Capital controls will put the euro at risk

This piece was first published in the Financial Times.

The currency in Nicosia will no longer be worth the same as it is in any other country, says Guntram Wolff.

Cypriot lawmakers have passed a bill that paves the way for capital controls. The legislation allows Cyprus’s government to introduce limits on transfers of bank deposits and cash withdrawals. It gives considerable discretionary powers to the state. Neither the European Central Bank nor the European Commission prevented the move. Both deemed it necessary to avoid uncontrolled outflows during the renegotiation of the island’s bailout deal. But the eurozone has now embarked on a process that endangers both the currency area and the single market.

The most important characteristic of a monetary union is the ability to move money – without any restrictions – from one bank to another in the currency area. With capital restrictions, the value of a euro in Cyprus is no longer worth the same as a euro held by any other bank in the eurozone. A euro in Nicosia cannot be used to buy goods in Frankfurt without limits. Effectively, it means that a Cypriot euro is not a euro any more.

The “bail-in” of depositors at the Bank of Cyprus, which was agreed on Monday as part of the rescue package for the island, will impose heavy losses on deposits above €100,000. This is an improvement on the generalised tax that was rejected last week by the Cypriot parliament, which would have punished even insured depositors and depositors in solvent banks.

Nevertheless, the problem of capital controls remains. Capital controls introduce the possibility for governments, both in Cyprus and perhaps in future bailed out countries, to decide whether a euro can move or not. This undermines the single monetary system and therefore the unity of the eurozone.

The eurogroup, the group of eurozone finance ministers, is well aware of the dangers of the road it has chosen. It has said that the “administrative measures” should be temporary, proportionate, and non-discriminatory. It remains to be seen what exactly is meant by these three adjectives but they seem to point in the right direction.

For example, I hope that “non-discriminatory” means that no distinction will be made between a transfer between two banks in Cyprus and a transfer between two banks in two different eurozone countries. Ideally, “proportionate” means that the administrative measures will only be applied to banks that are troubled – not all of them. “Temporary” should mean a period of a few days. But the capital controls in Iceland, introduced in 2008, are still in place. They ought to serve as a reminder that even temporary capital controls can be hard to get rid of.

What will happen now? There is a significant risk of bank runs. The eurogroup – eventually – took the right decision to protect deposits of less than €100,000. This should somewhat limit any rush for the exits for most savers. Yet, given the structure of the proposed deposit bail-in, a big number of large deposits in Cyprus are likely to be withdrawn immediately. Whether savers with smaller protected sums follow their lead will depend on the credibility of the eurozone response.

So what should policy makers do? Well, as it happens, the eurozone has clearly established rules for this kind of problem. It should follow them. The ECB is required to provide liquidity to any bank deemed solvent by its supervisor against appropriate collateral. The eurozone should provide liquidity to replace all outflowing deposits – so long as good collateral is available.

In a world of perfect information, where solvency assessments were instant and accurate, the central bank’s liquidity facility could take the place of the deposits. A solvent bank, then, could continue to operate normally. Perfect, fast valuations are not possible, but the central bank must nonetheless do its best to act as liquidity provider.

Furthermore, in these exceptional circumstances, the ECB must be ready to take on more risk than usual, by lowering its collateral standards. Doing so would send a powerful signal to markets and all other member states that there are no implicit limits to the eurozone payments system.

At some stage, however, the ECB may become queasy about the deteriorating quality of the posted collateral. If that moment comes, and banks still need help, new bailout funds may become necessary. With this solution, Europe would demonstrate its resolve to preserve the euro. The imposition of capital controls, however, risks sending a fatal signal to the markets that could very well trigger future bank runs elsewhere.

The writer is deputy director of the Bruegel think tank