Contagion, Capital Controls and Too Big To Fail: Outcomes of the Cyprus agreement

Corralito Protests in Buenos Aires

Just when I thought that nothing more would have to be said about the Cyprus experiment, a literature over capital controls, whether Cyprus should leave the Eurozone and if potential contagion is something to be feared in the future arose. Economists have been evaluating every one of the aforementioned issues and just as they always do, they could not agree on anything.

Capital controls have been in Cyprus for four days now and apart from the mess at the banks as a result of the 12-day "holiday" no significant flight of capital occurred (and no bank run, to the delight of everyone, even journalists). Although the ECB does not publish real-time Target2 balances, it appears that the capital controls have done their job (if one excludes the stupid decision to close down all banks and leave branches in Russia and Romania open). Probably every article online condones the measures taken by the Cypriot government, yet, some of them agree that there was no other option. Fellow blogger Protesilaos Stavrou commented that if controls persist even after the first tranche is paid by the Troika, then the whole programme was a fiasco; a statement I partially agree with.

Abolishing capital controls cannot happen over a day. The strict regulations applicable now should be transformed to more lax ones over time, with the aim of completely abolishing them until the end of the year (at the very extreme). Why the end of the year? Simply because anything that lasts more than 9 months should be considered as permanent no matter what the authorities may claim. Receiving the first tranche from the Troika does not really mean anything unless the ECB is willing to increase the ELA funding for the Cypriot banks, whose reputation has sunk over course of this deal. If €10 or €20bn of deposits exit the island will the ECB be ready to accommodate the lack of liquidity? 

Many compare Cyprus with Iceland. I beg to differ. First of all, Iceland was not part of the Euro-Area, which means that it had to create its own liquidity. If the ECB agrees to provide ELA funding for the Cypriot banks which may need it (so far only the Bank of Cyprus appears to be in need), then Cyprus can abolish the controls (again, over time) without any more harm to its reputation or economy. In addition, Cyprus banks only account for 10% of GDP and the economy receives a strong boost of foreign money in the form of the 2.5 million tourists who visit the island every year; not be rude to Iceland but we have to admit that their tourism is much less than that. Even without that amount of tourism, Iceland, having imposed capital controls for about 5 years now, exhibited a 3.1% growth in GDP in 2011 with an unemployment rate of less than 5% in mid-2012. Thus, although most economists discern capital controls they have really benefited the country's economic performance. Having capital controls is not bad per se; it's how long you keep them and how harsh they are that makes the difference.

Let's move on to contagion issues. A New York Times article stated that the Bank of Cyprus is no bigger than Indy Mac Bankcorp, a savings and loans institution in the US, which failed five years ago and needed a bail-out. The author misses a little detail though: the US has a GDP of $15 trillion while Cyprus's is about 1,000 times lower. Thus, Indy Mac was approximately 0.0018% of GDP (it had $27bn in assets), while the Bank of Cyprus is approximately 1.5 times as big as the Cypriot GDP. The difference between the two was that Indy Mac was NOT too big to fail. As stated before, there would be no severe contagion in any monetary terms from Laiki bank failing. Neither Bank of Cyprus for that matter. What made the two banks systemic was there strong presence in Greece. After selling that for the cheaper price they could get, they now pose no danger to the European economy (bad move for the Cypriots). 

What makes a difference though, are the psychological effects this issue has had. The banking union, planned for 2014, now appears to be a vague dream; no predictability of institutions exists in any form. If someone thinks that the situation is not so bad and people still trust their banks then why should Wolfgang Schauble have to tell us that the savings in euro are safe? Ordinary citizens have no other viable option in the EU but to place their savings in a bank account. Yet, the less-than-100k accounts do not amount to much. For example, in Laiki bank, only €4bn out of a total of  €20bn will be saved, i.e. 80% of deposits belong to large depositors. These are the people who have the ability and knowledge to transfer funds from one country to another at the click of a button. It is, unfortunately or not, the big depositors that the EU has to reassure to the small ones. In addition, it is not just depositors that have to be persuaded. It is also emerging economies or other countries who use the euro as a reserve currency. The Economist observes that countries in the developing world are drastically reducing their reserves in the Euro, with reserves being at their lowest in a decade. The Euro is as strong as its weakest link and we do not even know who that link is.

Uncertainty is running wild in the Union, as the Eurogroup does not appear to understand the decisions it is making. Another outcome of the Cyprus experiment is that a brand new Too-Big-To-Fail bank has emerged in Greece. Pireaus Bank, after securing €16.2bn of loans at the ridiculously low price of €524 million, has become probably the largest bank in Greece controlling 28% of loans and 27% of deposits. With no agenda on being pessimistic isn't market concentration in the banking industry a big issue, especially in an economy in recession? Time will tell. Yet, it now appears that Greece is being dominated by 3-4 banks, which is almost never good for competition and always never good for the economy if they face trouble. If the Eurogroup decided to reduce the Cypriot banking sector the EU average by making one bank default and make the other less systemic why isn't it doing the same in Greece? Oh, I forgot: we are only looking for solutions AFTER the problem has hit us over the head with a baseball bat. 

This is has been a great week for euro-skeptics. A Euro-exit appears to be less distant know that ever before. The question is who will take the first step. The outcome of Italy's elections will dominate the Euro-Area over the next few weeks, while all of us will keep an eye in France, whose fiscal deficit was still very high in 2012. If the austerity cycle resumes then we are all in big trouble; especially Germany.