Capital controls will intensify the slump while severely damaging the credibility of the euro
The introduction of capital controls in Cyprus is a textbook example of shutting the stable door after the horse has bolted. Rich Russians and wealthy Cypriots knew the crisis was coming and have had the best part of a fortnight to spirit their money out of the country since it broke, even assuming they did not do so beforehand. The restrictions will intensify the slump Cyprus faces while not removing the risk of bank runs when branches finally open for businesson Thursday. What's more, the controls severely damage the credibility of the euro.
That's not to say the controls are unnecessary. Even with the severe restrictions announced in place, there is a possibility of bank runs. Without them, bank runs would be a certainty. Modern banking is essentially based on a sleight of hand under which banks have readily available funds that are only a fraction of their total deposits. If all the customers demand their money at once, as would be the case in Cyprus without controls, the banks go under.
The government in Nicosia insists capital controls will be removed within a week, but that looks as heroic an assumption as the idea that the economy will shrink by just 3.5% this year, the current EU forecast. Iceland introduced capital controls in 2008 and still has them in place. There will no doubt be pressure from Brussels on Cyprus to lift the controls as quickly as possible, but most analysts expect them to be in place for a minimum of six months.
As far as the real economy is concerned, Latvia – which had pegged its currency to the euro – suffered an 18% contraction of its economy following a banking collapse. And bank deposits were just 100% of GDP in Latvia; in Cyprus they were 800% of GDP before the crisis. To sum up, Cyprus is going to have a collapsing economy buttressed by capital controls, but unlike Iceland will not have the option of devaluation to make itself more competitive. Speculation that it will become the first country to leave the euro will not go away. Indeed, it will intensify the longer the capital controls are in place.
There are, of course, wider implications for Europe despite attempts over the last week to say that Cyprus is a special case. When the euro was created just over a decade ago it was supposed to embody certain principles. One of those principles was that a euro would be a euro anywhere inside the single currency zone. That has now been violated; a euro in Nicosia is not worth the same as a euro in Berlin.
A second trait of the single currency was that it was supposed to be a secure store of wealth. International investors would have confidence in it and it would rival the dollar as a global reserve currency. That idea has also taken a pasting as a result of the disastrous handling of Cyprus; the decision to make deposit holders pay a share of the bailout has been accompanied by a fall in the value of the euro against the dollar. That's hardly surprising; savings in US banks are perceived as rock solid whereas those in eurozone banks are not.
A third core belief was that the euro would lead to economic convergence, with the weaker and poorer countries raising their performance to the level of the rich nations at the monetary union's core. This has looked increasingly absurd against a backdrop of bailouts for Greece, Ireland and Portugal, and the chronic lack of competitiveness displayed by Italy, Spain and – more recently – France.
So Cyprus has put two myths to bed. One is the myth of convergence; the other is that the debt crisis is over. A new chapter has opened, that's all.
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