both cases a good bet is to get some exposure through a tracker exchange-traded fund, such as the iShares FTSE MIB (LSE: IMIB) for Italy, and the Lyxor Athens ETF (Paris: GRE) for Greece.