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Sunday, March 24, 2013

Cyprus crisis shows Europe cannot perpetually move in one direction only

In an op-ed yesterday's Times, Mats Persson argued that:
No matter how the nail-biting drama in Cyprus ends, the eurozone has never been this close to waving goodbye to a member. Yesterday afternoon the deputy leader of the ruling party claimed that his country was hours away from agreeing an emergency package of tax rises and spending cuts to secure the EU’s €10 billion rescue loan.

If no deal is struck by Monday, the European Central Bank, on whose cash Cypriot banks depend, will pull the plug. With a banking sector seven times the size of GDP, Cyprus would default and probably crash out of the euro. The big question is whether a country can exit the euro without taking all Europe down. In the case of Cyprus the answer is straightforward: it could leave without causing a crisis, but it wouldn’t be pretty.

For Cyprus it would be extremely messy. To avoid massive capital flight there would have to be strict controls on financial movements, with border guards ready to stop people taking cash out of the country. After that would come a decree establishing a new Cypriot currency and a series of defaults on foreign debt. This would probably all have to be done in a weekend to avoid panic and contagion. A new central bank in Nicosia would fire up the printing press, which could trigger inflation. Cyprus could limp on with the help of external cash, possibly from the EU and the IMF or Russia — but it would be painful.

 For the rest of Europe there is a fear that a Cypriot exit could bring down Greece, Portugal, Spain or Italy. There are three ways in which contagion can spread: direct losses for banks or governments elsewhere in the EU start a chain reaction; depositors in other countries panic and cause a bank run; or nervous international investors fearful of losing out to the “next Cyprus” push the cost of borrowing up for other indebted governments.

But this is unlikely. Cyprus accounts for only 0.2 per cent of eurozone GDP, and vulnerable countries have little exposure to its economy. Greece would take a hit, but is already ring-fenced via EU bailout funds. Depositors in other countries have so far been unfazed by Cyprus’s troubles and even markets have been relatively calm. This suggests that Cyprus is a special, and financially marginal, case. In addition, the ECB’s promise to “do what’s necessary” to save the wider eurozone will provide extra reassurance to markets.

Instead the risks of a Cyprus exit are mainly geopolitical. The fear is that Nicosia turns to Russia for aid in return for, say, a Russian naval base on the island. Given its location, this would be a strategic nightmare for Europe.

To avoid such a scenario, it would be vital for Cyprus to stay in the EU, even if it left the euro. While life outside the EU may sound appealing to many Brits, it is different for a small open economy such as Cyprus. To complicate matters, EU treaties currently provide only a way to leave the EU (Article 50 of the Lisbon treaty), not the eurozone.

However, the EU specialises in legal acrobatics and there are articles in EU treaties that can be used for all kinds of purposes. One such clause provides a general legal base to achieve the “objectives of the treaties”, which include protecting the EU itself. It will be wrapped in a cobweb of legal jargon, but will effectively come down to a political decision by EU leaders.

And this is where it gets interesting for Britain. A Cypriot euro exit would have wide political ramifications: one of the founding principles of the EU — “ever closer union” — would be history. A swift, “Band-Aid” solution would almost most certainly have to be followed by a reworking of the EU treaties to recognise that the direction of travel is no longer only towards greater integration. The EU will have become a two-way street in which powers can be passed back to member states and its laws and institutions will have to reflect that.

Even if Cyprus does not leave the euro — and a revised bailout deal remains the most likely outcome — this episode signals that Germany and the other northern European countries are no longer willing indefinitely to foot the bill alone. At the same time the eurozone continues to lack the tools to deal with an acute crisis. This makes change almost inevitable for the way the eurozone is governed. Some governments have already called for a formal mechanism to allow a country to exit the euro. Europe cannot, perpetually, move in only one direction. And, in one way or another, Cyprus may be about to prove that.


Rik said...

You miss a few important points:
1. Art 50 if I remember correctly gives the opportunity to start negotiations to leave the EU.
First of all this is not the EU (an issue you refer to). Second it is start and not directly unilaterally implement (starting with the CYP).
2. But most important if things were as you indicate Scotland and Catalunya could join from the start. Case is pretty similar.
Legally it looks clear: Cyprus has to leave the EU, possibly the neg term can be shortened. And would have to reapply.
3. Only way to do it different is via a political solution. Basically overriding the treaty. Which in itself is already doubtful (how about Ireland's referenda for instance).
But why would Spain agree when it opens the way for Catalunya (and a few others). Scotland/UK won't be that much of a problem.
4. However the UK might want something in return (maybe a few others like Sweden as well). Ireland possibly need a referendum. Etc.

Another issue ECB can now buy bonds under strict conditions (bail out agreement in place). Which is something completely different from saving countries in the situation you describe, without a bail out in place.
The ECB programm is brought under 'transmission problems', not countries losing access to the market (what it would be). Would be a clear violation of the no-bail out clause (much worse than the ones previously done). Basically giving up all pretence of acting legally.
Also with a German CCourt case stil coming up.
No certainty here, it might happen it might not.

Anyway the Cypriotic situation is probably worse than Greece's. At normal percentages approx 75% cuts no way via ELA banks can be financed.
While it will be only money out and nothing in. There is a potential huge financing problem. How will it be solved.
Longer term 3,4,5 year deleveraging. But capital controls for that period? Stretching collateral rules that much highly uncertain.
Exchange deposits in long term bonds (a PSI 2.0).

Plan is based upon 1% growth, which is not going to happen. So imho we will see pretty soon Cyprus 2.0. Both country and banks.

All under the assumption that now a 1.0 can be agreed upon (which is still a ?)

jon livesey said...

The only important issue is obvious. Germany was willing to go to the brink of a break-up over E7bn.

That kind of step-taking, unimaginable even a couple of years ago, shows how much has changed.

The exact pedantic detail of this and that treaty are, as you indicate, irrelevant.

Ray said...

What I find most annoying is the language being used to describe what is a very simple thing, THEFT. Whoever the depositors be they crooks, mafia or just rich people, you cannot make it seem less wrong by describing it as something it isn't, it isn't a "haircut" or a "tax" or a "levy" it's a confiscation, a removal by force against the will of the owner, in simpler language, a THEFT.
To talk about this having a direct effect on the PIIGs is an oversimplification, apart from Germany to some extent, it sends the message that money is not safe in ANY Eurozone bank, that it can be taken almost at will by Brussels unelected Maoist communist regime is not going to encourage investment. On the other hand the UK may benefit to be seen as safer.

christhai said...

What Germany and Holland in tandem with the EU have done is to put a big question mark, a permanent doubt, over the safety of ANY investors' funds in ANY Bank in the EU or any EU Bank outside the EU.

All this fuss to protect Merkel's election campaign.

The whole of the EU is moving back in time - to pre-1945

christina speight said...

The way they'll get round the treaty is via the obligatory "negotiations" that go with Article 20 , Those talks could end with an agreement for quitting combined with a rejoin mechanism to be operated simultaneously.

I don't have a particularly devious but even I could work that out!