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Thursday, March 21, 2013

Why is the ECB threatening to pull the plug on Cyprus? And how would it work?

The ECB - which holds the key to Cyprus' future inside the euro by virtue of funding the country's banks - this morning issued a statement which essentially set Monday as the deadline for a Cypriot bailout deal. It said:
The Governing Council of the European Central Bank decided to maintain the current level of Emergency Liquidity Assistance (ELA) until Monday, 25 March 2013. Thereafter, Emergency Liquidity Assistance (ELA) could only be considered if an EU/IMF programme is in place that would ensure the solvency of the concerned banks.
Short but not sweet. It''s clear that Cypriot banks cannot survive without this liquidity. There either needs to be an EU/IMF bailout deal agreed by Monday or some deal with Russia to prop up Cypriot banks (although the political implications of this would be significant). Remember the four scenarios that we set out on Tuesday night following the No vote in the Cypriot parliament (which now many other analysts are echoing).

 In our flash analysis, we questioned whether the ECB might do this. We noted:
Would the ECB really pull the plug on liquidity to Cypriot banks?  
The key turning point here will be whether the ECB cuts off Cypriot banks...To pull the plug on ELA the ECB needs a 2/3 majority (15 out of 23 votes) at the ECB Governing Council. Although the Bundesbank and maybe the Dutch and Finnish central banks might vote to turn off the ELA a 2/3 majority is not certain. In fact since Mario Draghi took over the ECB it has not been particularly hawkish. Bloomberg reports that the ECB said after the vote: “The ECB reaffirms its commitment to provide liquidity as needed within the existing rules”. The crisis has shown so far that the rules of the ECB are incredibly malleable, so what exactly that statement means is unclear, but the vote could certainly go either way.
But why has the ECB taken such a tough line with Cyprus? Below we outline a few potential reasons behind its thinking (some of which were touched upon by @KarlWhelan on twitter yesterday):
  • ECB rules clearly state that ELA must be provided only to solvent but illiquid banks - without recapitalisation (under a bailout deal) Cypriot banks would certainly be insolvent.
  • Continuing to provide liquidity to Cypriot banks could also amount to a huge transfer of risk from depositors and investors to the ECB.
  • Even if a deal is reached there are likely to be huge deposit outflows particularly from foreign depositors (even more so if the banks open without a clear deal).
  • Cypriot bank ELA is currently around €9bn. Russian deposits total between €15bn and €20bn. If Russian depositors are hit hard, much of these deposits could be withdrawn.
  • At almost 30% of all deposits, this would bring the solvency of Cypriot banks into question. The ECB would have to extend ELA massively to keep banks afloat – possibly by another €10bn to €15bn.
  • This liquidity would therefore indirectly help fund outflows of deposits.
  • Even increasing the ELA would not be sufficient if this turns into a full deposit run. This means the banks could still collapse and Cyprus could leave the eurozone. In this scenario, the Cypriot Central bank would default on its Target 2 imbalance with the Eurosystem (currently €7.5bn but it could double if the outflows are significant) leaving the ECB with a loss.
  • Financially this loss would be bearable but it would hit ECB credibility hard and break the taboo of the ECB not suffering losses in the eurozone crisis, a No-No for Germany.
  • If the banks collapsed but Cyprus stayed within the eurozone, the eurozone would likely have to stump up further funds to keep the country afloat. 
  • Any losses from the ELA are the responsibility of the Cypriot Central Bank (and the Cypriot state which backs it), so they would not become a Eurosystem/ECB issue directly. That said, with Cyprus under a bailout programme the burden will likely fall on the eurozone since the Cypriot state would be unable to backstop the central bank alone.
So, extending the ELA without a clear deal could lead to a significant transfer of risk towards the ECB and questions over its credibility. This would be a particularly poisonous debate in Germany, something which neither the ECB nor the German government would want ahead of the German elections in September.

With this in mind, it is possible to see why the ECB has taken such a strict line here. That said, it certainly ramps up the pressure over the next few days.

Lastly, although the ECB is taking the decision based on technical considerations, it's clear the good folks in Frankfurt are now deeply embroiled in a highly political debate - precisely what the ECB wants to avoid at all costs.

11 comments:

Rollo said...

