Cyprus is on the verge of an unprecedented financial experiment: imposing controls on money transfers in an economy that doesn't have its own currency.
Countries from Argentina to Iceland have used similar measures in the past to defend against devaluation. Being part of the euro zone may make it harder for the Mediterranean island to enforce restrictions, as any money that leaves the banking system can be taken out of Cyprus without losing value.
That also may make it more difficult to meet the goal set yesterday by Finance Minister Michael Sarris to lift any controls in “a matter of weeks.” When economies in Asia and Latin America tried to stem the outflow of money in the 1980s and 1990s, they ended up keeping the measures in effect for six months to two years. Iceland, another island nation with an outsize banking system, still has capital controls five years after its banks collapsed in 2008.
“Thanks to political mismanagement, we now have a first: capital controls in the euro zone,” said Nicolas Veron, a senior fellow at Bruegel in Brussels and a visiting fellow at the Peterson Institute for International Economics in Washington. “How long is temporary? It could turn out like Iceland, extending to many years.”
Cyprus may announce what types of controls it plans to implement today, before its banks are scheduled to reopen tomorrow. The country's leaders are seeking to prevent the flight of money from the island's lenders, which have been closed for almost two weeks. Russian holdings in Cypriot banks are estimated by Moody's Investors Service to be $31 billion, or about a quarter of total deposits.
Parliament last week gave wide-ranging powers to the central bank governor, Panicos Demetriades, and Finance Minister Sarris, including the ability to limit daily withdrawals and force the renewal of time deposits upon maturity. The two officials also can restrict the opening of new accounts, credit- or debit-card use, wire transfers among the branches of the same bank and non-cash transactions.
“They're going to need some serious controls to make sure the money doesn't leave the country,” said Nikolaos Panigirtzoglou, a London-based strategist at JPMorgan Chase & Co. “Otherwise, I can't see how any of this money with a high propensity to leave will stay voluntarily.”
ECB Financing
A rush of money out of Cyprus would shift more financing responsibility to the European Central Bank, which provides about 10 billion euros of emergency loans to the country's lenders. After 30 billion euros, the ECB would have to lower its standards for the collateral it demands from Cypriot banks, Panigirtzoglou said. With deposit flight and rising loan losses in Cyprus and Greece, the ECB could lose money on the funds it lends.
The island's lenders have been closed since a plan by the European Union to force losses on depositors in exchange for a 10 billion-euro bailout touched off a political upheaval. Parliament rejected the deal, which would have taxed all bank accounts, including those under the 100,000-euro deposit- insurance limit. A new agreement shuts Cyprus Popular Bank Pcl, the nation's second-largest lender. Uninsured depositors of that institution and the Bank of Cyprus Plc, the biggest, will share losses, while insured deposits in all the banks are spared.
When Iceland imposed capital controls after a property bubble burst and its banks collapsed, political leaders said they would be temporary, too.
Financial firms, with assets 11 times the national economy at the peak, were too big to save. So Iceland let them fail, splitting them into good and bad banks. Bondholders bore most of the losses. Iceland's krona dropped by more than half.
Restrictions on the movement of capital out of the country were intended to stabilize the currency. They mostly related to the conversion of the krona to other currencies and targeted legacy foreign investments in the nation's securities.
Even with such a limited reach, the Icelandic capital controls have had a negative impact on the economy, according to Pall Hardarson, president of Nasdaq OMX Group Inc.'s Iceland unit. They've discouraged outsiders from investing and made it harder for Icelandic companies to sell bonds overseas, he said. After doubling every year for five years, foreign direct investment in the island collapsed in 2008 and has remained about 25 percent below the pre-crisis level.
“Ultimately we need to create confidence in the economy, and with these controls it's hard to do so,” said Hardarson. “Officially they only apply to legacy investments, but nevertheless they send a signal that things aren't the way they're supposed to be.”
Two Euros
Krona-denominated bonds left from the boom era cannot be converted to foreign currency when they mature. The proceeds need to be reinvested in krona assets. That has created two foreign-exchange rates for the island's currency — an official one traded domestically and one offshore.
