Cyprus rejects deposit tax

I am going to keep this one short. Today Cyprus voted to reject the deposit tax with 36 MPs voting against and 19 abstaining. One MP was absent. No one voted for the deposit tax. And so this trial balloon of bailing in insured depositors has crashed and burned spectacularly. The question everyone is asking is “what now?” It’s not clear what the answer is.

At a minimum, we do know that Brussels has been adept at rejiggering these issues enough to force re-votes using threats or stoking fears. This worked with the Lisbon Treaty. This worked with the Greek bailout and it could be a strategy in Cyprus as well. Let’s see what German Chancellor Merkel and her allies have to say about the vote. It should be interesting.

In terms of the Cypriot economy, the most important elements are the bank holiday and market closure. Clearly, banks cannot open now as there would be a run. And the markets would also be buffeted by extremely volatile trading. So for now, Cyprus will have to remain in lock down. And that is going to take a psychological toll, not just on the Cypriots but also on everyone in the euro zone.

Closed Cypriot banks mean the potential for contagion. So re-scheduling a vote on an amended deal is going to be the best option here. If you take out the insured deposit grab and increase the Troika loans slightly, you might get the package down to 10-12% of uninsured deposits. Moreover, there are other proposals. Felix Salmon wrote one up that converts some deposits into long-term CDs. On the face of it that looks interesting. Another suggestion I have heard is that Cyprus could simply impose a retroactive tax on interest. That sounds less promising. However, it does get at the notion that the money can be got within Cyprus by other means, as long as the reasoning behind the tax is sound, especially if there is some form of non-monetary or delayed compensation.

Another set of problems to think about is the banks’ funding. They have been living off of the ELA program and ECB largesse. Will this continue or will the ECB use this as leverage to try to extract something? Would they be successful. The ELA is run locally by Cyprus’ central bank and the ECB would need a two-thirds majority of 15 voting members to cut the central bank off. The Germans and like-minded allies have ony seven votes at most.

Getting back to the importance of the banks’  being open as soon as possible, my question here goes to what happens when they do open. You are going to need capital controls, of course – something forbidden under EU guidelines. What kind of capital controls will they have and how will they justify those controls under existing EU law? The IMF has said it now supports capital controls. But this is something for countries like Iceland outside the EU where no law specifically prohibits it. Capital controls within the EU would be akin to controlling how and whether residents of North Carolina could transfer funds to New York. It’s an insane kind of measure within a currency area – and it tells you why the euro zone is in big trouble.