It is their membership of the eurozone which has destroyed Cyprus, and they must get out of it. Print their own money and do an Iceland. Then they can start to recover.
Why are BP and Shell and BG not taking an interest in the Cypriot oil fields? This is the way out.

Anonymous said...

The People of Island took a harder hit than 10% of their savings (they lost 50% in real Terms).

Rik said...

@Rollo
It is:
- their lack of proper riskmanagement with their banks;
- being completely unable as a country to regulate internationally operating banks; plus
- large deficit spending,
that brought Cyprus down.

Printing would not have saved them their banks have losses in Euro and would have had those if they still had the pound. The morons that run their banks have more Greek gov bonds than their whole capital.
About what we are seeing in particularly Spain at the moment as well. If the state goes, half the banks go as well, likely taking with them the other half and the chaos is complete.

Like Iceland a bunch of clowns that thought they were giant squids, while in reality they were mainly shrimps.

The ECB has to send a sign to the PIIGS that these have to move forward with structural reforms. The ECB bought time and again it was waisted. It is also making clear it is not EZ politicial elites garbage collector. If the EZ wants it to be that it should change the treaty (which of course will not happen). If their own government/people donot want to pay for it why should a CB backed basically by Northern European countries. The rest is there for the form.

christina speight said...

Thanks, Open Europe, for that exposition - very helpful;

Rollo is right up to examining how Cyprus got like this. If there is an illegal money-laundering operation there large sums would be held there temporarily. Being Mafia money though (drugs for the whole EU?) they will have considerable political influence and this woulkd account for the Cypriot state not weeding out the money-launderers because they were making too much money from it!

Then there';s Russian funds. How much of this is known to and approved by Russia? Some may be clandestine and therefore also dodgy.

Remember this bit of CYPRUS is essentially Greek (way back there was ENOSIS for Union with Greece. which our troops had to fight the associated terrorists). Greece itself got into trouble because its accounts were dodgy too. So if one is looking for causes these stones are where the bodies are buried. No wonder The Turks were not keen on being a minority in a corrupt Greek island and had a mini-war to divide the island.

Anonymous said...

The Cypriot Rubel?

Denis Cooper said...

The EU runs according to the principle enunciated by the Italian politician Giolitti:

"Per i nemici le leggi si applicano, per gli amici si interpretano."

“Laws are applied to enemies, but only interpreted as regards friends.”

So the reason the ECB has delivered this ultimatum is not that it must respect its rules, but because by threatening that it will apply its rules it hopes to terrify the Cypriots into surrender.

German politicians have a history of bullying smaller countries, delivering ultimatums for the signature of documents which amount to a submission to German power, and they have a history of inflicting reprisals on populations which don't fall into line with their demands.

Unfortunately British politicians also have a history, a history of standing by and allowing the German politicians to take control of smaller countries and enlisting their resources to support the German march to hegemony.

OK, so this time round there's no question of the Luftwaffe reducing Nicosia to rubble or the Wehrmacht occupying Cyprus, and the reprisals would not involve extermination of whole villages and mass deportations to camps, but it does seem that old habits die hard.

Ray said...

What frightens me is the speed with which Western [and other] countries are putting themselves in debt to the "Enemy". Who despite the dominance of the USA since WW2 are now sitting pretty. Crazy considering the EU is using the Socialist ideology both have eschewed.

Anonymous said...

Doesn't take you lot long to resort to casual racism does it???

Pawel Cichowski said...

The milk is spilled and now it must be cleaned. Damage is to Cyprus and to EU. Unfortunately EU has done to itself on their own wish. EU ECB lost credibility and their financial system has been undermined. If they can do this to CY , they can do this to other countries in EU also.

jon livesey said...

You ask why the EU is playing tough with Cyprus, and I think the answer is obvious.

Cyprus has a big finance sector on a small economy, and the finance sector has little value to the EU, since it's mostly foreign money - in other words, the liabilities owed to foreign holders cancel out the assets.

The only thing about Cyprus that has value to the EU is its real economy, which is tiny.

So the EU is unwilling to commit funds to rescue deposits that don't even belong to EU citizens.

Anonymous said...

Cyprus is making money exporting financial services to non EU countries.

Lagarde Schauble dissjebloem, have destroyed this business, because of their socialist ideology. No one should get wealthy...Best to have all countries dependent on handouts. Then socialism works best.