Cyprus Reopens for Business: Now What?

The banks in Cyprus reopened today, with severe capital controls in place.  Withdrawals by residents are limited to €300 per day; local businesses are limited to a maximum of €5,000 per day.   Cross-border credit card transactions are limited to €5,000 per month, and border controls prevent travellers from taking more than €1,000 in bank notes out of the country per trip.  Beyond these totals, payments for imports are subject to strict documentation. The Cyprus stock market remains closed until next week.

The Cypriot government and central bank have defended the controls as temporary, but they could be in place for months.  Given the financial pressures that exist, and the difficulty any Cyprus bank will have reestablishing credibility after the events of the last two weeks, the controls will not be able to come off until the ECB is willing to fully back the banks, regardless of adequacy of collateral or credit quality.  (Iceland, which does not have the ECB standing behind it, still has controls in place from the crisis.)

European policymakers, including the ECB, have endorsed the controls, and it’s expected the IMF would do so when it approves the program.  Under the Fund’s Article VIII(2)(b), it can approve (and potentially provide additional legal protection for) controls its sees as necessary for successful completion of the program.

The experience of many emerging markets putting controls like these in place during crisis is that they can be effective, though evasion increases with time, and that the political and economic costs of maintaining such controls is high. Policymakers in Cyprus and Europe thus face a tough balancing act in finding the right timeline for removing the controls.

The events in Cyprus have been a reminder that, despite market calm over the last few months, the crisis in Europe is far from over.  Periphery banking systems remain vulnerable, the conditions for a healthy monetary union remain a distant hope, and the framework and policies Europe has in place for crisis resolution remain inconsistent and, at times, incoherent.

What lessons can we draw for how Europe will respond to periphery countries facing crisis in the future, as well as for other offshore centers with financial systems many multiples of their host countries?

One view is that the Cyprus rescue package is a template for future rescues. Eurogroup president Jeroen Dijsselbloem called the deal a “model” of “pushing back the risks” of paying for bank bailouts from taxpayers to private investors.  He later pulled it back a bit, and periphery finance officials have sought to distance their own situations from that of Cyprus, but he may be right. Cyprus could set a precedent for a US-style bank resolution system, in which large banks can be allowed to fail and be wound down, and creditors assigned losses based on traditional creditor rankings.  Private sector involvement would be established as policy well ahead of the 2018 deadline earlier envisaged. The ESM would still be needed for cases where sovereign debt remained too high, but in the first instance would be a backstop to the sector itself. The attraction of this approach for bailout weary European creditors seems obvious.

The alternative argument is that Cyprus’s solution represents more evidence of a new tougher line with small, poorly performing countries in the periphery, and not a precedent for Portugal, Spain or Italy.

In either case, Cyprus shows European policymakers willing to tax depositors because, as Willie Sutton famously is quoted as explaining why he robbed banks, “that’s where the money is.”  In contrast, the government still maintains it will make payments on its external debt, though it may be hard to explain after the events of the last few weeks why it would continue to pay external creditors in full while domestic depositors suffer losses.  In this respect, it’s a reminder that local law is weak protection for creditors when the European’s willingness to provide financing fails to fill the gap.

In sum, compared to the initial proposal that taxed insured deposits while leaving more junior creditors untouched, the final deal gets the creditor prioritization right, hits uninsured deposits at the two top banks hard while leaving insured depositors untouched, and gives the government broad powers to restructure banks and impose capital controls.  In sum, about as good a job of getting out of the hole European policymakers dug for themselves as could be hoped for.

Still, the contagion to investors elsewhere is likely to be significant.  Uninsured depositors, especially from outside the EU, are likely to flee, while even insured depositors are likely to be wary given events of the past week.  Further, the freeze and subsequent rapid deleveraging of the banking system likely will drive a sharp decline in activity in Cyprus.  There is no clear roadmap for restarting the banking system and getting lending going without massive capital flight. The risks that the program will fail are high.