The broken Euro

Imagine you live in a prosperous country, with a lovely climate, beautiful beaches, blue seas. But there's something funny about this country. It doesn't have a functioning banking system.

You can put money into your bank, but you can't get it out again. At least you can, through ATMs, but only in very small amounts.

If you have money on deposit, you can't take the money out and close the account. And if it's a time deposit, when it reaches the end of its life, you can't have the money to spend. You have to roll it over into a new deposit.

You can't cash a cheque in a high street bank. You can't pay bills in a high street bank, either. And no high street bank is lending any money, so if you want a loan, forget it. In fact high street banks are not much use.

Your employer pays you in cash, because there are no electronic payments. Which is just as well, really, because you need cash. There are no automated payments such as direct debits, so you pay all your household bills in cash. Credit and debit cards are no longer accepted anywhere, so you buy all your shopping and petrol for your car with cash. You can't make phone or internet purchases.

If you have more than one account, you can't transfer money between your accounts. If only one of your accounts has ATM access, once that account is empty, you are stuck with no money.

You can't go on holiday abroad because you can't take any money out of the country. Your employer won't send you abroad on business, either, because you might not come back.....

All the local shopkeepers will only accept cash, not cheques. That's because they have to pay suppliers in cash, and once you put money in a bank, you can't get it out again.....But all small businesses are having a very hard time. Shops are closing, businesses going bust, people losing their jobs. You're not sure how much longer you will keep yours. You've taken a pay cut already, even though it means you struggle to pay your mortgage.

It would really help if lots of tourists would visit your beautiful sunny country. But the place is deserted. Tourists are unwilling to come here's very cheap, but they can only bring cash with them and whatever they bring must stay here - and if they run out of cash they can't get any more.

This is Cyprus. Or rather, it will be - next week. When full capital controls are imposed. When Cyprus is ring-fenced from the Euro area and its membership of the European Union is effectively suspended.

I am not being dramatic. The above is a description of the effects of the capital control bill forced through the Cypriot parliament this weekend. From Tuesday, Cyprus becomes a black hole in the Eurozone: any money that goes into it stays there, and no money can leave......From a safe distance, it will appear frozen in time, a small cash-based economy, isolated from the rest of the EU. While inside, invisible to all except those who actually go there - or live there - its social fabric is torn apart as its economy collapses. Note the final clause in the capital control bill:
Any other measure which the Finance Minister or the Governor of Cyprus Central Bank see necessary for reasons of public order and safety
So as people's livelihoods are destroyed and their standard of living crashes, other measures may be introduced to ensure that they can't take matters into their own hands.

The IMF acknowledged in a paper a few months ago that capital controls can be helpful in crisis-hit economies. In Cyprus's case, the immediate need for capital controls is to choke off bank runs when the banks reopen after the extended bank holiday. The trouble is that bank runs are not necessarily acute. As we have seen in other countries, notably Greece and Spain, bank runs can be silent and extended. Even in Cyprus, deposit flight started some time before the attempted depositor haircut last week that forced closure of the banks. It is difficult to see how, with a wrecked financial system and collapsing economy, capital controls can be lifted at all without setting off bank runs. As things are set to get much worse, probably including bank failure and sovereign default in the not too distant future, capital controls are likely to remain in place for a long time. Despite the IMF's insistence that capital controls should be short-term, recent use of them has been anything but: Iceland has now had "temporary" capital controls for five years, and Argentina for ten (although that is probably for political reasons). Dismantling capital controls is not easy.

But the Cyprus capital controls differ fundamentally from those imposed in the Iceland banking crisis. Iceland is a sovereign state with its own currency. Cyprus is a member of a currency union - the Euro. And capital controls make a complete nonsense of currency union.

Once full capital controls are imposed, a Euro in Cyprus will no longer be the same as a Euro anywhere else in the Euro area. It cannot leave the island. The Cyprus Euro will in effect be a new domestic currency. The imposition of capital controls in Cyprus is therefore the end of the single currency in its present form. As this image shows, the single currency will have a bit missing - a bleeding chunk torn from its edge:

Yes, the Eurogroup will claim that it is "business as usual" in the Euro area. Draghi will continue to claim that the Euro is "irreversible". Eurostat will continue to produce statistics for E17 and E27 including Cyprus. But the reality will be that the Euro will be broken in two. There will be the Cyprus Euro, and the "mainland" Euro (if we can call it that).

