Cyprus bail-out: Q&A - capital controls



We examine what happens when countries impose capital controls, and why some analysts believe that Cyprus has already taken a step towards a euro exit by using them.

What happens when countries use capital controls?

Take Argentina in 2001. Although the country was not part of a monetary union like Greece, its fixed exchange rate meant an Argentine peso was worth one US dollar.

Mired in recession, the country’s borrowing costs quickly shot up, while the exchange rate meant exports became uncompetitive.

Although the IMF stepped in with a rescue plan, rumours quickly circulated that Argentina might not receive its November (Xetra: A0Z24E - news) loan tranche, and when the IMF also hinted that countries restructuring their debt would need to impose restrictions to put off capital flight - a bank run ensued.

Fears of capital controls became a self-fulfilling prophecy, and in December 2001, the Argentine government limited bank withdrawals to 250 pesos a week in order to stop the banking system from being bled dry. The move was known as el corralito, or little fence.

= Who loses out when bank runs lead to break-ups? =

In a word: savers. When Argentina’s new administration liberalised the exchange rate with pesofication, depositors saw the value of their savings drop by 75pc within 6 months.

A decade after the crisis, a deep distrust of the system remains. Bank safety deposit boxes in Argentina are still at near-full occupancy. Many have waiting lists.

Depositors in the past have also had assets seized. When the Austro-Hungarian monetary union fell after World War I, citizens converting more than 1,000 crowns into new currencies saw a fifth automatically converted into government bonds. This 'tax' enabled the government to fund itself cheaply.

= Are there any winners? =

Debtors. Large companies which had sent dollars abroad before the corralito in Argentina were able to repay their debts at a fraction of the cost.

Savvy investors also did well. Argentina’s banking system was on the brink of collapse at the end of 2001, yet the stock market in Buenos Aires rose dramatically. Argentine investors would buy shares in pesos, convert them into a different type of share called an American depositary receipt (ADR), then sell these shares in New York for dollars, thus dodging the capital controls.

One study estimated that these investors channelled out between $835m and $3.4bn in the first four months of 2002.

= Hold on, are capital controls even legal? =

It depends. Article 63 of Europe’s internal market rules states that “all restrictions on the movement of capital between Member States and between Member States and third countries shall be prohibited" unless there is an issue of “public security”.

Michel Barnier, the European Commissioner responsible for the 27-member European Union's single market, said on Monday that "any measures to restrict or limit freedom of movement may only be enacted exceptionally and temporarily […] that is what has been requested by the Cypriot authorities.

"This is a restriction on movement that may only last a few days," he said.

Others argue that capital controls are the first step towards a break-up because a euro would be worth more in one part of the monetary union than it is in another, therefore voiding the notion of a single currency.

Societe Generale (Paris: FR0000130809 - news) described the precedent of capital controls as “deeply troubling”, and said its use amounted to "a partial exit from the eurozone" by Cyprus.

"We find this development both stunning and deeply troubling. If this can happen in Cyprus with ease and so quickly, it can happen elsewhere too should a government not perform in line with euro area expectations," said analysts Ciaran O'Hagan and Vincent Chaigneau.

There have also been legal challenges. In 2002, hundreds of thousands of Argentine savers recovered their savings through the courts by arguing that the corralito was unconstitutional.

At one point in 2002, around $130m was being pulled out of the Argentine banking system every day because of legal rulings that came down on the side of depositors.

= How long could capital controls last? =

If you believe Mr Barnier, only a few days.

But as JP Morgan highlighted in a note on Monday, Iceland's unlimited guarantee on domestic deposits managed to stem deposit outflows in late-2008 because the government guaranteed deposits in its own currency, and foreign exchange controls prevented money moving abroad.

"On the other hand, Cyprus is slated to impose losses on deposits based in Cyprus, but not in Cypriot banks' branches abroad, in essence reflecting the fact that its deposit haircut is set to be implemented as a domestic wealth tax," said Nikolaos Panigirtzoglou.

"The IMF forecasts the Iceland's capital controls will not be removed until 2015, suggesting that any Cypriot capital controls could turn out to be quite extended."

= So, do capital controls always lead to break-ups? =

No, but it's one of the first steps. One of the fastest break-ups happened between the Czech Republic and Slovakia in 1993. The divorce took just five months from the announcement, but things didn’t start well. The two countries said they would separate politically, but continue to use the same currency for a minimum of six months. This only served to hasten the flow of money from the Slovak side of the border to the Czech side, and the capital flight became so extreme that they had to seal the border.

Three weeks later, a decision was made to split the currency in two. The separation date was announced on February 2, and the new currencies were introduced by August.

"We learned that postponing solving the problem is most dangerous," a spokesman for Czech PM Vaclav Klaus, told an American newspaper at the time.

Hmm. Sound familiar?

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