Doomsday scenarios: With capital controls in place, is Cyprus effectively outside the Euro?

2013-03-29

This post is archived. Opinions expressed herein may no longer represent my current views. Links, images and other media might not work as intended. Information may be out of date. For further questions contact me.

As has been the case with all the other periods of duress in the 3.5 year-old eurocrisis, the case of Cyprus has provided the impetus for the cultivation of a number of doomsday scenarios regarding the fate of the Euro. One of them is that Cyprus is the first case where a country has effectively exited the euro, by virtue of the administrative measures imposing capital controls that have been introduced, which render obsolete one of the key features of a currency area and a single market, namely, unencumbered movement of capital. While I certainly am a fervent detractor of closed borders (and minds), be it in the movement of capital, goods, services or people and, while I would never support the use of the state’s monopoly of coercion to protect its cronies in the corporate world and the rest of their flunkies, I nonetheless perceive of this argument on Cyprus’ predicament as an exaggeration, which essentially stems from two sources:

1. Extent of capital controls: In terms of the duration of the capital controls, the argument on Cyprus’ effective euro exit, already perceives, quite erroneously, of these restrictive administrative measures as permanent; when it is well expected that they will be relaxed in the very short-term, while their life-span is supposed to be strictly limited, in order for them not to become counter-productive by severely hampering economic activity. While the authorities have promised to lift these limitations within the next days, I do not believe they will be in the kind of position of confidence that would allow them to do so, at least not before they receive the first tranche of loans envisaged in the Memorandum of Understanding with the troika. As unpleasant as a troika-led adjustment programme may be, we ought to recognize, for the sake of honesty and integrity, that it certainly provides a minimum of solace to an otherwise bankrupt state, by guaranteeing that funds will be offered to it after compliance with certain stringent conditions. For that reason, I doubt the government of Mr. Anastasiades would be willing to take the risk of lifting the capital controls prior to the implementation of the memorandum with the troika. Besides, the overall complacency and clumsiness of the Cypriot political class over the last years has now led Cyprus in a balance of power where no real allies are to be found.
2. Fragmentation as the main feature of the eurocrisis: To carry the argument further, as to why I think this is an overstatement, allow me to elaborate on market fragmentation being an impediment to a common currency. Prior to the introduction of the Outright Market Transactions of the European Central Bank, the single currency was at an advanced stage of financial disintegration, as the so-called “convertibility risks” (euro exit risks) where already priced in to the markets—and by extent to the real economy in terms of usurious interest rates for small and medium sized enterprises or for individuals. At that time the expected value of a euro deposited in, say, a Greek bank, was substantially less than the expected value of a euro in a German bank. This growing chasm was reflected, inter alia, in the unsustainably divergent Target2 claims against the Eurosystem; while also this fragmentation was clearly a driving factor underlying these massive capital outflows from the periphery to the core (also directly related to the controversy over the Target2 payment system). This evident divergence could, with a dose of exaggeration perhaps, allow one to issue the Olympian pronouncement that the GIIPS are de facto outside of the euro, since their banks cannot be regarded in the same light as their counterparts at the euro area’s core and hence “their” euro are of a lower expected value. Understandably, in drawing these parallels I am not assuming that the context is identical, but only that both the assumptions of the argument and the underlying mechanics of the economy and finance are essentially the same. Thus, if Greece, Portugal, Spain, Ireland, Italy or any other have not been “outside” the euro because of the perceived discount their domestically deposited euro have, then neither can the argument on Cyprus’ de facto exit withstand close scrutiny, especially since it brusquely ignores a series of events that have preceded it.

Nevertheless and without prejudice to the above, one ought to recognize the modicum of truth on which this proposition is predicated. It is undoubtedly sound to postulate that no common currency can exist while there is fragmentation among its constituent parts and that capital controls on one region do constitute an impediment to a single currency area. In this case the euro zone has been temporarily compartmentalized among a de jure free-capital-movement part on the one side and a market-restricted zone on the other, courtesy of the capital controls that have been imposed by the domestic government in south Cyprus. Here one has to stress the importance of the “de jure” aspect of this, since capital flows across the euro area are already constrained by cyclical factors.

If capital controls in Cyprus are to be strictly temporary, then it is pointless to create all this unnecessary pother. However, if they are to persist for a significant amount of time, such that would in fact swipe into the dustbin of the history of European integration the much-touted principle of the free movement of capital, then I am afraid that the exaggerations will become modest notes on the reality of things… Time will tell.