One of the interesting effects of capital controls is that the Cyprus Euro would be likely to depreciate against the mainland Euro - a de facto floating exchange rate. This might help to protect the Cypriot economy from the worst of the coming economic collapse. The ECB would of course enforce convertibility at par for any Euros that did manage to get in or out of the island, but as this traffic should be small, the purchasing power of the Cypriot Euro within Cyprus itself would be far more important. Cyprus would in effect have gained control of its own currency without the costs and risks of redenomination.

But this is not as good as it sounds. There would be likely to be serious shortages of Euros in Cyprus once capital controls were in place. Currently the Cypriot central bank cannot print Euros: the Euros in circulation in Cyprus are printed in France and the Netherlands on behalf of the Cypriot central bank and transported to Cyprus. These Euros are printed in accordance with the ECB's rules, which operate strict proportionality in relation to the size of the economy and overall Euro area money supply, but Cyprus's need for cash will be much greater when there are no alternative methods of payment. I can't see the ECB being particularly keen on expanding the physical money supply in Cyprus because of Cypriot capital controls.

Because of this, I would expect to see alternative currencies starting to circulate in the Republic of Cyprus. The obvious candidates are sterling, because of the large UK expatriate community and military presence; and Turkish lira, because of the presence of the (unrecognised) Northern Republic on the island of Cyprus.*
And because of the ban on electronic transactions in Euros, I would not be surprised to see e-currencies and mobile money becoming popular: they would be an effective way of avoiding capital controls. It is unclear exactly how the Government and central bank would respond to this, but remember that final clause in the capital controls bill: is a ban on private use and holdings of alternative currencies beyond the bounds of possibility? Or would they simply accept (gratefully) that use of alternative currencies relieves the pressure on the Cyprus Euro, enabling more economic activity than would otherwise be possible? Much depends, I suspect, on the pressure on public finances caused by the now inevitable economic collapse. Declining tax take might encourage  a desperate government to enforce use of the Euro, despite shortages, to help ensure that taxes can be collected. Using alternative currencies is of course a standard way of avoiding tax. Personally I think this would be a mistake: repressing alternative currencies would depress economic activity and slow down recovery. But as the Troika would be overseeing Cyprus's public finances and enforcing the agreed austerity measures (and probably harsher ones too, once the debt/GDP ratio started to rise due to economic collapse), counterproductive repression of alternative currencies to increase short-term tax take seems likely.

The fact that the ECB will still control the purse strings, and the Troika will still oversee public finances, may eventually make the shortage of Euros and the lack of control of monetary policy intolerable. If this were to happen, then Cyprus should formally break free. The fact that it cannot print Euros means that it would then have to redenominate, probably into Cyprus pounds at one-to-one par value with the Cyprus Euro. This is not a step to be undertaken lightly, though: it would mean that Cyprus's public debt would then be denominated in a foreign currency. Some form of currency peg, perhaps to sterling, would in my view be necessary to prevent collapse of the new currency and disorderly debt default. I'm not at all sure this route should be followed yet. It may be that the fragmentation of the Euro caused by capital controls will give Cyprus sufficient protection to enable it to recover from this awful mess - if the Troika's hamfistedness doesn't scupper the whole thing anyway.

So the nature of the Euro will be fundamentally changed by Cyprus's capital controls. The single currency will exist in name only: the reality will be fragmentation. But it is not just the single currency that will be compromised. The isolation of Cyprus is clearly in breach of the founding principles of the European Union. It is unclear whether the capital controls are legal: Article 63 says they are not, but Article 65 1b and 2 suggests they may be. I leave that to the lawyers: I am more interested in the principles. The European Union was founded on "four freedoms": free movement of goods, free movement of services, free movement of capital and free movement of people. Capital controls are direct prevention of free movement of capital. In fact it is worse than that, because strict capital controls also severely curtail free movement of goods and services and free movement of people - the other founding principles. Will other countries want to trade with Cyprus, if it is difficult to get money out of the island? How can anything other than subsistence-level trade within the island operate, if payments can only be made in cash? How can people move in and out of Cyprus, if they can't take any money with them? Indeed, how can any of these freedoms be said to operate in a country with capital controls as tight as those now signed into law in Cyprus? In effect, Cyprus is no longer a full member of the European Union.

