Cyprus's four options to avoid banking collapse
THE only thing worse than Cyprus accepting the rotten bailout program that European policy makers agreed on late last week was Cyprus rejecting it. Yesterday, the parliament voted decisively against the terms of the bailout, with 36 members opposing it, the ruling party abstaining and not a single vote in favor.
Policy makers will have to come up with a new plan, and they had better hope the European Central Bank buys them enough time to do so before Cyprus's financial system melts down.
A bank holiday was declared at least until tomorrow to prevent panicked savers from withdrawing their deposits from banks when they learned over the weekend that a levy may be imposed on deposits as part of a bailout program.
If depositors were worried about losing their savings before, they should be even more worried now. Last week, the ECB threatened to cut off emergency liquidity assistance to Cyprus's two main banks in the absence of a bailout program. This would result in the immediate collapse of both banks, and they would default on their debt and most, if not all, of the 30 billion euros ($39 billion) in deposits they hold.
Faced with a bank run and the collapse of its largest financial institutions, Cyprus would only be able to rescue its banks and its economy by printing money and leaving the euro. Luckily, this needn't happen. A much more likely outcome is that the ECB will first impose capital controls. The euro area is founded on the principle of freedom of goods, labor and capital, but Article 65 of the Treaty on the Functioning of the European Union stipulates that capital controls are allowed when "justified on grounds of public policy or public security." We have already seen capital controls this week in Cyprus, with the bank holiday and transfers frozen. Once banks reopen -- scheduled for tomorrow but probably postponed until next week -- we can expect deposit flight from Cypriot banks. A bank run is no problem as long as the ECB continues to finance it by plugging the gap with continued emergency liquidity assistance. After parliament's rejection of the bailout deal, the ECB announced yesterday that it would offer Cyprus liquidity within "existing rules," a strong indication that it will back down from its earlier threat to take the punch bowl away and shut down emergency funding to banks.
Capital controls and the ECB's emergency financing can buy time for Cyprus, but the tiny island will still need at least 17 billion euros in bailout funding. So far, the 10 billion euros that the International Monetary Fund, the European Union and the ECB offered in the original deal are still on the table, but Cyprus needs to find an additional 7 billion euros. There are four potential sources.
The best option would be for the government to accept that wealthy Russian depositors have already been well and truly scared off from Cypriot banks, given developments over the past few days, and impose a big enough levy on uninsured deposits to avoid having to tax insured deposits. The government remains stubbornly protective of the country's status as a tax haven, so this option seems unlikely, though not impossible.