Cyprus: What next?

March 25, 2013
Obsession
Euro Crunch
March 25, 2013

Although negotiations between Cyprus, the EU, and the IMF have ended with a deal to preserve the country’s place in the euro and prevent its banking sector from failing entirely, the smoke around the event remains thick. Last night, euro zone policymakers adopted some unprecedented measures to keep the Cypriot financial system from failing and cut down the amount other euro zone countries will have to pay to make that happen.

But when the dust settles, what will be the effect on Cyprus and the euro zone?

Capital controls—days or years?

The most immediate short-term debate appears to revolve around capital controls, which will limit how much money can leave Cyprus. When banks in Cyprus open, they’ll face immediate runs that could decimate the country’s money supply, so EU leaders hope that temporary capital controls will allow confidence in the country’s banking sector to be rebuilt. It’s unclear how long the controls will be in place.

Some commentators argue that capital controls send a worrisome signal: that the free flow of capital in Europe—the raison d’être for the euro in the first place—is no longer important. Think tank Open Europe compares their adoption to a de facto break-up of the euro (our emphasis):

[Capital] controls are severe and could de facto lead to Cyprus being seen as out of the euro. Ultimately, money is no longer fungible between Cyprus and the rest of the Eurozone and, at this point in time, it’s hard to argue that a euro in Cyprus is worth the same as a euro elsewhere. The real problem though may not be imposing the controls but removing them – Iceland still has capital controls in place, five years after it installed them (despite having the advantage of a devalued currency).

Then again, others, such as British stockbroker and economics writer Daniel Davies, argue that capital controls won’t be in place for long. Instead, they will function as a temporary life support that will allow markets to reopen without too much of a ruckus:

Cyprus’s economy—how will it recover?

Even with capital controls in place to stifle the immediate collapse of the Cypriot economy, the prognosis for recovery within the euro currency is grim. A respected fund manager and strategist who tweets as @Pawelmorski compares the impact of the negotiations in Cyprus to a full-on war (our emphasis):

Take a moment to realise the scale of what’s been done here. No human agency has acheived so much economic destruction in such a short time without the use of weapons. The combination of laying waste to the financial sector and tearing up the savings of thousands of residents means that Cyprus won’t return to current levels of output for a decade, a funeral pyre which bears comparison only with Greece. There are four shocks happening at once; the bog-standard austerity shock; the trauma of bank withdrawal controls; the wealth shock; and the structural shock of wiping out the financial sector.

The Economist’s Charlemagne blog wonders where growth may even come from, perhaps some day in the distant future, if Cyprus’s financial sector has been wiped out:

Some sources in the troika tentatively estimate that GDP will shrink by about 10% before any hope of recovery. Perhaps the biggest question is this: once the banks have been cleaned up and shrunk, where will Cyprus find economic growth? The promise of offshore gas deposits is still too uncertain, and tourism may well decline if Russians suddenly find the island to be less hospitable to their money.

The rest of the euro zone—knock-on effects

We’ve argued before that this wasn’t a “good” outcome for the euro zone. Other commentators seem to agree with us that damage has been done in the last week to euro leaders’ credibility, their relationship to the IMF, and the shaky standing of other countries in the euro area.

In a report published late yesterday (March 24), Moody’s ratings agency warned that poor handling of negotiations with Cyprus “increases the likelihood of high-severity tail risks” (pdf, registration required):

The hard line adopted by euro area governments during negotiations suggests it is more willing than in earlier stages of the crisis to tolerate a risk of inducing financial market disruption when imposing conditions – a willingness designed in part to appease domestic political pressures, particularly in Germany.

It would appear that EU policymakers have so far failed to recognize this, even commenting at press conferences early today that the market clearly hadn’t reacted poorly to the situation. FT Alphaville’s Joseph Cotterill noted that, despite the drama of negotiations, EU leaders seemed happy to have subjected Cyprus to years of hardship:

Incidentally, there was no sign of contrition at the Eurogroup presser about the grievous mistakes of the first deal. If anything, they were all rather smug about how clever the new arrangement was: “we deal with the problems where they have arisen,” Dijsselbloem said.

From an investment perspective, however, it’s hard to look at Cyprus, Greece, and a handful of other EU financial institutions and not decide to move your money to a safer place, says Peter Tchir, founder of TF Market Advisors, in a client note. En masse, this kind of behavior could produce bank runs or slow flows of capital from the periphery to the European core, exacerbating the “two-tier” Europe that has emerged since the crisis took hold:

You are now relying on other companies [to be] either brazen risk takers, completely stupid, or just lazy when it comes to why any company or individual would have deposits greater than €100,000 at any bank in Greece or in Bankia at very least, and possibly in the entire PIIGS universe.  For all the “Russian Oligarch” talk, there was no distinction about large deposits, and even if there was, why wouldn’t the next time include “subsidized banker gains” or something.

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