And this sets a dangerous precedent. The Troika's mishandling of the Greek crisis and the ensuing contagion to Cyprus has fundamentally weakened the European project. If it can bully one state into imposing capital controls in clear breach of the principles of the European Union, and in so doing destroy the integrity of the single currency, then it can do it to others. And this is on top of the damage already caused by the disastrous attempt to impose losses on small depositors in Cyprus, and the imposition of highly damaging "deficit reduction" programmes against the will of the people in a number of states including Cyprus. The Troika has already demonstrated that it will sacrifice democracy in the cause of the European project. But now it shows that it will sacrifice the very principles of that project to maintain the sham of unity. How much longer before the whole thing unravels?

Related links:
Cyprus, capital controls - The Prodigal Greek (Yiannis Mouzakis)
Capital controls in Cyprus: the end of Target2? - Guntram Wolff, Bruegel
Cyprus: The operation was a success, shame the patient died - Pawel Morski
Sowing the wind - Coppola Comment
The liberalization and management of capital flows - IMF
The Icelandic financial crisis - Wikipedia
Internal market - Wikipedia
TMM Thoughts on Cyprotoxins - Macro Man
Analysis: "Lex Cyprus" will set precedents for closer EU union - Paul Taylor (Reuters)
Will Germany turn Europe into Latin America? - Christopher T. Mahoney

and once again, a strong plug for FT Alphaville's excellent Cyprus Coverage.

"Broken Euro" image courtesy of George Mitakides

* Turkey has already expressed an interest in reopening negotiations with a view to achieving recognition of the Northern Republic, apparently in return for allowing the Cypriot government to exploit the natural resources in the southern part of the island and offshore waters. This is an interesting and rather disturbing development: at present the Republic of Cyprus appears to be ignoring Turkey's offer (and associated warning), but that may change if the EU freezes them out and they are faced with economic collapse.


  1. Please email to the troika, for they don't know yet what they have done...

    1. What do you mean?...hmmm An "expensive" economic experiment? "Cyprus:The small scale experiment", "Greece: another experiment... blah...blah"

  2. A nation as Cyprus enjoys the right of economical suicide. It cannot blackmail or exploit other eurozone nations willing to help and bite the hands that promised to feed them. Russia and the UK don't even help.

    1. I can't comment on Russia. But the UK is a member of the EU. It is not able to undermine or circumvent the actions being taken by the Eurogroup. All it can do at present is protect its own people in Cyprus as best it can, particularly the members of its armed forces.

      You speak of blackmail. I speak of the consequences of compliance. The broken euro is caused by the capital controls introduced with the agreement of other eurozone nations. They have fractured their own currency.

    2. Members have agreed to a hard currency system, if you break the requirements you end up like in a system of corresponding tubes with the mess you created. Bailouts are illegal under the treeaties. We are beyond this stage. The UK is free to aid Cyprus if Cyprus feels like it can gamble a gracious eurozone offer. Cyprus enjoys the democratic right to financial suicide. Their parlament voted against their agreed deal, so no need to take their drama seriously. As a sovereign state they have a right to destroy their economy. A chopped off head of the Cyprus chicken would restore trust in the eurozone order and help to enforce discipline.

    3. I think the UK (or anyone else) making a donation of 7 billion euros (or whatever the hole is) to Cyprus would have been welcomed by everyone involved. A loan would be undermining, a donation, no. Could the UK have done that? Certainly, it's only about £100/head, and a one off, which is pocket change for UK taxpayers.

    4. I don't see any "other eurozone nations willing to help" anywhere. I don't even see any of the northern members being willing to pay their share of the cost of maintaining a common currency.

      (For those keeping score of such matters, the fair share of the cost of maintaining a currency zone is equal to the member's current account surplus net of any existing EU-level transfers, since CA surpluses net of fiscal transfers are destabilizing under a fixed FX regime.)

      - Jake

    5. Bertram "A chopped off head of the Cyprus chicken would restore trust in the eurozone order and help to enforce discipline"

      I see it as the exact opposite. A lack of trust in the eurozone due to the ham handed enforcing of discipline

    6. That's because you're parsing the newspeak wrong. "Restore trust" means "reassure Bild Zeitung's readers," "the Eurozone order" means "German hegemony," and "discipline" means "Germany's dead-end economic policies."