Does the Cyprus deal herald the start of the Euro’s demise?

Regarding the apocalyptic theories on the unravelling of the euro because of the painful Eurogroup deal on Cyprus, I shall enumerate the following remarks, with an emphasis on the bail-in scheme that has been the new paradigm in this crisis:

• First of all, the modus operandi of the bail-ins in Europe has neither been standardized nor institutionalized, suggesting that the entire discussion pertaining to the exact nature of this scheme, rests on shaky grounds. The intellectual trend in Brussels certainly points towards the direction of bail-ins becoming an integral part of the toolkit of the Single Resolution Mechanism that will soon be incorporated in the range of new responsibilities the ECB will have under the Single Supervisory Mechanism. Yet, we still are at an early stage in the process, where things are quite fluid.
• The regime that has been applied in Cyprus has been ad-hoc, ill-designed, unpredictable and opaque, while it has been placed within the context of capital controls (among others), increasing uncertainty and a geopolitical environment that is rather unfriendly. While there is relative calm in Cyprus at the moment, the inference to be drawn from this cobweb of factors is that the case of Cyprus is neither the prolegomenon to a genuine European bail-in scheme, nor the “template” for future policies applying similar techniques, Mr. Dijsselbloem’s litanies to the contrary notwithstanding.
• Bail-ins are by their very nature quite heterogeneous among themselves contrary to bailouts, for the former take into account the specific conditions that apply to each problematic bank, whereas the latter applies without serious consideration of the specifics. The only reason bail-outs were hitherto the choice of preference for policy-makers, pertains to their simplicity relative to bail-ins; and given that the Economic and Monetary Union’s institutional architecture was quite incomplete, it was practically impossible to concoct any bank-support scheme other than these expensive bail-outs.
• Concomitant with the point above, is the fact that for a bail-in mechanism to be credible and effective, there need to be legitimate and concrete arrangements in place that will facilitate the mobilization of the resources necessary to proceed with orderly bank resolutions or restructuring. For the time being, we are nowhere near that in the Euro area.
• All this may be very impractical (more time-consuming) in the context of extreme and sustained market duress, which implies that bailouts can never be ruled out as an option or possibility, even if bail-ins are instituted as the new orthodoxy of the future banking union.
• Lastly and in principle, a bail-in does not engender the perverse incentives a bail-out does, as bankers and those investing in banks do not labor under the assumption that the “generous” taxpayer will provide them the ultimate backstop they need in proceeding to their speculative bonanzas.

With all this noted, I must dare to suggest that the case of Cyprus will not trigger a domino-effect, nor will it bestow on the minds of investors a fear of a renewed “pop-corn” effect (which in my opinion is what is actually happening in Europe, given the systemic features of the eurocrisis).

Concluding remarks

To digress from the aforementioned, I wish to conclude this post with a short comment on the picture right above. The person holding the placard is Mr. Björn Luley, the director of the Goethe Institut in Cyprus. Apart from the fact that I agree profoundly with the message he disseminates, especially the part concerning the need for solidarity with the people rather than the banks; I have selected this image to stress once again, as I have always done, that we must not allow age-old stereotypes and prejudices to cloud our judgement, nor must we facilitate the recrudescence of ethnicist, racist and misanthropic ideologies.

Extremists, or in certain cases the soothsayers of an eschatological perception of the economy and the modern polity, have throughout history promised to enact a convenient remedy to the ills of the present; yet, by making meticulous application of the toxic and monolithic “we-against-them” device, they would single out the target, demonize him, her or it and proceed blithely to justify any argument or measure against it, no matter how despicable, inhumane or odious that might have been.

If there is one reason we should laud the European project, it is that it has contributed to bringing peace to this war-torn part of the earth; and despite the indubitable inadequacies and design flaws of the European Union, I uphold that it is much more prudent to labor towards improving the EU from within, than providing grist to the mill of nationalist isolationism, which if followed to its logical conclusion, will once again pit us all in an inane, self-defeating race to the bottom.

This is in no way an obscurantist apologetic to the evident shortcomings of the present inter-governmentalist and technocratic superstructure that is the EU, but only a call for rational judgement. As such, I must hereby thank Mr. Luley for reminding us in the midst of a climate of doom and gloom, that fission shall be our demise, and that unity and genuine solidarity among people must be the lofty ideals underpinning all efforts henceforth.

May common sense prevail!

Picture source