Euro zone remains stuck in a horrific mess

Which Cypriot template will be adopted?

Wed, Mar 27, 2013, 06:00

The crisis in Cyprus may be a storm in an economic teacup. But it has important lessons for much larger vessels, including the euro zone as a whole. Some of those lessons are encouraging. But others are disturbing. The euro zone remains stuck in a horrific mess.

Last week, in a desperate attempt to preserve its offshore banking model, the Cypriot government decided to impose losses on deposits of less than €100,000, the ceiling for deposit insurance in the euro zone. Not surprisingly, this idea went down well neither in Cyprus, nor anywhere else within the euro zone.

The current plan is closer to what one would wish to see in an orderly bank resolution. Laiki Bank is to be split into good and bad banks. Deposits of less than €100,000 in the bank and assets worth €9 billion – the sum owed to the central bank as part of its liquidity support – will be transferred to Bank of Cyprus. The remainder will be wound down.

Those with claims to deposits in excess of €100,000 will obtain whatever the value of the bad bank’s assets turns out to be.

Accounts frozen
Meanwhile, savers at the Bank of Cyprus with deposits of more than €100,000 will have their accounts frozen and will suffer “haircuts” of still unknown size. That reduction in value is likely to be large: perhaps 40 per cent.

Finally, temporary exchange controls are to be imposed.

What is one to make of this? I suggest at least four lessons. First, the euro zone does indeed have the capacity to do the right thing in the end, though not before first exhausting all the alternatives.

In saying that this plan is the “right thing”, I do not mean that one could not imagine superior alternatives. But all such alternatives assume a degree of solidarity among member states and peoples that is for now (and the foreseeable future) absent.

Given unwillingness to make outright grants to Cyprus, the present plan is almost certainly the least bad one. It protects the small deposits and imposes a rational resolution process.

The International Monetary Fund will be happy. So will the redoubtable Jeroen Dijsselbloem, the Dutch finance minister and head of the euro group, who believes a tough approach to creditors is right for the euro zone.

Second, a euro is indeed not a euro everywhere. While a euro note is a euro note, nearly all euros are, in fact, the liabilities of banks.

The outcome in Cyprus underlines the fact that the value of a euro of bank liabilities depends on the solvency of the bank itself and the solvency of the government standing behind the bank.

If both bank and state are insolvent, lenders are likely not only to lose a big proportion of their money outright, but to find that the rest is frozen behind controls, introduced to prevent a collapse of a country’s banking system.

How long might such “temporary” controls last? The French say “ c’est le provisoire qui dure ” (it is the temporary that lasts).

Currency controls
This has tended to be true of exchange controls, as Iceland shows. Yet, as Guntram Wolff of Bruegel, a Brussels-based think tank, notes, a currency union with internal exchange controls is a contradiction in terms.

Only the willingness of the European Central Bank to finance Cypriot banks without limit could end these controls in the near future.

Will it be willing to act soon?

The third lesson from Cyprus is that the relationship between banks, sovereigns and the euro zone is more complicated than it once appeared.

One could conclude that the action over Cyprus tells us little about the monetary area. After all, the island is unique because of the size of its banking liabilities, the unpopularity of its banks’ creditors and the borderline insolvency of its state.

Or one could believe it is a template, but only for other countries with similarly weak states.

Or you could see it as a template for all euro zone states, except when there is a financial crisis of 2008 dimensions.

Finally, an observer could believe Cyprus is a template for all euro zone states in all circumstances.

Which of these readings is right? Nobody knows. But it is probably the first or the second.

A consensus on the principle that creditors, not taxpayers, should pay if a bank becomes insolvent does not yet exist across the euro zone.

Does anybody imagine the German government would not rescue Deutsche Bank if it were in trouble?

Of course it would.

More capital
The ideal conclusion from the Cypriot imbroglio would be that all euro zone banks should have more capital. Indeed, because of the limited fiscal capacity of member states of a currency union, their banks arguably need to be better capitalised than those elsewhere.

But the actual conclusion is likely to be different: the safest banks will be those in the fiscally strongest jurisdictions. The alternative to that outcome would be a true banking union. But that would require either fiscal union or willingness to apply the same tough resolution regime to all banks. Neither outcome is likely.

A final lesson of this crisis is that what I have called the “bad marriage” that binds the euro zone members together has become worse.

Cyprus is not significant for the euro zone as a whole; the borrowing costs for banks and states have changed little. But the crisis is another occasion for anger to bubble to the surface. Old fears that the euro would undermine European unity rather than strengthen it seem more plausible.

High price
The crisis has also demonstrated that, even when the price of staying inside the union seems high, as it has been for many Cypriots, debtors are willing to pay it. Divorce seems even more frightening, at least at the moment of the decision. This is also true for creditors.

They resent being abused for “bailing out” debtors. But they prefer doing so to leaving the union, for reasons both economic and political.

Thus the euro zone limps on through crisis after crisis. Can – or will – this continue indefinitely? I do not know.

I am close to certain that the strategy of competitive austerity cannot return the euro zone to economic health. It guarantees a feeble eurozone economy and debt, banking and joblessness crises in weaker economies for the indefinite future.

At the same time, the will to sustain the eurozone intact is formidable.

This then is a clash between an irresistible force and an immovable object.

The crisis in Cyprus is a small and, in some ways, unrepresentative episode in a long and painful story.

Its last chapter is not even close to being written.

– Copyright The Financial Times Limited 2013