      - Jake

    7. Just some questions:
      - If the trust in the Euro that so much devastated, why did the british pound (and other currencies) devaluate against the Euro over the last years? I don't get the logic.
      - To avoid bank run, capital control are a usual possibility. Why it should be awful to do in Cypria what they did in Iceland? Of course, in normal times capital controls are a no-go. But cyprus is not at all in normal times but was very close to the Iceland-situation, on the intensive care unit due to its broken banks. So is it it fair or at least intelligent to expect normal situations behaviour?

      Roger, without account

    8. The GB£ likely depreciated against the €-Mark because British economic policy is even dumber and more austeritarian than German economic policy, difficult as that may be to believe.

      But caveat lector here: Usually you need way longer than 1 year time scales to see any effect of fundamentals in the currency markets - on a one-year time scale, the exchange rate is basically a martingale, and on a quarterly or shorter scale it's driven almost entirely by hot money chasing interest rate differentials.

      Capital controls are different in Cyprus than in Iceland, because Cyprus cannot print its own currency for its own local needs (well, it could print greenbacks and dare the ECBuBa to do anything about it). This inability means that Cyprus is dependent on having enough currency on hand to maintain the purely internal cash flows that keep a modern economy operating. Which means that it cannot simply put up a barrier against cross-border money flows and be done with it, the way Iceland could.

      - Jake

    9. Thanks, Jake, expecially for the second point.
      Sounds logic for me.
      If no foreigner wants Iceland money and cant use it abroad, there is no risk for money drainage. That's a huge difference to cyprus.

      It needed time for me but I start thinking too, that the Euro is contraproductive toward the ideal of european unity. So it will be interesting how it couldt get dissolved carefully.

      Roger again :--)

  3. Cyprus' central bank cannot offer euros (unsecured loans) but the Cyprus government can issue 'greenback' euros (demand notes) and dare the ECB to do anything about it!

    It would be funny w/ Draghi accusing the Cypriots of cheating/counterfeiting! Pot, meet kettle!

    The problems are with transmission mechanisms -- distressed banks -- but the Cypriots would at least have funds with which to conduct business ... and retire some of their maturing obligations. The banks themselves cannot complain as they are in no condition to do so.

    What is needed is a government with spine ... something so far not in evidence in this modern, post-petroleum world.

    Who knows how all this is going to turn out. The rest of the world is going to start leaning on the EU establishment if they haven't started already. The entire euro edifice is on the knife edge. China and Japan hold trillions of euro-denominated securities. A break and there is nowhere to go with these issues.

    1. "Greenbacks" are indeed a possibility - probably in the form of the Cyprus pound, which they can already print. Run it in parallel with the Cyprus Euro with enforced parity. I like it.

  4. The Cyprus Euro will still be worth exactly the same as a German or Dutch Euro. If I had a handful of Cyprus Euros and walked into a German shop in a months time then that Euro would have the same value as any other Euro. The difference is the purchasing power of that Euro. A Euro in Cyprus has
    always bought than a Euro in Germany. That doesn't mean it is worth less in Cyprus and capital controls won't change the value of a Euro. What it will change is that Cyprus will no longer be able to import goods as it can't pay for them. It will become a mini economy within Europe but unable to trade with Europe. The Euros in Cyprus will just move around the country rather than Euros coming and going. Other currencies (sterling especially) won't matter as it will be harder getting sterling into Cyprus as it would to get Euros.
    Bartering your skills or trade will be the new currency.

    1. I beg leave to differ about sterling. Capital controls apply to Euros. There are currently, as far as I am aware, no controls on the movement of other currencies. That is not to say that controls might not be imposed on other currencies at some point, as I discussed in the post.

      In the end it is the purchasing power of the currency that matters, not the value that authorities say it has. And a ring-fenced, isolated Cyprus Euro - which is what capital controls would create - would have a different purchasing power from any other Euro. Capital controls are, after all, one of the ways of manipulating the exchange value of a currency.

    2. Yes but only local purchasing power and fundamentally that is really what any currency is worth. A dollar in a fancy New York bar buys less than a dollar in a small town bar. What will create a problem is not the imposition of capital controls but the lifting of them. Cyprus will survive capital controls but when they are lifted it will be like rejoining the Euro but at a hugely inflated defacto exchange rate and they may well not survive that. The deal that has just been made in Brussels merely postpones the collapse of Cyprus if capital controls are part of it.

    3. Yes, I think that was what I tried to say in the post when I suggested that dismantling capital controls would not be easy. You've put it better.

