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					Nomura | Euro area Economics                                                                                     18 March 2013




Euro area Economics
Economics Research | EMEA



Cyprus bailout - Systemic implications                                                      18 MARCH 2013




                                                                                            Global Economics
In this note we look at: (i) the imminent risk around the Cypriot parliamentary vote        Economists
where we see slightly above 50% probability of the vote going through; (ii) the Cypriot     Jacques Cailloux
                                                                                            +44 20 7102 2734
economy could contract by around 15% over the next two years if the measures are
                                                                                            jacques.cailloux@nomura.com
implemented, as announced; (iii) the history of losses and taxes on bank deposits
where we find no historical precedents comparable with that of Cyprus apart from,           Dimitris Drakopoulos
                                                                                            +44 20 7102 5846
perhaps, Hungary in 1920: and (iv) the broader implications for the euro area where         dimitris.drakopoulos@nomura.com
we see a higher risk of instability in deposits and also some increased political divide
between the North and the South.                                                            Lefteris Farmakis
                                                                                            +44 20 7103 9242
                                                                                            lefteris.farmakis@nomura.com
1. The risks from Monday’s parliamentary vote in Cyprus                                     This report can be accessed electronically
                                                                                            via: www.nomura.com/research or on
Cypriot consent to the extra-ordinary levy on all depositors following Friday‟s             Bloomberg (NOMR)
Eurogroup agreement has opened the floodgates of political turmoil on the island.
The Cypriot government has already postponed the vote on the levy to late Monday
afternoon (around 14:00 London time) despite pressure from the Troika to hold it
during the weekend as originally agreed. As things stand, it is still very uncertain
whether the Cypriot Parliament will approve the levy.

In more detail, for the bill to pass the majority of the quorum of MPs is required. The
headcount in the Cypriot Parliament is as follows:

Of a total of 56 MPs, the government is supported by 30 (20 from DI.SY, 8 from
DI.KO and 2 from EVRO.KO). DI.SY‟s 20 MPs are widely expected to support the
vote, although it is possible that one may not be present for the vote. Major coalition
partner DI.KO supports the government with 8 MPs. The party until late tonight was
consulting with the president to change aspects of the Eurogroup
decision. Nonetheless, 1-3 MPs from DI.KO may dissent. Finally, minor coalition
party EVRO.KO support the government with 2 MPs and initially said they would not
support the measure.

In recent hours, however, there have been some discussions regarding the
compensation depositors can receive, which leaves a window for a potential change
of their voting intention. According to the public address of the president on Sunday
night, the depositors will receive equity of the crisis banks (presumably Laiki and the
Bank of Cyprus) equal to the full amount of their “taxes”. Furthermore, depositors that
keep their deposits for two years in Cyprus will receive half of the value of the current
“tax” contribution in bonds linked to future natural gas revenues to the state. The
latter measure was added tonight in order to avoid a prolonged bank run even after
the imposition of the tax

The opposition consists of AKEL with 19 MPs, EDEK with 5 MPs, the Greens with 1
MP, while there is also an independent (ex-DI.KO) MP. All opposition parties have
announced that they will not support the bill, and the independent ex-DI.KO MP is
expected to do the same.

In effect, the Cypriot government appears to be able to collect 25-27 votes with
relative ease (19-20 from DI.SY and 5-7 from DI.KO), with the support of
EVRO.KO and the few DI.KO MPs that are potential dissenters the big unknown
factors at the moment.

The government has the luxury of only one dissenter in a quorum of 56 MPs, which
means that as things stand the passing of the vote is very uncertain. If some of
                                                                                                           Nomura International plc

 See Disclosure Appendix A-1 for the Analyst Certification and Other Important Disclosures
Nomura | Euro area Economics                                                                18 March 2013


AKEL‟s MPs (or those of another opposition party) abstain, then the threshold for
approval of the bill declines accordingly. However, there is no evidence, at the
moment, that such a development is likely. Incidentally, AKEL has already raised the
issue for a referendum on the Euro and has said that it will propose its own
alternative plan to replace the tax on deposits, so it is unlikely to do any favours for
the government, in our opinion.

Overall, we believe the outcome of the vote is very uncertain; we would,
however, place a probability slightly higher than 50% that the bill passes
mainly on the expectation that once the parliamentary discussion starts, a
compromise will be reached by the political system to avoid collapse.

