Cyprus Shows Trust in ECB is Misplaced
March 26, 2013 3 Comments
Ever since European Central Bank President Mario Draghi said last July that the bank will do whatever it takes to preserve the euro, complacency has pervaded Europe’s single-currency area. Markets have weathered potential crises in Italy and Spain with surprising calm, secure in the knowledge that the ECB will save the day if needed.
This was always a false assumption, as events in Cyprus have made clear. There are significant limitations to the support the ECB is willing or able to offer, even to such a tiny island economy whose needs are easily affordable.
The ECB relies on two primary mechanisms to help euro-area countries in crisis. The first, emergency liquidity assistance, allows a country’s banks to access cheap funding from their national central bank, even when all they have left is low- quality collateral that doesn’t meet the criteria for the ECB’s standard liquidity operations. This emergency facility has helped a number of countries make it through liquidity squeezes over the past few years, keeping banks in Belgium, Greece and Ireland on life support since the beginning of the crisis in 2008.
The ECB has kept Cypriot banks alive in this way, too, providing about 9 billion euros ($11.6 billion) of financing to date. The ECB threatened to cut Cyprus off, however, if a bailout deal wasn’t agreed on with the so-called troika of international creditors — the ECB, the IMF and the European Commission — by March 26.
In response to the ECB’s threat, the Cypriot parliament passed a bill on March 22, allowing for capital controls. Emergency ECB funding would have plugged the gap in bank balance sheets created by deposit flight. Without this funding, deposit flight would have to be stemmed by force of law to prevent the island’s banks and economy from imploding. This is a serious line for a euro-area country to cross: Capital controls are legal under extraordinary circumstances, but they go against the notion of freedom of goods, labor and capital that is the principle tenet of the European currency union.
To read the rest, please see the original piece on Bloomberg View.