    4. Feels quite an honour to see you say that!

  5. Losses on small depositors was an idea strongly supported by the Cypriot government so that large depositors wont be disproportionately hurt).

    There is already a treaty provision for capital controls that can be found here:

    Furthermore, National central banks produce currency so what you mention is not right:

    1. Losses on small depositors was suggested by the ECB, proposed by the Cypriot government, agreed by the Troika then thrown out by the Cypriot parliament.

      The treaty does - reasonably - include provision for capital controls against third countries. But capital controls imposed by countries WITHIN the union undermines the entire principles of the union and destroys the integrity of the single currency.

      National CBs issue currency, but they don't actually print it. The printing is done by, er, various member states. In Cyprus's case the actual printing is done by print houses in Netherlands and France.

    2. "Losses on small depositors was suggested by the ECB"

      [citation needed]

      I'm genuinely curious where you got that from, as it contradicts some other reports.

    3. There are conflicting reports on the original negotiations. The most definitive account is in the Wall Street Journal, which is behind a paywall. The WSJ says the small depositor haircut was suggested by Asmussen of the ECB.

  6. Totally agree.

    I also think the Schwarzenegger solution of IOUs, which was itself a strategy used by local governments in Argentina is extremely likely to emerge.

    It's no surprise that we've observed more community schemes and time banks emerge in Spain and Greece. The scarcity of physical euros is debilitating for domestic economies.

    Indeed, I strongly believe a dual currency system would be fantastic for the southern economies: keep the euro for energy and food and use an internal currency for services. Greek to Greek, Cypriot to Cypriot commerce would increase dramatically.

    The government could start it off. Pay the police partly in IOUs and make the IOUs legal tender for certain transactions.

  7. Your story is based on the idea that they will actually enforce capital controls. It's not because they passed a catch all bill just in case in a hurry, that they have to enforce it. (A few days ago you were writing as if the <100K haircut was a done deal...)

    If they did, I'd tend to agree with your conclusions. But then so would the wonks at the ECB who are familiar with your arguments. The consequence is that they will probably provide enough liquidity for up to a 100% bank run for what is left of deposits after the deal. My bet is that there will be little or only short term effective controls, to clear up the practical mess of a week's bank closure.

    If there's a full run it may mean that Cypriots end up running their banking from overseas. That's OK. Wales seems to manage very well using mostly banks from other members of the pound zone. East Germany has very little indigenous banking/insurance industry and it works well too.

    You can even argue that for small members of currency unions it is actually judicious to shrink their local banks and to freeride on the banking system of their bigger brothers.

    As for exiting, it seems there's no situation where it would be beneficial. If you convert all existing deposits to Cypriot pounds, you suddenly have a monetary base which is totally out of whack with the real economy at anything close to parity so there's unlikely to be any escape from massive devaluation/inflation (most of the offshore-owned newly converted pounds will want to exit). If you truncate the deposits to resize the monetary base before conversion, well, your core problem is solved and there's no reason to go through the mess of switching currencies at short notice.

    1. You seem to be operating under the assumption that the ECBuBa is acting in something resembling good faith.

      All available evidence is that Germany has decided that Cyprus is to be made an example of, pour encourager les autres. And the ECBuBa, being run by insane ideologues, is perfectly fine with that.

      You also seem to be operating under the misconception that devaluation/inflation would be a *bad* thing. Forced conversion followed by devaluation and inflation - soft default - is the bar none least painful way to reduce an unsustainable private sector debt burden.

      (Oh, and the "monetary base" is irrelevant. Cash flows matter, money supply doesn't.)

      - Jake

    2. cig

      Of course I write as if it is a "done deal". The capital controls bill has been passed by the Cypriot parliament and some of these controls are already in place. However, as the point of writing this stuff is to attempt, in some small way, to influence policy by getting people to think about the effects of their decisions, if they choose NOT to implement full capital controls I shall be delighted.

      I did not suggest exiting. In fact I said that I didn't think it was a good idea at the moment. But I do think parallel currencies would be likely if capital controls were in place. the IMF is insisting that Laiki Bank's ELA assistance must be transferred to the Bank of Cyprus - in other words, that the Target2 balance must be settled - I would suggest that the IMF, at any rate, thinks exit is a distinct possibility.

      The infrastructure is not there for Cypriots to run their finances from elsewhere at the moment.

