High & Low Finance: Cyprus Capital Controls Come Years After They Were Needed

The new controls are aimed at stopping that hot money from fleeing Cyprus too rapidly. They limit how much cash anyone can take out of the country. Electronic transfers are banned. So is check-cashing. The controls are supposed to be temporary. But they sure don’t look like one-week wonders. There are limits on how much cash can be sent abroad each quarter for a student’s overseas education. There are monthly limits on how much any Cypriot can run up in credit card charges abroad.

That something like this was necessary seems clear. That it will work is not.

During 2008 and 2009, as it became obvious that the Irish banking system was imploding, Cyprus became the new euro zone locale for hot money. Cypriot banks paid higher interest rates on euros and — by some accounts — were not too picky about the provenance of the money coming in.

In 2008, according to a study by the McKinsey Global Institute, $40.7 billion was funneled into Cyprus through loans and bank deposits. In the context of world capital flows, that was a blip. But it amounted to 161 percent of Cypriot gross domestic product that year.

During the Asian currency crisis of the late 1990s, the world learned just how vulnerable a country can be to hot money. If it seems nice on the way in, it can be very nasty on the way out. It is one thing for international capital flows to take the form of direct investment, in factories and companies, or even portfolio investment, through the purchase of corporate stocks and bonds. The nature of that investment does not involve a promise to repay it on demand. But loans and deposits can be demanded just when a country and its banking system can least afford to repay them.

During that crisis, Malaysia broke from the consensus that capital controls were always bad, that the free market knew best. It proved to be a wise decision, although it was endorsed at the time by few economists.

What is happening in Cyprus now bears more than a little similarity to what happened in Ireland earlier. The Irish also enjoyed capital inflows that were a multiple of G.D.P., and the country’s oversize banking system eventually collapsed. There the largest part of the problem was a housing bubble, brought on by lenient lending. When that bubble burst, foreigners wanted their money immediately, and Ireland decided to stand behind its banks, virtually bankrupting the country’s government.

Most of the capital that flowed into Ireland during the good times was not bank deposits. And Ireland had enough of a real economy — absent banking and real estate — that it has continued to attract some foreign direct investment every year since the collapse.

But it used to be said of Cyprus that it had only banks and beaches. It got little in the way of foreign direct investment during the good times. When money flowed in, it took the form of demand deposits that were supposed to be available at any minute.

Luckily for those who had put money into Irish banks, or bought senior bonds from those banks, the Irish banks failed early, before governments realized they could not afford to do bailouts. In Cyprus’s case, the European institutions that were making the decisions first came up with the idea of “taxing” all bank deposits, whether they were insured or not. Fortunately, the Cypriot Parliament balked at that, and the eventual plan makes more sense.

Shareholders and bondholders at the worst bank are wiped out. Deposits up to the 100,000-euro limit for insured deposits are protected, although the capital controls may mean it will be a while before depositors can get their hands on the money. Deposits over that limit in the most troubled bank could be wiped out. At best, those depositors are likely to wait years before they get back a small fraction of their money. The central bank estimates large depositors in the largest bank will do a little better, perhaps getting most of their money back. But such estimates could prove wildly optimistic if banks lose most of their deposits when, or if, capital controls come off.

Article source: http://www.nytimes.com/2013/03/29/business/cyprus-capital-controls-come-years-after-they-were-needed.html?partner=rss&emc=rss