The ECB is playing a risky game over Cyprus ultimatum

Raoul Ruparel
THIS time next week, Cyprus could be on its way out of the Eurozone depending on the final position taken by the European Central Bank (ECB). Via its secretive €9bn (£7.6bn) Emergency Liquidity Assistance (ELA) programme, the ECB is the only thing preventing Cyprus’s banking sector – over seven times its GDP – from collapsing. But the ECB warned yesterday that, without an EU/IMF bailout in place by Monday, allowing Cyprus to recapitalise its banks, it will cut this emergency assistance off.

This decision could have huge political and economic ramifications. With no bailout in place, a bank run and subsequent collapse is likely. Without external assistance, Cyprus would be unable to bail out its banks or guarantee deposits in euros, meaning it would be forced to leave the Eurozone and print its own currency. This would likely lead to a damaging inflationary spiral and a collapse in GDP.

So why has the ECB taken such a tough and potentially risky line? There are a number of reasons. First, the ELA programme is already pushing the boundaries of legality. ECB rules clearly state that it can only be provided to solvent banks and, without a recapitalisation, Cypriot banks do not meet this criteria and would not in the near future.

The second reason could be that the ECB fears a significant transfer of risk from depositors and investors in banks to its own balance sheet. Consider the situation if it did not stop liquidity support. Once the banks open, there will likely be a swift outflow of deposits. This would be much worse without a deal, but is likely to happen to some extent anyway given the erosion of trust. With deposits leaving quickly, the banks would become ever more reliant on the ECB for liquidity support, and this would certainly increase the risk profile of its balance sheet.

It must also be remembered that Russians account for almost €20bn (30 per cent) of deposits in Cyprus. Russia has not taken kindly to the accusations of “illicit” investments in Cyprus and depositors are reportedly looking to withdraw money quickly when banks open. If the deposit outflow got to the stage where it reached more than €10bn, the banks could begin to look insolvent once again. As mentioned above, if the banks did collapse, it could drive Cyprus out of the euro. In this scenario, where the ECB had continued its support, its losses would be even higher than if Cyprus left now or if it left after it had cut off support.

The issue comes down to the ECB’s credibility, and extending the ELA without a bailout deal would undermine this. This would be a particularly toxic debate in Germany ahead of September’s federal elections. Germany already has significant anxiety about the ECB’s integrity, after the Bank’s president Mario Draghi put the option of “unlimited” bond buying, via the Outright Monetary Transaction programme, on the table.

Despite the technical details, it’s clear the good folks in Frankfurt are becoming ever more embroiled in a highly-political debate – exactly where they did not want to be. It also drives home the limits on ECB action at a time when it has become central to the stability of the euro.

Raoul Ruparel is head of economic research at Open Europe.