    3. I think you're at serious risk of being delighted then. It worked for the 100K thing. Soon the problem we'll have will be merely democratic accountability: that you make eurozone policy without being properly elected! :-)

      I would think that the core infrastructure you need to bank overseas is there, it just means Cypriots behaving (financially) like eurozone tourists. Local "banks" become effectively cash machine operators/cash deposit processors on behalf of overseas banks. The one thing that would be slow in that scenario is to have overseas or otherwise new institutions filling the void on the local loans market.

      Re Target2, I don't understand how transferring the ELA balance from one private sector bank to another changes the net balance with the ECB at all. Are you perhaps confusing the Bank of Cyprus, a notionally private sector bank, with the central bank of Cyprus?

    4. No. The ELA balance is being transferred to the Bank of Cyprus so that it can be included in the haircut on Bank of Cyprus depositors. In effect, BoC's debts are being inflated by E9.2bn then written off against its large deposits. That settles the Target2 balance without involving the central bank of Cyprus.

    5. BoC's assets are also presumably inflated with the 9.2B worth of matching ELA assets, which should be the best assets from Laiki. It would be odd to leave the best assets of Laiki in Bad-Laiki!

      The BoC large-depositor haircut is (I would guess) against BoC's own bad assets, not as part of their role as the contractor operating Good-Laiki. All of this would be clearer if Good-Laiki was a distinct institution, but one can see why a merger is operationally more convenient.

      In any case, for the Cypriot banking sector Target2 balance with the eurosystem to change, there must be a cash flow which this reshuffle (as such) does not involve regardless of where Laiki assets end up. Or maybe I've completely misunderstood what Target2 is.

    6. cig

      The assets backing the ELA liabilities are Greek and Cypriot government bonds, neither of which are worth anything like the amount they say they are - or anything like the value of the ELA. They are, to put it bluntly, junk. Consequently the ELA liabilities far exceed the value of the backing assets. The ELA liabilities are being loaded onto the Bank of Cyprus balance sheet and large deposits will be raided to cover the difference between the value of the collateral (not much) and the value of the ELA debt outstanding.

    7. Again, [citation needed] for the "ELA liabilities are Greek and Cypriot government bonds". From there:

      It seems Laiki has only about 3 billions worth of things that could be government bonds at most ("held to maturity financial assets", including some of the other non-loans small items wouldn't change the argument materially). Even then, we don't know if that is what was pledged for the ELA, and at what price (or do we?).

      Even if it is the case that the ELA assets are not a sufficient match for ELA balance, I'll expect them to put enough of the other best assets to match. It's a bit of guesswork, but why would they otherwise leave any assets in Bad Laiki?


  8. Ironically, capital controls are only effective if Cyprus is within the eurozone itself. If it reverts it is hard to see how the eurozone could effect any controls at all, even over the flow of euros! The EZ could limit cross-border flows to-and-from Cyprus only as far as it could limit flows between the EZ and other non-euro countries.

    Cyprus could still be a part of the European Union and revert, of course it would become like Hungary. Out of the frying pan into another IMF frying pan!

    It's just the silly, self-defeating EZ rules that get in the way of preventing this fiasco from mushrooming.

    Bernanke should step in w/ euros just to keep the interest rate and forex risk from getting out of hand. All that is needed is a measly E10 billion today. They'll need a trillion by the end of the month.

    (That's a wild guess don't hold me to it!)


  9. Unfortunately Cyprus has been run by a bunch of corrupt politicians who had no clue about finance and then tried to fool the ECB for about three years about the viability of their banking system and tax-haven. The FAZ reports that capital flows out of Cyprus despite a bank halt.

    How is it possible that cash is leaving the country even with a bank halt? It isn't, unless of course, the banks aren't really halted, and some outbound wire transfers, which are permitted, are more equal than other wire transfers which are stuck on the island. Of course, that would imply an "Europe Farm" type of arrangement, which in the bastion of fairness, equality and honesty which is Europe, would be absolutely impossible.

    On the other hand, if indeed the drain of the Cypriot banking system has continued despite all the enacted halts during the past week, then it's game over for Cyprus, which will soon have only the ECB to thank for providing liquidity, an arrangement that may not be the best long-term outcome for a nation whose economy has basically been gutted in the span of one week.

