Cyprus exit risk is real – and manageable
By Neil Unmack
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
Is the European Central Bank ready to start a Cyp-riot? It has threatened to cut off Cyprusâ banks if Nicosia doesnât take a bailout, potentially triggering the countryâs exit from the euro. The ECB has threatened to cut off banks and countries before but backed off. This time it may be serious.
The ECB has not explicitly threatened to throw Cyprus out of the euro zone. Rather, it has said it will only lend to solvent institutions and that a bailout would ensure the solvency of Cyprusâ banking system. Cutting off the banks could be the first step to an exit. Without an extension of the ECBâs 9 billion euros of so-called emergency liquidity assistance (ELA), the banks would collapse, forcing the government to impose capital controls or print money.
The Cypriot parliamentâs rejection of the euro zoneâs bailout proposal agreed last Friday night has put the ECB on the spot. And it is easy to see Nicosia being tempted to call the central bankâs bluff. The reality is that pulling ELA isnât easy. The ECB governing council needs a two-thirds majority to stop the operation, so just eight out of 23 members could keep liquidity flowing.
And some members may have doubts. The argument that the ECB canât lend to insolvent banks looks lame. The ELA given to now insolvent Anglo Irish Bank was three times that provided in Cyprus. If the ECB had to fund all the countryâs deposits, its total exposure would be less than its Italian government bond holdings. Balance that with the unpredictable fallout from a Cypriot exit. Depositors might flee banks across the periphery. The ECB would have to pump liquidity into the banking system and buy government bonds. Thatâs tricky while there is no government in Italy.
Still, providing liquidity to a government that refused to cooperate would be a dangerous precedent. An exit from the single currency is probably manageable given Cyprusâ small size – gross domestic product is less than 0.2 percent of the euro zone total. Moreover, it is not necessarily the case that an exit would increase the chances of Italy or Portugal leaving – Nicosiaâs economic and political situation is unique. The sight of a painful departure may even quell euro scepticism in the periphery.
The ECB doesnât need to decide until Cyprusâ banks are close to re-opening. Even then, there may be a way of buying time, such as short-term capital controls. Still, the threat is real even if an exit is undesirable. And its credibility makes Cyprus more likely to step back from the brink.