Another financial crisis in paradise?

Jack Cranston, writing from San Miguel de Allende

Editor’s Note: Cyprus has had one of the fastest-growing economies in the European Union during the past several years. However, it doesn’t seem that long ago when Europe looked on in despair as the island appeared on the brink of financial collapse.

In March 2013, Jack Cranston wrote about the “Cyprus Solution” as panic spread through the Cyprus financial system. Fast forward to March 2016, after a three-year, €10 million financial aid package, a raft of reforms, and austerity measures, the country exited as one of the more robust eurozone economies, albeit at the expense of those who had invested their hard-earned money in Cyprus banks.

The COVID-19 pandemic has interrupted Cyprus’s strong economic growth. To cushion the impact of the crisis, however, authorities seemingly learned from mistakes of the past, rapidly introducing a targeted set of fiscal and financial policy support measures that have helped limit loan defaults and job losses, enabling a rapid, albeit uneven, recovery.

Given how quickly we moved on from Cyprus being a unique “one-off” event to the Cyprus solution being the basis for a new model for rescuing collapsing banks, investors the world over need to realize that the world has changed.  The banking industry will never be the same, and bank customers now have to worry about ravenous governments inventing new justifications for confiscating their deposits.

The new mantra for rescuing troubled banks and bailing-out bankrupt countries is “deposit to equity conversion.”  This is where government authorities forcibly convert bank depositors’ funds into equity in a troubled bank, with no guarantee that the equity will have any value in the future.   From now on, a good rule of thumb will be when you deposit money in a bank, think of it as if you invested in the bank’s stock.  If you wouldn’t buy a bank’s stock, then you should be leery of depositing money in that bank. 

A potential safe harbor, at least for the near term, is that the confiscating authorities seem to respect the concept of deposit insurance.  Yesterday, in an incredibly revealing quote that lifted the curtain on the true plans of political authorities, Jeroen Dijsselbloem, the Dutch Finance Minister and President of the Eurogroup of eurozone finance ministers, in an interview with Reuters, said, “If there is a risk in a bank, our first question should be ‘Okay, what are you in the bank going to do about that? What can you do to recapitalize yourself?’ If the bank can’t do it, then we’ll talk to the shareholders and the bondholders, we’ll ask them to contribute in recapitalizing the bank, and if necessary, the uninsured deposit holders.”

In addition to this being the first admission that the Cyprus solution is the new model for dealing with failing banks, notice the reference to “uninsured deposit holders.”  Because of populist political pressure, the EU caved on taxing Cyprus deposits under €100,000, which was the threshold for Cypriot deposit insurance. Don’t count on this as your primary line of defense, but because it is evident that those with more than €100,000 on deposit don’t have sufficient political clout, holding more than that amount in a risky bank (undercapitalized) or in a potentially desperate jurisdiction is not advisable.

This leads to several takeaways from the Cyprus crisis that can serve as guidelines for what to do now.

• If you are a foreigner, especially one perceived to be taking advantage of “offshore” banking in a jurisdiction under the influence of bankrupt nation-states, your funds on deposit will now be a target.

• When selecting a bank, country risk has suddenly become a much greater concern.  If possible, you should consider stable countries with solid banking traditions such as Singapore, Hong Kong, Switzerland (as long as you are not hiding money), and Austria, as well as off-the-radar places such as Andorra and Norway.

• Although it is not as much to bank on as it used to be, a decent Plan A is that if you can’t open a bank account in a first-tier secure jurisdiction, then at least don’t hold deposits above the local deposit insurance limit.

• Holding assets in harder-to-confiscate forms is also a good idea. These include income-producing real estate (not in your home country) and precious metals.  Holdings of precious metals would ideally be in physical form (bullion coins and bars), with some in your physical possession, and some in offshore secure storage (not stored a bank!).

The downsides to holding assets in real estate and in precious metals are increased price volatility and illiquidity.  Real estate can be especially illiquid, and metals can be especially volatile.  So this presents a challenge for investors with a low-risk tolerance and who don’t want to hold the cash in a form, and in a place, where it could be easily confiscated.

That’s why we stick with the tried-and-true Permanent Portfolio approach developed by the late, great Harry Browne.  As a refresher, Browne recommended a simple 25% allocation of your core portfolio in the following asset classes: gold, cash, bonds, and stocks.  Even with the volatility of metals, and the risk that a particular asset class will produce no return, or even a loss, the balanced and non-correlated allocation of assets reduces overall portfolio volatility, and over time the portfolio has produced consistent and good returns.  The trick is to find the appropriate investments in each class. 

We prefer a mix of metals rather than just gold, being especially enamored of silver.  And for current income and risk reduction, you could hold a portion of your precious metals allocation in paper assets and then sell options against your holdings.  This is a good idea over the near term but be prepared to liquidate and convert the proceeds into physical metals if brokerage accounts come under attack.

Even better would be to use a separate entity that you control to hold those assets, or use a self-directed retirement plan, or a combination of both.  These add additional layers between your assets and the long arms of confiscating authorities.

Cash is not King these days, at the artificially low rates of interest manipulated by the Federal Reserve, but there are short-duration non-dollar fixed income investments that are almost as liquid as cash but generate better returns with less dollar risk. U.S. Treasury bonds are in the mother-of-all-bubbles so we would stay away from them, but there are many opportunities for reduced risk fixed-income investments that fit the bill.  And high-quality dividend stocks are a good bet for equity allocation. 

Now more than ever there is an urgent need to act.  It is quite clear that governments believe your private property is something to be confiscated to solve the problems that they created.  Get yourself and your assets out of harm’s way, or at least lay the foundation for a good escape plan.  Smart, international diversification is the key.

Jack Cranston is a partner of Sovereign X and resides in San Miguel de Allende.