    It also means game over for the bailout as envisioned, as the EUR17 billion is history, and much more cash will have to be injected to cover for the stealth outflows.
    Quoted from ZH

    1. Right. So you don't think Cypriot banks' extensive holdings of Greek debt at the time of the PSI had anything to do with it. Or the failure of the ECB to accept losses on Greek securities pledged to it at the time of the PSI. Or the failure of the EU and the ECB to address the contagion to the Cypriot banking system from the Greek PSI. Cyprus lent heavily to Greece because of its historic and cultural ties. Its banks were torpedoed by the Greek crisis and have been slowly sinking ever since. The Troika have had literally years to deal with it and have done nothing. I'm not blind to the foolishness and corruption of Cypriot politicians, but really this crisis is very far from being entirely due to them. The Troika has made a complete pig's ear of it.

    2. Do you have a source for those rumors that's not FAZ, Bild or Pravda? Because those are, eh, not very reliable.

      - Jake

  10. The one thing we know about European institutions is they are very good at making things up to suit the circumstances. I don't think the legality of capital controls is much of an issue because the option always existed for emergencies. Moreover, the articles outlawing capital controls also applied to Iceland as an EEA member. As you say implementing capital controls is one thing, but lifting them will be fraught with danger. I think the European institutions have just decided Cyprus is too small to matter and drawing a line in the sand. They do not particularly care about crossing the Rubicon or breaching a principle against capital controls in a single currency area. This is the politics of prodding the bear to the east in the rather old Great Game variety of regional geopolitics. Cyprus is just the unfortunate pawn in the middle.

    It will be fascinating to see how things develop in the internal Cypriot economy. Money substitutes and even government scrip may become a reality. However, how cross border trade and financial flows are going to be handled looks like something they will make up as they go along.

  11. Great piece. You set a lot of the blame on the EU, and although I fully agree that they seem to have abandoned their fundamental oaths, as a resident in Cyprus I must admit we are solely responsible for allowing this mess to occur. Keep in mind it is openly stated that our president Anastassiades' brother is a notorious criminal, remanded in prison often, and our finance minister Sarris is allegedly wanted for inappropriate acts with a minor in an orgy in the Turkish North of the Island. When you put our fragile economy in the hands of such people, all surprise is eradicated from the fact that they near destroyed us by setting the moral hazard of even accepting to present the ridiculous depositor tax bill to parliament. Now, after reading the informative material you have set before us, it is clear there is no going back.

    You may find this insignificant or even unrelated but considering your strong stance and insight on the matter I would love your opinion on something I believe could have played a significant part in allowing Cyprus to regain growth, the legalization and regulation (with high taxation) of marijuana. Cypriot leaders preferred to rob their depositors, destroy their economy, ruin their reputation, and even turn to religion (by considering help from the biggest mafia on the island, the church), to solve a debt problem we could in the least partially overcome by adopting modern, logical laws to replace damaging, archaic ones.

    1. I don't personally have a problem with the legalisation of marijuana, and it may very well have helped Cyprus's economic position. But I'm not sure what the EU's laws are on this. The Netherlands used to have very liberal laws on marijuana, but I believe they have had to tighten up in response to EU pressure. I may be wrong - certainly not an expert on this.

    2. Thank you for your prompt reply, there are very limited official experts on the matter as education and information would only bring about further realization that we are spending billions worldwide, annually, on a war against a naturally occurring and renewable commodity that, back in the day at least, was presented as a threat to the competitiveness of other industries (paper, cotton, textile...) due to its 5000 industrial, and hundreds of medical uses. The Netherlands has lax soft drug policy but because they seem not to require the extra income they employ nothing to the extent that would be required to make an economic difference (in terms of proper regulation for revenue legalization, not decriminalization, is required). Washington State has recently made moves towards legalization including appointing a specialized team to hammer out the details, this will be unprecedented and I am excited to see the difference it will make to the state and the US as a whole. I am hoping I will get a big "I told you so!" out of it,(not to you, to our incompetent government).

  12. I came across you blog, when surfing the twitter on Cpyprus. Beautifully articuled and explained.

    Hope to read your blog more regularly.

    Best to you

  13. Reminds me of the recent story about the NY Cop who bought a barefoot homeless man a pair of good boots. The homeless man decided to “hide“ them, as he said, and preferred to walk on his bare feet.

    That's how I see the capital controls: preventing that the rescue money and the rest of the deposits is used for something other than paying the bills.

    Maybe that's not nice. Maybe everone should have the right to gamble with his live (or with the pension funds of the people).