With Monday‟s vote essentially in the air, it is worth looking at the two possibilities
after the vote:

a) Levy approval: In the event of a positive outcome we believe there is likely to be
a broad-based relief rally, as the road will be open for the ratification of the deal in
euro area parliaments. Despite the fact that there remains some residual risk as
regards ratification in Germany and some other northern European countries, the risk
of an imminent collapse of the Cypriot banking sector that would ultimately raise the
question of the country‟s ability to remain in the eurozone will have receded and the
market is bound to re-price this fact.

Such an outcome would be particularly beneficial for front-end Cyprus bonds, as
there has been no mention of a PSI operation and the bailout money is intended to
cover the bond redemptions within the program horizon. (Note, however, that an
implicit assumption of the bailout is that Russia will agree to extend its €2.5bn loan to
Cyprus that matures in 2016, an issue that has likely become more complex than
before the Eurogroup decision).

b) Levy is blocked: This would be a highly disruptive scenario and seems not to
have been well thought through so far. In a sense, there is no plan B, but clearly a
number of possibilities could open up in the aftermath of a negative vote. One
possibility is the return of the two sides to the negotiating table, perhaps in an effort
to soothe the losses imposed on small depositors or to improve the form of
compensation accorded to all depositors, and in the hope that an improved deal
would fare better on a second vote in parliament. (This would likely be linked to the
announcement of two-three day bank holiday to avoid a run on the banks.)

Another possibility is that the ECB proceeds with its threat to stop providing
emergency liquidity assistance to Laiki. This option, however, would likely trigger a
system-wide bank run and would likely force a multi-day long-term bank holiday
during which the issue of a withdrawal from the eurozone and a hard-default would
take centre-stage. We think that a negative vote followed by the interruption of the
liquidity provision by the Eurosystem would have important adverse systemic
implications for all eurozone assets as the question of a break-up of the Euro area
would return in full force.

2. The deal and its implications on debt sustainability
The bailout deal that the Cypriot government reached with the rest of the Euro area
following Friday‟s Eurogroup is designed to meet national parliamentary concerns in
Germany, Finland, Austria and the Netherlands, as the Cypriot government
capitulated on virtually all topics (apart from the imposition of the Financial
Transaction Tax) they attempted to negotiate.

The most important and also controversial part of the bailout deal is a one-off
"stability" levy applied to all resident and non-resident depositors (but excluding the
€14-15bn of deposits kept in the Greek branches of Cypriot banks), irrespective of
which bank they have deposited their money in. For every euro of deposits below
€100k the levy will be 6.75% and for every euro of deposits above €100k it will be
9.9%. The domestic press is already suggesting that alternatives might be proposed
during the course of Monday, including a 13% tax on deposits above €500k and
lower rates at below €100k and potentially 0% below €25k. Irrespective of any last




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Nomura | Euro area Economics                                                                    18 March 2013


minute changes, the goal would still be to gather around €5.8bn from this levy,
according to the Eurogroup president.

As mentioned above, branches of the Cypriot banks in Greece will be ring-fenced. An
existing Greek entity will buy part of their assets (about €20bn) and take on their
liabilities (about €14bn). The capital deficit after the transfer to the Greek entity will be
covered mostly with Cypriot money. According to Capital.gr the amount required is
€1.4-1.5bn out of which €400m will be contributed by the Greek government.
Furthermore, ELA exposure of the Greek central bank will most likely increase to fill
the funding gap of the Cypriot units.

Cyprus and Eurogroup also agreed with regards to the Terms of Reference for an
independent evaluation of the implementation of the anti-money laundering
framework in Cypriot financial institutions. This involves Moneyval alongside a
private international audit firm, the step up of efforts in the area of privatization, the
increase of the withholding tax on capital income, an increase of the statutory
corporate income tax rate from 10% to 12.5% and the bail-in of junior bondholders.

Most of these measures will have to be voted on probably before mid-April, and could
pose further problems to the government given its weak parliamentary majority.
Sweeping privatizations, in particular, were always meant to be politically contentious,
however the privatizations process is expected to be a long one given that there is
not yet a complete inventory and valuation of the assets that could be sold.

