Cyprus must avoid capital controls

By Hugo Dixon
March 24, 2013

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.

8 comments

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congrats for this post. Hopefully somebody in Brussles will read it….

Posted by lisandro | Report as abusive

Hugh – Sorry but I am not sure if I agree with you on this for the following reasons

1. Malaysia imposed capital controls during the Asian
crisis and thus it did not experience the huge
currency depreciation that hit Indonesia and Thailand
as all the hot money ran for cover. While things were
tough in Malaysia at that time their downturn was
not nearly as brutal as that in Thailand or Indonesia
and were able to ultimatley lift them when things
calmed down without material adverse onsequences.

2. Iceland would have been much worse off if they had
not imposed capital controls.

3. All the hot money from Russia that is currently in
Cyprus will run out the door in an instant if given a
chance and will NOT return.

4. Given that most of the hot money has been reinvested
back into Russia, if the ECB were to provide
liquidity using these loans as collateral then it is
highly questionable whether it would be able to
collect on these assets if it had to.

5. The history of financial crises is very similar -
fast hot money flows to take advantage of a perceived
opportunity (or the latest hot fad) but then when the
preverbial hits the fan, these so called “investors”
push the case for a compliant central banker to take
over their dud assets while they run away without any
responsibility.

Making them take their losses sends a strong signal
that they will not be bailed out in the future, helps
prevent moral hazard and will make them think about
imposing some financial disipline on the people they
lend to in the future (i.e would someone lend to a
bank with 35+ times leverage unless they thought a
central banker would bail them out.)

6. The Cyprus scenario has actually demonstrated how
restritions on a tax havens activities could be
curtailed in the future (i) if the country uses the
same currency as the EU then by restricting the ECB
backstop to its banking system the hot money
will be less likely to go there as it cannot be
assured of being bailed out.
(ii) Applying capital controls/witholding taxes to
cash flowing to or from the tax haven is a good
first step in reducing the extent of such
activity.

I understand your concern about runs on Spain and Ireland etc but the couter argument is that the fear of such a run will act as a strong incentive for all involved to get the bank systems properly recapitalised much faster than would otherwise be the case.

Posted by Maunsell | Report as abusive

Cypriot banks have reinvested their deposits into Russian assets? Is there documentary evidence for this? I would have thought Russians would use their Cypriot deposits to buy or leverage into EU assets out of reach from the Kremlin…The whole point of Russian deposits in Cyprus is to diversify away from mother Russia.

The whole Cyprus fight is about getting rid of an offshore inside the Euro family and force Cyprus into a different business model such as tourism and the like.

Why does the Cypriot government agree after all on a 20+% tax on deposits over €100th as long as they are with the Bank of Cyprus and a 4% tax on all other deposits over €100th at other banks? Because only 4% of BofC deposits are from Russia. Bingo, as long as the Cypriot president wants to save the tiniest bit of possible future as an offshore, Brussles will shoot him down. That is why all his counteroffers to the original proposal from Brussels are shot down.

Posted by lisandro | Report as abusive

I do not see reasons for panic in Spain, Portugal or Greece.

In Cyprus the majority of the bank deposits where over 100,000€.

Spain, Portugal and Greece are not offshore laundries. The majority of bank deposits are below 100,000€.

P.D: the case of Cyprus banks is a singular one, because there was no significant equity or bonds in their balances.

Posted by RafaelMtz | Report as abusive

better to annihilate the speculators and profiteers

like hanging an admiral, it sets an example for the others

Posted by scythe | Report as abusive

A good agreement. No capital controls. We needed a first stop to offshore funding. We need to get away from money of quastionable origin. We need to get balanced economies. We need to concentrate on a sustainable and honest value added chain and earned and developed competitive advantages.

Russians will pay for their opportunism and reclessness and Cyprus president will pay for his recklessness of wanting to save his Russsian cronies and the business model of an offshore center for Cyprus. He should have negotiated today’s agreement from his own accord and from the start. Once again Cyprus shows that what is rotten at the core is our democratic governance model and I mean the governance in most EU countries. It is a model built on debt, easy money and easy promises.

Cyprus will go through deflation but it is so small that a sprinkle of EU funds can restart growth with infrastructure programs. Cyprus has two huge military bases which are a source of Euros/GBPs and it has natural gas. Get a move on and do not invite Russian companies…I wish Portugal or Spain had natural gas….

Posted by lisandro | Report as abusive

What was done in Cyprus should have been the model used in Ireland, Greece and Spain as well.

Why should taxpayers be liable for bank losses? THAT is “crass” in the extreme.

Depositors knew, or should have known, that uninsured deposits over $100k would be lost if the banks foundered.

In fact, the same is true in the US, but the American taxpayers were not only forced to bail out greedy bankers, but they are still on the “dole” from Bernanke.

The banks that were “too big to fail” in 2008 are now larger and more unstable than they were then.

How is that a solution?

This nightmare will only end when the wealthy are taken off of “welfare” and forced to act responsibly again, which means taking their losses as well as gains.

It is NOT too late to claw back those welfare payments, providing we first establish capital controls over their assets — no matter where they are located.

Posted by PseudoTurtle | Report as abusive

I don’t think the reality of what just happened in Cyprus has sunk in yet. It should be interesting to see how this plays out over the near future.

I think this comment from the Prudent Bear sums it up quite nicely:

“Not a Decent Banker Among Them”

by Martin Hutchinson
March 25, 2013

“Legality seems to have been utterly irrelevant to those arranging the bailout. Instead, by arranging a “tax” that fell so heavily on small depositors, they blew a hole in deposit insurance schemes worldwide. Depositors in banks elsewhere in the EU, or indeed the U.S., can no longer believe that the first $100,000 (or whatever figure is “insured”) of their savings is secure. Inevitably, calls upon the deposit insurance scheme will be made in times of financial stress, and at those times governments can use the depositors’ funds to recapitalize the banks or indeed themselves. In 2008, depositors in Western Europe and the U.S. could be reasonably confident that their governments were in decent financial shape, so would have no need to raid their citizens’ piggy banks. In the next financial crisis, thanks to years of foolish, indeed evil monetary and fiscal “stimulus” there will be no such assurance.”

The entire article can be read at this website:

http://www.prudentbear.com/index.php/the bearslairview?art_id=10777

Posted by PseudoTurtle | Report as abusive