Cyprus is announcing new steps, known as capital controls, to prevent a massive run on the nation’s banks when they reopen Thursday.
The controls are also aimed at stopping depositors from pulling their money out of troubled Cyprus and taking it elsewhere in the euro zone. But such free movement of capital is the entire point of a unified currency. This is why experts like Guntram Wolff, deputy director of the Brussels-based Bruegel think tank, worry that Cyprus’s imposition of capital controls, or restrictions on the flow of money, might mark the beginning of the end of the currency bloc.
“The eurozone has now embarked on a process that endangers both the currency area and the single market,” Wolff wrote in a Financial Times editorial on Monday.
Analysts at Nomura explained the problem in a recent research note: “A common currency, by definition, means that a euro in country A is equivalent to a euro in country B,” they wrote. “It seems fairly clear to say that a euro held in a bank in Cyprus is no longer worth exactly the same as a euro held in a German bank.”
That’s a big deal. But it doesn’t have to end the unified-currency experiment.
In some ways, the decision to impose capital controls rather than let the markets sort things out in Cyprus reflects a decades-long intellectual shift. In the wake of World War II, capital controls were widely accepted as useful by economists. Then, in the let-markets-be-markets Alan Greenspan era, they fell out of vogue and became less common, more taboo. But in 2012, the International Monetary Fund endorsed them.
Cyprus's controls come on the heels of two whirlwind weeks of negotiations, protests and nail-biting approaches to the brink of bankruptcy. Over the weekend, finance ministers in the European Union agreed to a €10 billion rescue package for Cyprus, with tough terms: The banking sector is going to be downsized and restructured, and depositors with over €100,000 in their accounts are expected to take a sizeable hit. The controls are the latest in the series of steps the country, whose financial sector had grown to more than eight times the size of its gross domestic product, is going to take in order to save itself from collapse.
There's good reason to believe that they will work without also contributing to the downfall of the eurozone.
A major concern is just how long the controls will be in place. The Eurogroup said they must be “temporary, proportionate and non-discriminatory.” But economists say it will take time to reassure depositors their money is safe in Cyprus, necessitating a lengthier period of controls. And since Cypriot euros are, in effect, worth less while they're in place, the longer they're kept up, the less of a part of the eurozone Cyprus seems.
Worriers point to Iceland, which adopted capital controls on a temporary basis in 2008 when its banking sector was on the verge of collapse. Now, in 2013, they're still in place.
But Cyprus and Iceland are very different cases. The solvent banks in Cyprus are backed by the European Central Bank, which has said it will stand behind them, giving them credibility. And even if the ECB pumps a lot of cash into the Cypriot banking system, it’s not likely to cause runaway inflation throughout the eurozone. “Neither is true in the case Iceland,” said Jacob Funk Kirkegaard, a senior fellow at the Peterson Institute for International Economics, because Iceland has its own central bank.
“The threshold for lifting the capital controls in a place like Iceland is much, much higher than I think it will be in Cyprus,” Kirkegaard said.
Timing is one issue, but perhaps the biggest concern is that these controls could set a precedent for the eurozone. Worried investors in other troubled European nations might scramble to pull out their money at the first sign of trouble, hoping to get ahead of expected capital controls. In turn, that could create a capital flight situation that, ironically, would lead to needing capital controls. It can become a self-fulfilling prophesy--one that was not helped by Dutch finance minister Jeroen Dijsselbloem, who heads the Eurogroup of eurozone finance ministers and made headlines this week when he suggested Cyprus could be a blueprint for future bailouts.
Cyprus is unique. Countries like Malta and Luxembourg, to which it is most frequently compared as fellow small eurozone nations with large banking sectors, are different. (For what it's worth, they also balk at the comparison). Part of the reason Cyprus needs capital controls is that an initial bailout deal was badly botched, raising concerns that all Cypriot depositors could lose money and stretching the final deal over days as citizens fretted over the state of the banking system, and part of the reason capital controls are necessary.
There is a precedent being set, and it's that the euro-area may, going forward, put the onus of paying for bank failures on investors rather than taxpayers. That does not necessarily mean widespread capital controls will become necessary when a bank failure seems imminent.
Finally, European policymakers have again and again shown they are willing to do what it takes to keep the currency union together.
“If there was a bank run in other euro-area countries because of the circumstances that we have talked about, then that will be the gun to the heads of policymakers to agree on [a single resolution mechanism],” Kirkegaard said of the controls. “I have no doubt in that situation they will do so because the preservation of the euro area ultimately trumps any other political concern,” he said.
The eurozone doesn’t yet have a single authority responsible for unwinding troubled banks the way the United States does, for example. Negotiations over how best to achieve this are expected to be contentious. The Cyprus crisis underscores why the discussions are so important.