The goals of the bailout terms are to fund the Cypriot sovereign until at least mid-
2016 using €10bn from the IMF and the ESM, allow Cyprus' public debt to reach
100% of GDP in 2020 and downsize the domestic banking sector from 7x GDP to 2-
3x GDP by 2018.

Details on the exact measures are scant. Our interpretation is that from a baseline
scenario of a full bailout that required about €17bn to get Cyprus through H1 2016
the same would now be achieved with €10bn. The €17bn amount was split with
€10bn for the banks, about €1.5-1.8bn for deficit financing and €5bn for debt
redemptions. The agreed bailout aims to fill the financing gap of €17bn with €5.8bn
from the one-off levy, €10bn from the ESM/IMF and the rest through privatization
revenues and potentially more fiscal revenues (arising from the higher corporate tax
and withholding tax on capital income).

In terms of the debt ratio the full bailout would have seen the debt to GDP peak at
about 145% of GDP in 2014 and only go down to about 125% in 2020. However, this
projection was based on a rather mild assumption regarding the recession in 2013-14
(cumulatively reaching -5%) and with GDP slowly recovering to about a 2% per year
increase in 2018-20. The draft MoU in November envisaged fiscal consolidation
measures of 7% of GDP in the period up to 2016.

This new bailout aims to get the debt ratio to 100% of GDP in 2020, which clearly
becomes more than achievable using the same macro assumptions as the original
bailout, but with 32.5% of 2012 GDP raised from the one-off levy and 8% of GDP in
privatizations.

However, it is unclear how the one-off levy and the other measures will impact the
behavior of households and corporates. The levy could be close to 15% of gross
disposable income of Cypriot households, or 10% of GDP. Even though their
deposits will be replaced with equity and potentially natural gas-linked bonds, deposit
holders‟ spending behavior would surely be affected. Furthermore, the increases in
the corporate income tax and the withholding tax on capital income could easily be
targeted to yield another 2% of GDP per year (€100-150m for corporate tax and
€150-200m for the capital income tax. Note that details on the latter tax have not be
made public yet), and will also change the corporate behavior especially of those
offshore companies that contribute about half of all corporate tax receipts.

It is also unclear whether the total fiscal consolidation will remain at 7% of GDP (of
which 4.5% of GDP have already been approved), or the measures agreed on Friday
will be on top the 7% of GDP figure. In any case, the assumption of a -5% of GDP




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Nomura | Euro area Economics                                                                  18 March 2013


recession in 2013-14 will probably have to be revised by the Troika significantly. Our
view (with the partial information we have so far) is that a figure closer to -15% for
2013-14 is more realistic, and will largely depend on the speed with which
financial/economic stability can be re-established to avoid the recession continuing in
2015.

What is even more important is the longer-term impact on growth potential given
Cyprus‟ rapid downsizing of its financial services industry and related services (e.g.
lawyers, accountants, auditors) that have a significant share on the gross value
added of the economy.

With these two observations in mind, with a -15% recession in 2013-14 and 0%
growth in 2015 the debt to GDP is set to peak around 128% of GDP during the
program period from 145% in the baseline. However, the 2020 impact is quite
uncertain, especially since around 2018 the effects from natural gas investments
should also have an impact. If the economy stabilizes by 2015-16, debt at 105-110%
of GDP in 2020 is feasible even with a substantially lower potential growth (e.g. at
1%).

3. What history tells us about levies or losses imposed on
depositors
It is very hard to find an historical comparable experience. Of the 147 banking crises
recorded in the Systemic Banking Crisis database of the IMF since 1970, we find no
similarity to the Cypriot deal with any of the resolutions of banking crises over that
period. We find 17 instances where losses on depositors were born but in no cases
were losses born by all depositors. Recent cases in Denmark and Iceland are also
very different cases.

Losses on deposits, while rare, are not unusual. Deposit freezes, bank holidays,
deposit / debt swaps and forced conversion of deposits into new currencies or
through below market rates have occurred during resolution of banking crises in the
past (see Figure 1).

We found two cases where depositors were given stakes in bank equity, during the
1995 Lithuanian banking crisis and in 2001 in the Philippines. But, here again in both
cases the swaps took place only for those banks that were resolved and did not
seem to impact the depositors below the guarantee in the case of Lithuania.

