Running through unilateral Cyprus exit scenarios

It occurs to me that the sovereign debt levels in Cyprus are unsustainable. As I have said previously, I believe this will lead to a government bond default. And given that capital controls already exist, the move to eurozone exit is much easier.

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A recent analysis by Pawel Morski on the situation in Cyprus was good at getting at why the sovereign should default. He sees four shocks occurring simultaneously. First, there is the standard austerity pill which should contract the economy as it has elsewhere in the eurozone periphery. Second, there is the credit and bank deposit decline and concomitant bank asset fire sales that will result from deposit withdrawals and capital flight. Third, there is the bailout bill for the state, which will rise because of this capital flight, meaning that the restructuring has to be larger to take this into account. And then there is the deleveraging that will occur due to asset price declines that go hand in hand with austerity and shrinking credit. This scenario is probably as bad if not worse than it is in Greece.

I suspect, we will see a popular outcry against these circumstances, and in the face of capital controls, this makes a eurozone exit appealing. Having read today’s piece by Jeremy Warner at the Telegraph, I realized this was the case. Warner writes that “If capital controls are introduced in Cyprus, it is the end of the single currency in all but name“. He states further:

the perhaps more widely significant part of the proposal is the planned application of capital controls. This is of course entirely necessary to prevent a further run on the banks the moment they open their doors on Monday. Many Russian depositors are threatening to remove their spoils if they are subjected to any kind of a haircut. This would quickly render these organisations essentially insolvent regardless of the recapitalisations. Almost no amount of capital is sufficient for a bank which has lost the confidence of its depositors.
Yet the point is that if capital controls are introduced, it basically makes Cypriot euros into a national currency, rather than part of wider monetary union. The capital controls will severely limit your ability to get your euros out of Cyprus, rending them essentially worthless in the wider eurozone. It would be a bit like telling Scots they can’t spend their UK pounds in England.

Reading this it occurred to me that this could be advantageous rather than a dilemma. I bolded and underlined the key bit there. With capital controls, Cyprus has a de facto national currency already. That’s big. Now I have run through unilateral Italian and Greek eurozone exit scenarios. In the Italian case, it would be horrific for the eurozone, in the Greek case, less so. Clearly, the trauma for the eurozone would be even less were Cyprus to leave. However, as opposed to Greece and Italy, I believe Cyprus would have to leave the European Union altogether were it to leave the euro zone because it is a post-euro entrant into the euro zone. And all post euro entrants had to commit to joining the euro if they joined the EU. To me that means that if any of these countries try to escape the euro, they would have to leave the EU as well.

But, let’s think quickly about the exit scenario here.  I had already been thinking about this in the context of euro bank note serial numbers when the crisis began. Every euro banknote has a serial number that is preceded by a letter which corresponds to the country that printed the note. Cyprus could declare these notes and only these notes – the ones with the ‘G’ prefix – to be a national currency, exchangeable at par with other euro bank notes. Doing this would solve the problem of having to print banknotes and preparing government and corporate computer systems for the new currency. It means instant national currency, all because capital controls are already legally sanctioned by Cyprus and the EU.

So adding this in to the Greek exit scenario I outlined early last year gets you the following.

  • Plan. The Cypriot government can plan for a redenomination into Cypriot euros and then New Cypriot Pounds in secret.
  • Government debt. If the Cypriot government defaults and works out a restructuring before the exit, this is preferable. Then the debt would be down to manageable levels. So they should look to accelerate the restructuring so that they can implement the exit plan. Afterwards, the Cyrpiot government would have to begin issuing new debt only under Cypriot law to replace old bonds in English law in order to make sure they had as much sovereign debt in a currency they control if the redenomination occurs. If not, legally the old debt could be considered euros instead of the Cypriot national currency, which in the case of a redenomination and devaluation would be a problem.
  • Capital controls: ATM withdrawals would be very limited and all wire transfers out of the country would be subject to review. Money coming in would flow freely as before.
  • Law. “Euroization” would remain in place and the euro would continue as the currency of physical payment. However, euros with the ‘G’ prefix denoting Cypriot euros would become the national currency. All debt under Cypriot law would be redenominated into Cypriot euros.
  • Taxes. The government would announce that henceforth it will tax in Cypriot euros but accept either Cypriot euros or non-Cypriot euros for tax payment. All municipal governments could tax in New Cypriot euro or non-Cypriot euro as well. 
  • Banks. Like the Argentines before them, the Cypriot government would convert all euro bank accounts legally into Cypriot euros. The systems would process as if it were euros because of the fixed peg, but legally the money would be Cypriot euros. This would make the Cypriot economy “euroized” but make the banking system redenominated into Cypriot euros.
  • Retail. Retailers, all sellers of Cypriot goods, would then be forced to return to the double accounting treatment of pre-2008 whereby they denominate all transactions in both Pounds and Euros. Again, the paper money would be euros and each euro would initially be worth the same in Cypriot euros but the systems would also record 0.585274 per New Cypriot pound as well. The electronic money would legally be Cypriot euro.
  • Physical currency. New currency would be printed by the Central Bank of Cyprus to replace euros, but the Cypriots would continue to use the Cypriot and non-Cypriot euros interchangeably for as long as they could, just in case they could rejoin the euro zone.
  • Redenomination. If the Cypriots cannot re-attain entry into the euro, then New Cypriot Pounds, having been printed, would become the new national currency, pegged at 0.585274, exactly the same rate as the Cypriot Pound was fixed on 10 July 2007 and converted into euros on 01 January 2008. All debt under Cypriot law would be redenominated into Cypriot Pounds at the 0.585274 New Cypriot euro/Pound exchange rate peg. This would effectively bring us back to 31 December 2007 for Cyprus. The government would announce that henceforth it will tax exclusively in New Cypriot Pounds. All municipal governments would be required by law to tax in New Cypriot Pounds. 
  • Float. If forced into new Cypriot pounds, on day one after the Pound goes into effect, immediately after redominating, the Cypriot government would drop the 0.585274  exchange rate peg and float the new Cypriot Pound as a freely floating currency. From that day forward, foreign currency adjustments would need to be made between euro and New Cypriot Pounds.

This would be a fixed exchange rate regime which would clearly get you a black market in exchange rates in a hurry. So it would be imperative to make the switch over quick. If and when the devaluation occurred, the fact that Cyprus had not started printing a ‘real’ national currency would leave open the option of re-joining the euro at a new depreciated exchange rate level. Now, of course the Germans would apoplectic. The question is what could they do? The ECB’s threats via ELA would not be important, so the leverage would be minimal. I see this as a good contingency plan that Cyprus should consider as a nuclear option.

Legally sanctioned capital controls would make a euro zone exit easier to effect, but careful planning in secret would be necessary.

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