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A historic error

24 March 2013 By Hugo Dixon

Imposing capital controls would be a historic mistake for Cyprus and the euro zone – even worse than the crass idea of taxing uninsured deposits. Non-cash transactions would be limited, while withdrawals from cash machines would be rationed.

This would be equivalent to Argentina’s “corralito”, which lasted a year in 2001/2002. If capital controls are imposed, it will be almost impossible to lift them because people will stampede for the exits once they are removed. But such heavy-handed rationing of limited cash would clobber an economy which is already heading for a slump.

Some people will say that Cyprus has already endured a week of capital controls because of the extended bank holiday since last weekend’s botched bailout. But officially imposed indefinite capital controls – blessed by the euro zone and the International Monetary Fund – would be far worse.

They would also be a terrible precedent. Savers in Italy, Spain, Greece and other vulnerable euro zone countries might worry that they would be next and rush to remove cash from their banking systems. If that led to capital controls being imposed in these much bigger economies, the euro zone might then be staring at the end of its single currency.

The least-bad solution is for the European Central Bank to offer to supply unlimited liquidity to the Cypriot banks and fund a run. Some of the money would never return. But, after a few weeks when the people realised that the cash really wasn’t running out, some deposits would return. For the ECB to do this within its rules, the banks must be properly recapitalised and have sufficient collateral.

The key is to separate the rotten parts of the banking system from the good ones. The uninsured depositors can then go with the bad banks and effectively be tied up until they are wound down. This will cut substantially the liquidity that needs to be provided to the system. Nicosia has effectively accepted such a solution for its second-largest bank, but may still be resisting doing so for the biggest one.

Provided such a good bank/bad bank split can be agreed, the good banks will be in a healthier position to get liquidity from the ECB or Cyprus’ own central bank (via so-called emergency liquidity assistance). If they still don’t have enough suitable collateral, the ECB should change the rules to allow other types of assets to be accepted. If there’s still a shortfall, the good banks should be allowed to manufacture collateral by issuing government-guaranteed bonds.

More specifically, a six-point plan would consist of the following:

1. “Resolve” Cyprus Popular Bank, the second-largest and most troubled. That will cut the amount of deposits that can run there, as all uninsured deposits (those above 100,000 euros) will be locked up in the bad bank. (Resolution is effectively a type of controlled bankruptcy.)

2. Either resolve Bank of Cyprus, the country’s largest lender, or turn its uninsured deposits into long-term certificates of deposit as recommended last week by Lee Buchheit and Mitu Gulati, U.S. debt restructuring experts. Again this will cut the amount of money that can run.

3. Allow the good Cypriot banks’ large holdings of Cypriot government debt to be used as collateral with the ECB after a bailout has been agreed.

4. The extra capital to be pumped into the Cyprus banking system as part of the bailout should also be made available immediately as collateral. One way of doing this would be for Nicosia to provide the banks with “bridge capital” in the form of a promissory note and allow that to be used as collateral until the real capital arrived. Such a solution has been used in Ireland and Greece.

5. If there’s still a shortfall, the ECB should let the Central Bank of Cyprus widen further the collateral it takes.

6. If that is still not enough, good banks should be allowed to issue government-guaranteed bonds and use them as collateral. This technique was used with Greek banks and Spain’s bad bank. The IMF may be worried that such guarantees are an off-balance-sheet liability that will damage Cyprus’ debt sustainability. But provided the banks are properly recapitalised, the contingent liability shouldn’t be large.

Some plan like this needs to be put in place to avoid capital controls. If not, it might even be better for Cyprus to quit the euro, terrible though that would be. At least then, Nicosia would have control of its own currency and the euro zone wouldn’t have blessed a scheme that could be its own undoing.


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