Going back in history there seems to be some similar policy action that was more of
the kind of capital levies where taxes were raised on land owners in a view of
repaying public debt (See Eichengreen “The capital levy in theory and practice”, 1989
NBER paper 3096, and Feldman Gerald et al. (eds), “The experience of inflation”,
1984). In Feldman‟s book, Elizabeth Boross reports that on 23 December 1920, the
Finance Minister of Hungary Lorant Hegedus decided to impose a capital levy of 20%
on deposits. However, even in that instance it looks as though small depositors were
excluded and the aim was to address spiraling inflation.

Historical successes of capital levies on wealth and deposits typically require a
number of conditions which are unlikely to be met in the case of Cyprus. First, it
needs to be absolutely clear that it will be a one-off event that will not take place
again and second, it needs to provide enough clarity on the ability of the measure to
solve the economic problems faced by the country. With the economy likely to go into
a tail spin and the negotiations of the broader bailout unlikely to conclude for at least
another month, uncertainty is likely to remain high. This is likely going to result in very
significant capital flight out of the country.

In essence, European policymakers confronted with the inter-temporal choice of
taxing later versus taxing now have opted for front-loading the tax increase via what
is probably the highest ever upfront deposit tax levied across the deposit base. This
suggests to us that the deal in Cyprus would have had a very different form had
Cyprus been outside of the euro area and would have most likely not included a tax
on the overall deposit base. A resolution of the banks with greater haircuts on large




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Nomura | Euro area Economics                                                                                                                                              18 March 2013


depositors not covered by the deposit insurance would have likely been the template,
as been the case in most banking crises in history.




Figure 1. Historical examples of losses on depositors in banking crises
   Country       Year          Losses                                                               Com m ents

  Argentina      1989           Large        BONEX plan converted time deposits into long-term bonds at an exchange rate below the prevailing on the market.
  Argentina      2001           Large        Dollar deposits w ere converted into domestic currency at ARG$1.4, w hich w as below the prevailing market rate.
   Bolivia       1994    Minor to Moderate   Large depositors of the 2 closed banks received as a compensation non- interest bearing bonds.
    Chile        1981    Minor to Moderate   In 1983, depositors at banks forced into liquidation w ere paid only 70 percent of face value.
 Cote d'Ivoire   1988           Large        In the liquidation of BDN, only 85 percent of depositors w ere compensated fully.
   Denmark       2011            small       Follow ing the failure of tw o banks in February and June, depositors above the guaranteed limited faced losses
                                             Frozen deposits w ere significantly eroded by accelerating inflation and depreciation of the currency and some
   Ecuador       1998           Large
                                             payments to depositors are still pending (despite the blanket guarantee)
   Estonia       1992           Large        Depositors of Tartu commercial bank w ere only partially paid

   Iceland       2008            Large       All deposits in foreign branches
                                             With the collapse of Baltija Bank the government compensated depositors for LVL 500 ($1000) per depositor (LVL 200 in
    Latvia       1995           Large
                                             1995 and LVL 100 over next 3 years).
                                             Depositors of Litimpex Bank had their deposits turned into equity. Furthermore, depositors of Innovation Bank received
                                             some cash (Lt.4000 in 1997 and Lt.4000 in 1998 per person) and the difference in 5- year, non-interest-bearing
  Lithuania      1995    Minor to Moderate   government bonds; legal entities received 10- year, non-tradable, non-interest bearing notes for the entire claim; certain
                                             public organizations, embassies, charities, etc received cash during 1998; other creditors received their pari-passu
                                             share of residual funds left from collection of Innovation Bank‟s assets; Public sector deposits w ere w ritten off.
  Lithuania      2011          very small    Only non insured depositors of Snoras Bank
  Philippines    2001                        Deposit to equity sw ap

                                             Some depositors (those w hose savings w ere not transferred to Sberbank) sustained losses at insolvent banks. Even
   Russia        1998    Minor To Moderate   those w ho benefited from the transfer faced some losses since the exchange rate used in the transaction w as less
                                             than half of the market exchange rate prevailing at the time.
  Thailand       1997    Minor To Moderate   Depositors of the closed finance companies received certificates yielding below market interest rates.
   Ukraine       1998           Large        Depositors w ere not fully compensated.
                                             Depositors at Banco Latino w ith more than 10m Bolivars received long- term non-negotiable bonds w ith interest rate
  Venezuela      1994    Minor to Moderate
                                             below market, for the amount exceeding the 10m.