    1. That's not my understanding of the reason for the capital controls. The reason is to prevent bank runs - which have been happening ever since the attempt last week to haircut small depositors. The flow has been stemmed for the moment by the bank holiday, temporary restrictions on electronic transfers and limits on ATM withdrals. Once banks reopen, though, there is a real risk of major outflows. The capital controls bill has been put in place as an emergency measure to prevent those outflows.

  14. Warren Mosler's proposal:

    "ECB guarantees deposits for .25% annual fee
    ECB takes over regulation, supervision, enforcement of banking regs etc.

    This becomes the model for regulating all EU banks

    I finally got a quick minute to add some color to the above proposals from earlier today.

    With about 70 billion in assets, the banking system has negative capital of about only 2 billion, or about 3% of assets. And that no doubt includes markdowns on EU member nation debt that ‘goes away’ with the ECB ‘doing what it takes’ to sustain solvency."

    More here:

  15. On the plus side (if there is one) this may be an opportunity for the two sides of the island to improve cooperation. I can see a trade of Euros and commodities crossing the border and entering/exiting via Turkey which is not subject to any controls. In fact I find it hard to see how capital controls of cash can actually work. Euro notes are not national in their design (coins are) so unless people are tracking the note number, there is no way of knowing the origins of a Euro from Cyprus spent in a shop elsewhere in EZ.

    On the minus side, having to hold everything in cash can only lead to an increase in crime, along with the inevitable crash in the economy. This doesn't sound good for tourism which will be the main economy at least until something else turns up.

    Of course these two are linked - it is an opportunity for gangsters from all sides to make a profit. The Mafia does not respect capital controls.

    Sad. What a mess.

    There will be blood on the hands of Cypriot banks, politicians, Greece and of course Germany which really has stood in the way for a long time.

    As JakeS said, it is really pour encourager les autres.

    Poor people.

    1. The leading letter in the note serial number is a country-of-issue identifier (see, e.g.: ).

      But nobody cares about the cash economy - the cash economy is a sideshow in Cyprus, not the main event. (Russia and Spain are a different stories, as is Greece becoming these days).

      I don't think this will lead to any rapprochement between the two halves of the island. Neither the Turkish nor the North Cypriot government is trusted/expected to negotiate in good faith when they have Cyprus over a barrel like this (whether this expectation is fair or not I can't say, but it's beside the point anyway - the expectation itself precludes such talks). It is more probable that assorted nationalist bigots will come out of the woodwork to capitalize on the chaos. That has, after all, been the experience in Hungary, Spain, the Baltics and Italy, to name but a few.

      - Jake

  16. Looking at the Central Bank of Cyprus statistics, it looks like almost a third of deposits in the country are in foreign currencies (mostly dollars). Does this mean a chunk of BoC's debt will be written off using dollars?

  17. With this deal, what's the possibility of bank runs on local banks in other small Eurozone members? Like Slovenia, for example. Would anyone keep more than 100000 Euros in any bank?

  18. Very helpful summary. Can I ask a question. Is the confiscation limited to individuals accounts or are corporate accounts included?

    1. Corporate accounts are included. There will be a big hit to Cypriot SMEs.

  19. Thanks Frances for a very good post, thoughtful and to the point.

    As you mention capital controls open a Pandor'a box. Once the Cypriot Euro is compromised by another currency in circulation (pounds, dollars dinars...) then we indeed have the problem of how to collect taxes to fund the bail out (or in depending on your orientation as debtor or depositor...) If a significant grey economy in cash (even multiple cashes) takes off then the Euro project become less a project and more of an "experiment."

    I note that Modern Monetary Theory posits that the money gains its legitimacy with the power to tax. If the power to tax is in Euros and the economy is in pounds then what happens? I can only think of Jesus flailing the money changers in the temple as a somewhat fit image.

  20. There are good capital controls, like limiting speculaton and movement of hot money and bad capital controls. Cyprus has been saddled with bad capital controls.

  21. Being a new blogger, I would like to tell you that you have given me much knowledge about it. Thanks for everything.

  22. Reminds me of the recent story about the NY Cop who bought a barefoot homeless man a pair of good boots. The homeless man decided to “hide“ them, as he said, and preferred to walk on his bare feet.

    That's how I see the capital controls: preventing that the rescue money and the rest of the deposits is used for something other than paying the bills.


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