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Cyprus crisis: EU risks the unthinkable if bailout ultimatum fails Cyprus crisis: EU risks the unthinkable if bailout ultimatum fails
(6 months later)
Deadlines have been set. Ultimatums have been delivered. The EU has given Cyprus until Monday to come up with €5.8bn to part fund its own bailout or have its financial lifeline cut off by the European Central Bank.Deadlines have been set. Ultimatums have been delivered. The EU has given Cyprus until Monday to come up with €5.8bn to part fund its own bailout or have its financial lifeline cut off by the European Central Bank.
Unthinkable less than a week ago, the possibility of the eurozone losing one of its 17 members is now being discussed. Reuters reported that a meeting of eurozone officials openly canvassed the need to impose capital controls to insulate the rest of the single-currency club in the event of Cyprus leaving.Unthinkable less than a week ago, the possibility of the eurozone losing one of its 17 members is now being discussed. Reuters reported that a meeting of eurozone officials openly canvassed the need to impose capital controls to insulate the rest of the single-currency club in the event of Cyprus leaving.
It was never envisaged that any country would ever leave the euro. There is therefore no template for an exit strategy that would prove painful for Cyprus and have potentially wide-ranging implications not just for the rest of Europe, but for the whole global economy.It was never envisaged that any country would ever leave the euro. There is therefore no template for an exit strategy that would prove painful for Cyprus and have potentially wide-ranging implications not just for the rest of Europe, but for the whole global economy.
The first stage of the process would involve the EU calling Cyprus's bluff. At the moment, Cypriot banks are being supported by the European Central Bank's Emergency Liquidity Assistance, which allows them to remain open for business. The moment the ECB pulls the plug, Cyprus's banks will go bust. They have a €17bn cash shortfall, no equity and could raise only perhaps €2bn from forcing bondholders to take a haircut. The banks would shut and deposits would be worthless.The first stage of the process would involve the EU calling Cyprus's bluff. At the moment, Cypriot banks are being supported by the European Central Bank's Emergency Liquidity Assistance, which allows them to remain open for business. The moment the ECB pulls the plug, Cyprus's banks will go bust. They have a €17bn cash shortfall, no equity and could raise only perhaps €2bn from forcing bondholders to take a haircut. The banks would shut and deposits would be worthless.
Stage two would involve the government in Nicosia re-introducing the Cypriot pound as legal tender. This would cause logistical difficulties, unless the government has stashed away piles of the old currency when it joined the euro five years ago. This seems unlikely, so the government would have to start printing new notes.Stage two would involve the government in Nicosia re-introducing the Cypriot pound as legal tender. This would cause logistical difficulties, unless the government has stashed away piles of the old currency when it joined the euro five years ago. This seems unlikely, so the government would have to start printing new notes.
This would take time to organise and in the meantime the government would have to use euro notes re-denominated as Cypriot pounds. One way of doing this would be to over-print the notes in a distinctive way, as happened in Germany during its currency crisis in the 1920s. Nick Parsons, head of strategy at National Australia Bank said the capital controls on withdrawals from cashpoints would make this process simpler, since there would be fewer euros in circulation when the crunch came.This would take time to organise and in the meantime the government would have to use euro notes re-denominated as Cypriot pounds. One way of doing this would be to over-print the notes in a distinctive way, as happened in Germany during its currency crisis in the 1920s. Nick Parsons, head of strategy at National Australia Bank said the capital controls on withdrawals from cashpoints would make this process simpler, since there would be fewer euros in circulation when the crunch came.
The government would then have to set an exchange rate for the Cypriot pound against the dollar and would probably set it at the level that existed before it entered the single currency. If the currency was allowed to float freely on the foreign exchanges, the pound would drop like a stone. If the authorities set a fixed exchange rate, the official value of the currency would bear not the slightest resemblance to its black market value. When Argentina abandoned its convertibility against the dollar in 2002, the peso depreciated by around 75% in the subsequent 15 months.The government would then have to set an exchange rate for the Cypriot pound against the dollar and would probably set it at the level that existed before it entered the single currency. If the currency was allowed to float freely on the foreign exchanges, the pound would drop like a stone. If the authorities set a fixed exchange rate, the official value of the currency would bear not the slightest resemblance to its black market value. When Argentina abandoned its convertibility against the dollar in 2002, the peso depreciated by around 75% in the subsequent 15 months.
A plunging currency would lead to dearer imports, rising inflation and sharp cuts in living standards. The government would impose strict capital controls to prevent money leaving the country. It would also try to ensure that all transactions in euros ceased. Unofficially, the euro – along with other hard currencies such as the dollar – would circulate on the black market.A plunging currency would lead to dearer imports, rising inflation and sharp cuts in living standards. The government would impose strict capital controls to prevent money leaving the country. It would also try to ensure that all transactions in euros ceased. Unofficially, the euro – along with other hard currencies such as the dollar – would circulate on the black market.
One additional problem would be whether contracts agreed in euros could be enforced. The concept of lex monetae means debts in euros would become debts in Cypriot pounds and settled at an exchange rate decided by the government in Nicosia.One additional problem would be whether contracts agreed in euros could be enforced. The concept of lex monetae means debts in euros would become debts in Cypriot pounds and settled at an exchange rate decided by the government in Nicosia.
So what are chances of this happening? Parsons says it is still unlikely but the risk is far greater than it was. He writes: "A few months ago I would have put the possibility of Cyprus leaving the euro at 1%. Today I would put it at about 30%."So what are chances of this happening? Parsons says it is still unlikely but the risk is far greater than it was. He writes: "A few months ago I would have put the possibility of Cyprus leaving the euro at 1%. Today I would put it at about 30%."
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