Source: Systemic Banking Crises: A New Database, IMF 2008 and IMF 2012, Nomura Global Economics


                                                                                       5
Nomura | Euro area Economics                                                                        18 March 2013




Other country experiments

Denmark

During the course of 2011 in Denmark, two banks were resolved (Amagerbanken in February,
with total assets of EUR4.5bn, the eigth largest bank in Denmark and Fjordbank Mors in June)
which included some haircuts on senior creditors including depositors. The chart below shows
little impact on deposit trends despite deposit haircuts. However, we believe there are major
differences compared with the Danish situation: First, the problems were localized in two small
banks and losses were imposed on creditors of those banks not on the whole system. (For
example, in the case of Amagerbanken only 700 of its 100k customers were affected.) Second,
depositors under the guarantee scheme (with deposits of below €100k) were fully compensated.
Third, the legal environment around banking resolution, while relatively new, had been spelt out
very clearly and so the rules of the game were very transparent. Four, there were no restrictions
of banking transactions and banks were open “as usual” on the Monday following the imposition
of the haircuts. Finally, while estimates on losses of depositors about the €100k guarantee are
hard to find, the Central Bank of Denmark in its Q3 2011 Policy review suggested that
depositors in Fjordbank Mors faced losses “in the range of 26%” for those deposits not covered
by the Guarantee.

In the case of Amagerbanken, the initial loss seems to have been around 40% for the
depositors above the guarantee. Both losses were obviously a function of the recovery rates on
the assets and were thus maximum losses. While these losses imposed on depositors above
the guarantee levels are higher than those imposed in Cyprus it is possible that such a level of
haircut would have been sufficient to protect the smaller depositors. Evidently, a decision was
made that the deposit guarantee could not be used as it would end up putting the sovereign in
an even more unsustainable position.

Iceland

The 2008 Icelandic case is also very different as losses were only imposed on foreign
depositors in foreign branches. Meanwhile, domestic depositors were protected. Interestingly
enough, Iceland won a court ruling earlier this year where the court of the European Free Trade
Association stated that “How to proceed in a case where the guarantee scheme is unable to
cope with its payment obligations remains largely unanswered by the Directive.” This ruling,
made in January this year, basically sets a precedent in providing room for countries to
discriminate between domestic and foreign depositors, something that Cyprus could have opted
for given the very significant share of foreign deposits.

Mexico

In July 2008, Mexico put in place a tax on cash deposits, the so called “Impuesto sobre
depositos en effective”. The tax was of 2% and imposed on deposit above a certain threshold
(25k pesos). The measure‟s main aim was to reduce tax evasion within the informal economy.

Italy

In July 1992, Italy's Socialist Prime Minister Giuliano Amato imposed a one-off levy on bank
accounts as part of the “urgent measures for the consolidation of public finances”. This took
place against the backdrop of a deteriorating financial and economic situation in Italy. The
withholding tax was of 0.6% and applied to all deposit and savings accounts.

Norway.

In January 1936, Norway introduced a tax on bank deposits and this led to withdrawals until the
fall of that year (Hubbard, Glenn “Financial markets and financial crises”, 1991, page 53).
Unfortunately we could not find more information around this particular measure.

4. Implications for the region
We see a number of implications from the Cyprus deal for the rest of the region. They are based
on the assumption that the deal is seen as: (i) being imposed upon by “the North”. (As
suggested above, we believe that no such deal would have been reached had Cyprus not been
a member of the Euro area.) In addition, the deposit equity swap for those deposits below the
€100k guarantee will be seen by most depositors and observers as the very same thing as


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Nomura | Euro area Economics                                                                           18 March 2013


haircuts on their deposits over and above what they would have lost should they have been
covered by the deposit guarantee..

4.1. Contagion risks

4.1.1. Deposits

First, it is important to recall that deposits across the region and in the most stress countries
have on balance been far stickier than most observers would have thought a few years ago.
Greece is a case in point where deposits by households and corporates are down “only” 30%
from their peak in 2008.

Having said that, it is quite likely as we described above that the levy on deposits will not be
seen as sufficient to resolve all problems. This may well generate some significant capital flight,
especially for the most mobile part of the deposit base.

