It is not yet too late to drop the idea of capital controls in Cyprus

The Cypriot finance minister Michael Sarris yesterday announced that Cyprus would introduce capital controls (see an FT report here). He announced that measures would be “very differentiated” according to the situation of the bank and as loose as possible in order to allow for a restart of the economy. He acknowldeged that for some foreign and liquid banks with "transient" funds, "detailed and strict" capital controls would make little sense. The government also fears that a rigid regime of capital controls could further panic depositors. After 7 days, the measures would be re-evaluated.

We see these announcements with great concern as in our reading effectively they will amount to far reaching limitations on access to deposits, payment restrictions and cross-border capital controls, which risk sending a fatal signal to the markets that could very well trigger future bank runs elsewhere (see FT post here). These are our main concerns.

1) The measures seem to cover many banks if not all of them. In fact, even for foreign banks that are liquid, some forms of controls will be imposed. Effectively, the controls are thus not limited to just one bank, the Bank of Cyprus, where temporary restrictions would make sense in order to fully pull-through the deposit-equity transformation. Instead, the administration appears to go for a broader approach.

2) There is no reason to believe that after 7 days depositors would be less concerned and panic would abide. On the contrary, having been restricted for another seven days in performing transactions means that panic is likely to have increased. We therefore expect that the capital controls will be continued beyond the seven days and there will be a lasting protest against the measures and public anger, feeding the Cyprus crisis. (We also see no reason for the choice of seven days in the first place as pure technical reasons can hardly justify such a period.)

3) But if controls last long, they would cause more damage and will be challenged on legal grounds. The free movement of capital in the European Union is a fundamental principle codified in the Treaty on the Functioning of the European Union (TFEU); see Article 63(1). While the TFEU allows countries outside the euro area to “take the necessary protective measures” when a sudden balance of payments crisis occurs (Article 144(1)), euro-area countries do not have such a right. Artilce 65(1b) acknowledges the right of all EU Member States to “take measures which are justified on grounds of public policy or public security”, but on the one hand, it is not clear if the current Cypriot situation qualifies for such concerns. In addition, Article 65(3) states that such meaures “shall not constitute a means of arbitrary discrimination or a disguised restriction on the free movement of capital and payments as defined in Article 63.” Therefore, we conclude that there is no legal basis in the TFEU for introducing restrictions on capital and payment flows in euro area member states. If the restrictions will be challenged and the European Court of Justice will decide against the measures, a decision which will probably take some time, then the compensation of the unduly restricted depositors may constitute a huge burden and such a decision could evoke a new crisis.

4) A significant control effort is contemplated. Ultimately, we understand that this could result in many discretionary decisions on which payments will be allowed and which ones are not allowed. While a non-discriminatory approach may have been agreed with the Eurogroup, we see a significant risk of a misuse of the controls.

5) An administratively managed payment system is unlikely to provide the desired capital allocation. The very idea is, of course, to limit panic-driven deposit transfers but to allow for payments justified on economic transaction grounds. In practice, it is difficult to observe the motive for a payment. Therefore, the system will not deliver an appropriate payment flow.

Given the circumstances and the alternative options, such as an immediate exit from the euro with dramatic consequences, the final deal for Cyprus was rather sensible (see our post here). But an eventual introduction of lasting payment and capital controls would do a lot of harm and can destabilise the situation. Deposits are guaranteed up to €100,000 and depositors should be given full access to their savings. A massive bank run will likely take place in any case, but with the emergency liquidity assistance (ELA) of the ECB, the situation can be manageable. After the siutaion has stabilised, deposits also started to return to eg Greek banks and we expect the same for Cypriot banks. But if lasting payment and capital controls are introduced (except perhaps a 2-3 days control of the Bank of Cyprus for insured deposits, to allow for a proper merger with the “good” part of the failed Laiki Bank, and the freezing of uninsured deposits at the Bank of Cyprus till recapitalisation of the bank is completed), we see very little prospect for returning confidence in Cypriot banks.

The bail-in of uninsured depositors of the failed Laiki bank, and a partial deposit/equity swap of uninsured deposits of the Bank of Cyprus is unlikely to cause much harm elsewhere in Europe, because Cyprus is so special (see eg the same view from a key market thought-leader, Marco Annunziata, here). Also, bailing-in uninsured deposits in Denmark in 2011 did not case harm elsewhere (see our post on this here). But an eventual imposition of payments and capital controls in Cyprus would signal that a fundamental principle of monetary union can be discarded with the assistance of the Eurogroup and the ECB. That would set a really dangerous precedent. It is not yet too late to drop this idea.