Capital controls in Cyprus: the end of Target2?

After the decision of last Saturday, an even bigger mistake is under way. Cypriot lawmakers have on March 22 almost unnoticed passed a restriction bill that allows the introduction of capital controls. This step was supported by the ECB and the European institutions to avoid uncontrolled capital outflows that could threaten financial stability in Cyprus. The bill prevents simple transfers of deposits from Cyprus to other countries in the Eurozone without an approval by authorities, with the ECB playing a role in the approval process. It effectively means that a euro anywhere is not a euro everywhere. This is the single most important mistake made in the Cyprus crisis. Here is why:

The most important characteristic of a monetary union is the ability to move money without any restrictions from any bank to any other bank in the entire currency area. If this is restricted, the value of a euro in a Cypriot bank becomes significantly inferior to the value of a euro in any other bank in the euro area. Effectively, it means that a Cypriot euro is not a euro anymore. By agreeing to this measure, the ECB has de-facto introduced a new currency in Cyprus.

It is, of course, clear that at the day of opening of Cypriot banks, all depositors will want to withdraw their deposits and ship them to other countries in the euro area. This is their right and one should not stop them from doing so (except for the tax that seems unavoidable). As a consequence, Cypriot banks will be left without funding from deposits. For such a situation, the Eurosystem has clearly established rules. In fact, the Eurosystem is required to provide liquidity to any bank deemed solvent by its supervisor against collateral. By agreeing to capital controls, the Eurosystem is avoiding taking its responsibility as a liquidity provider of last resort to the banking system. In addition, Europe is breaching the Treaty which prohibits capital controls inside the monetary union.

What should be done instead? The eurosystem should provide liquidity to replace all outflowing deposits as long as collateral is available. Collateral standards would certainly have to be lowered significantly as otherwise collateral standards would limit the amount of liquidity that could be provided, a point I made almost 2 years ago in this letter to FT (Lack of collateral will stop euro flows). At the same time, the Eurogroup should agree to an ESM programme similar to the one in Spain with very intrusive European Commission powers in bank restructuring. De facto, the European institutions should take control of those banks in Cyprus that run out of eligible collateral. They should then do gradual bank resolution by selling assets of banks at an appropriate speed. Alternatively, if the value of assets is high, then the bank could also be sold to new investors. This will mean putting up more resources upfront but it may be not a big loss in the end as Cypriot bank assets cannot evaporate over night. If the ESM is effectively in control, it will improve confidence of the Eurosystem and allow for the type of liquidity provisions that will be necessary. Eventually, it will ensure that even in case of a collapse of the Cypriot financial system, the ESM would ensure the proper functioning of the payment system and essential banking services.

Taxing depositors should not be seen as the main mistake of this crisis provided those below the 100K are protected. In fact, it must be possible to get a financial contribution of depositors of oversized and insolvent banks – even though this contribution should ideally be received in an orderly bank restructuring process. But by introducing capital controls, the eurozone has embarked on a process severely endangering the currency area and the single market. A euro in Cyprus now has a different value than a euro in Frankfurt. De facto, the ECB has showed that it is ready to contemplate implicit limits to the Target2 balances. It is not too late to correct this mistake.