Other countries might suffer similar trends with corporates likely to „arbitrage‟ the deposit levy
risk in the countries most at risk of similar policies. Those countries are essentially all the
periphery. In the case of Greece, there is a widely held view that the next step to bring the
country back to sustainability will be via OSI. The Cyprus deal suggests that a levy on Greek
deposit cannot be ruled out when and if OSI will be considered.

The decline in deposits per se is not necessarily the trigger for any imminent systemic risk.
Indeed, the combination of ELA and ECB liquidity can match every euro of deposit flight for as
long as there is enough collateral available. In extremis, the issuance of debt guaranteed could
be considered.

4.1.2 Reduced banks’ buying power of their own sovereign debt

A significant decline in deposits could have some serious implications in terms of domestic
banks‟ ability to buy their own sovereign debt.

Indeed, a recent feature of banks‟ balance sheets, especially in Spain and Italy, has been the
shifts on the asset side towards increasing holdings of sovereign debt and reducing the loan
book as private sector deleveraging follows its course. With confidence returning due to the
OMT, the liability side of the banks saw a stabilization in deposit trends. Should deposits start
falling again, it would probably be more difficult for banks to continue increasing their sovereign
bond holdings at the same pace as they have done in the past 12 months.

4.1.3 “Uniqueness” of each bail outs keeps uncertainty high for future bail-outs

Another important outcome of this bailout is that for as long as the goal posts keep being moved,
investors will be in no position to assess correctly the amount of risk that there is in the system.

In particular, in this instance, there was no clear respect of the usual pecking order that is
followed in crisis resolutions. Not only are depositors hit, but those typically under guarantee
protection also are penalized very significantly.

Euro area policymakers took the unprecedented decision to hit small depositors in Cyprus,
perhaps to protect debt holders. Yet, it is hard to think that sovereign bond holders and bank
debt bond holders should feel reassured and conclude from this that they are now senior to
depositors. Quite the contrary, the conclusion from this, in our opinion, should be that the
uncertainty around future resolutions remains very high and thus the risk premium on debt
instruments in cases where indebtness remains a concern should rise.

4.2 Implications for future architecture of the euro

4.2.1 Economic governance and bail out mechanism in the hands of the North

The Cyprus deal suggests that little can be expected in the form of outright solidarity in the
upcoming decisions on the future of the architecture of EMU. The banking union is likely to keep
the risk largely in local hands before mutualizing any of it. While this makes economic and
political sense for the North, it is probably not compatible with the view of the South.

Likewise in the field of fiscal union, the message is pretty clear with no sovereign debt
mutualization in sight. Those who have pinned their expectations around the political
announcements to further economic integration during the course of 2013 should reassess their
expectations and scale them down, in our view.

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Nomura | Euro area Economics                                                                             18 March 2013


Finally, even if there was some support for a European deposit insurance mechanism, this deal
has practically put paid to any hope that such a scheme will have any credibility. The euro area
has jeopardized a critical instrument to maintain depositors‟ confidence in the banking sector.
Imposing haircuts on large depositors is one thing, but imposing them across the board will
create doubt about the value of such mechanism if it can be avoided so easily. The US created
its deposit insurance scheme in the 1930s to restore confidence at a time that deposits looked
seriously at risk. The euro area might have lost the opportunity to create such a guarantee
scheme at the regional level for a long time.

4.2.2 Political governance

It is unclear to us that such a deal would have been reached if Cyprus had been a country
outside the monetary union. In fact the role of Germany seems to have been instrumental, as
suggested by Schäuble himself. The decision seems to have even gone against the opinion of
the ECB, the Commission and the Cypriot government. Only the IMF seems to have sided with
Germany.

We believe this sets a new, bad, precedent in terms of North/South politics. Whatever the
rationale behind the deal, it is clear that it will be perceived by politicians and large parts of the
population of the South as policies imposed by Berlin.

Finally, there is an obvious risk of contagion directly into Italian politics at the very moment that
it needs to form a government. An update piece on the Italian situation will be published in due
course.




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Nomura | Euro area Economics                                                                                                                   18 March 2013


                                                             Disclosure Appendix A-1


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Nomura | Euro area Economics                                                                                                                  18 March 2013


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