capital controls in Cyprus

Controls on capital flows from Cyprus were inevitable, because the eurozone does not have a genuine banking union. FT columnist Wolfgang Munchau explains that, if the eurozone had a full banking union, there would have been no risk of a bank run following the decision in Cyprus to bail in uninsured depositors, thus no need for capital controls.

The US shows how this works: if the Federal Deposit Insurance Corporation raids a bank in San Francisco, and bails in uninsured depositors, there is no bank run on neighbouring banks as California is not liable for the banking system. Instead the US has a federal resolution authority and deposit insurance system.

But as each eurozone country remains responsible for their banking systems, Cyprus had no choice but to impose capital controls after the bail-in. Despite official protestations, these controls will persist for a very long time. The authorities have in effect launched a new parallel currency convertible to the standard euro at an exchange rate of one to one, but only up to €5,000, the monthly transfer limit. It is not hard to imagine that exit from the eurozone would have been more traumatic to the population, but it would have brought the benefit of a devalued exchange rate [and] … a faster resumption of economic growth. ….

In an environment in which the creditor countries refuse a genuine banking union, the hurdle for an economic case in favour of leaving the eurozone is shockingly low. Of course, economics may not be the main criterion in a country’s decision. In the short term, politics may trump economics. But in the long run, you cannot operate a monetary union in the face of economic logic.

Wolfgang Munchau, “Economics will catch up with the euro“, Financial Times, 1 April 2013.

The greatest danger now is contagion – bank runs in other countries. Mr Munchau thinks that, if Cyprus becomes the precedent for handling bank failures, “it would be rational for every southern European to take their money out of the country and deposit it outside the eurozone.” Capital controls affect small and large deposits alike, so even the insured are not protected.

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