The offshore krona trades lower than the official one because it reflects the difficulty exchanging them for dollars or euros, according to Hardarson. One euro was worth 159.54 kronur on official markets yesterday and 220 kronur offshore, according to Keldan.com, an Icelandic data provider.
The same is going to be true for the euro now that a member country is walled off from the rest, said Raoul Ruparel, chief economist at Open Europe, a London-based research group.
“Now there are two euros, one in Cyprus, one elsewhere,” said Ruparel. “The whole point about a single currency is that money is fungible, it can cross borders without any restrictions. The capital controls in one member basically ends that arrangement.”
To be effective, controls in Cyprus will have to be stricter than those in Iceland, Ruparel said. Iceland's importers and exporters have been exempted from currency- conversion restrictions as long as they can show the exchange is for trade purposes. If a similar exemption were to be made in Cyprus, Russian companies on the island could use the loophole to take their money out swiftly, Ruparel estimated.
Cyprus-based Russian companies, taking advantage of the island's lower tax rates, are the largest source of foreign direct investment in Russia, according to central bank data.
Most efforts to restrict capital flows out of a banking system or a country have failed to protect the currency they were intended to prop up, according to separate papers by Sebastian Edwards, an economics professor at the of University of California at Los Angeles, and Graciela Kaminsky, an economics professor at George Washington University.
Argentina Restrictions
Argentina restricted bank withdrawals in 2001, when it was faced with a banking crisis following the government's debt default. Three months later the country had to abandon its currency peg to the dollar, which it had maintained for a decade. The government imposed losses on deposits through forced conversion of dollar savings to pesos at unfavorable rates.
Being a member of the euro zone is similar to maintaining a peg to another currency at a fixed-exchange rate. When the local currency is overvalued as a result of inflation, countries with pegs eventually end the fixed regime and devalue, as Argentina did. Cyprus might do the same, faced with dire economic prospects, Open Europe's Ruparel said.
“Stuck with an overvalued euro, Cyprus loses out on tourism, one of its two main economic activities,” he said. “The other one, banking, is dead with capital controls. So what advantage does Cyprus get from being in the euro now?”
Cyprus's 18 billion-euro economy is the third smallest in the 17-nation euro area. Before the bailout, which was coupled with an austerity package, the European Commission predicted a contraction of 3.5 percent in 2013. Economists said afterward that the damage will be greater.
The decision to burn depositors with more than 100,000 euros and restrict money movements will hurt confidence in other weak economies and banking systems of the euro zone, according to a report yesterday by DBRS Inc., a Toronto-based rating firm.
“During the current period of low to no growth in Europe, it is certainly possible that a run on Cypriot deposits could spread, in spite of existing or future controls on capital,” wrote Fergus McCormick, head of sovereign ratings at DBRS.
A total of 378 billion euros was pulled from banks in Ireland, Spain, Portugal, Greece and Italy in the 13 months through August, according to data compiled by Bloomberg. The flight was reversed only after the ECB pledged to buy government bonds of those countries, calming investors.
Greek Ties
Cyprus's three biggest publicly traded banks had a total of 6.5 billion euros of losses in 2011 after writing down the value of their Greek bond holdings. They have also been bleeding on their loans to companies and individuals in Greece, which is in its fifth year of a contracting economy.
At least 1,600 Greek shipping, trade and tourism companies headquartered in Cyprus are threatened with closure, according to National Confederation of Hellenic Commerce. Greek firms that held deposits in Cyprus were unable to meet a deadline this week for paying taxes in Greece, the Athens-based organization said.
The divided island's internationally recognized southern part is ethnically Greek and has close ties to the financially troubled country. The northern part is controlled by a breakaway government backed by Turkey.
Russian companies with banking ties to Cyprus will face the same hurdles as their Greek counterparts, though the impact on the Russian economy will be less significant. Russian economic output, which expanded by about 4 percent last year, is almost 10 times as much as Greece's.
The biggest losers may be Cypriots themselves. Unemployment could double to 30 percent as a result of the planned bank restructurings, estimates Hari Tsoukas, a professor at Warwick Business School in Coventry, England.
“Life will be difficult for people living in Cyprus,” Tsoukas said. “The country will be another version of Ireland and Greece, with a tough austerity program. In another decade, we can look forward to another recovery.”
Bloomberg News
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