Some post-Cyprus thoughts from Citi’s Buiter et al… first on rolling capital controls and the chances of a new Cypriot pound being forced into existence (our emphasis):
The lack of internal convertibility of euro notes (through the limitations on cash withdrawals and on electronic payments) will, if they persist for more than a few weeks, likely lead to a search for alternative media of exchange for internal transactions. IOUs of large, respected enterprises could for example be countersigned and start to circulate more widely as media of exchange and means of payment. This was the case, for instance, during the 1970 bank strike in Ireland, uncleared cheques were made negotiable (like bills of exchange) and pubs and shops served as credit verifiers. These could later develop into more full-fledged parallel currencies, if internal euro liquidity in Cyprus remains very scarce.
If a parallel currency developed, the New Cypriot Pound (NCP), say, its impact on the speed and cost of the necessary downward adjustment of real wages and international competitiveness would depend on whether domestic wage and price setting would shift from using the euro as numéraire to using the NCP, and on whether, if the NCP were to become the new unit of account, contracting and invoicing currency for domestic transactions, these NCP money wages and prices would be sticky in nominal terms, rather than increasing in line with the increasing value of the euro in terms of NPCs.
The external inconvertibility of the onshore euro will likely lead to financial innovation even before the limited internal convertibility of deposits and onshore euros. Since a euro note within the jurisdiction of the Cypriot authorities is no longer freely convertible into a euro note outside their jurisdiction, the incentives for exchanging the one for the other at a non-unitary exchange rate (and with the Cypriot euro note at a discount) exist.18 The means are not hard to find. Cypriots planning a holiday abroad with friends abroad planning a holiday in Cyprus could make mutually advantageous and effectively untraceable currency swaps, possibly involving time delays. Companies with cross-border activities and other entities with legal personality can use a wide variety of stratagems to avoid and evade the administrative restrictions imposed on the free movement of capital, deposits, currency and credit across the Cypriot border. At a one-for-one exchange rate of ‘onshore’ euro currency, euro-denominated deposits and credit for their ‘offshore’ counterparts, there is almost certainly a massive excess supply of onshore euros and euro-denominated financial instruments.
The ad-hoc, pair-wise matching of buyers and sellers of onshore euros and eurodenominated instruments will, if the controls remain in place, rapidly evolve into a still informal and unofficial, but much more organised and efficient ‘curb market’, involving specialized market makers and intermediaries. The “black market” price of the onshore euro will be well below the official one-for-one exchange rate with the offshore euro. We think it will, if controls last more than a few weeks, become a useful indicator of the exchange rate of a new, distinct Cypriot currency that would emerge if Cyprus should exit the monetary union.
Should the capital controls, exchange controls, currency controls and deposit controls last, the gradual development of an alternative internal currency to cope with the scarcity of onshore currency and deposits, and the creation of a black market exchange rate between onshore and offshore euros could merge and produce a full-fledged parallel currency. These developments would be greatly accelerated if and when Cyprus moves towards euro area exit.
And on a related note:
In that important sense, Cyprus already is, de facto, not a part of the Eurozone at this moment. In another sense, Cyprus remains a de facto member of the Eurozone as long as the banks of Cyprus have access to Eurosystem funding, either through conventional repo operations with the Eurosystem available through the Central Bank of Cyprus but for the risk of the Eurosystem as a whole, or through the Emergency Liquidity Assistance (ELA) provided by the Central bank of Cyprus, subject to the approval of two thirds of the 23-member Governing Council of the ECB but supposedly for the risk of the Central Bank of Cyprus (and the Cypriot sovereign standing behind it) rather than for the risk of the Eurosystem as a whole.
Both sources of bank funding are subject to the creditworthiness of the borrowing banks and the quality of the collateral they can offer. For Cyprus, regular Eurosystem funding of most of its banks is a thing of the past because of the poor creditworthiness of the banks and the collateral they can offer. This will be restarted only once the ECB’s Governing Council is confident that both the banks and the collateral they offer are of minimal acceptable quality. The less exacting standards for eligible counterparties and collateral at the ELA will probably make it possible for the Cypriot banks to fund themselves through that mechanism. However, the ability of a two-thirds majority on the ECB’s Governing Council to stop ELA funding means that the continued membership of Cyprus in the Eurosystem is dependent on it maintaining the support of a blocking minority on the ECB’s Governing Council.Without the access of its banks to the balance sheet of the Eurosystem, either through the normal liquidity facilities or through the ELA, we believe Cyprus would have no choice but to exit from the Eurozone. Even though political pressures no doubt have been, continue to be and will be brought to bear on the Governing Council as regards Cypriot bank access to the facilities of the Eurosystem and the ELA, we find it extraordinary that so much political power rests with unelected technocrats. It is reminiscent of the Emminger letter episode, when in a secret document drawn up in 1978, the German Bundesbank President Otto Emminger was granted power by the German Chancellor Helmut Schmidt to ignore formal obligations to support weaker countries via (potentially open-ended) foreign exchange intervention during European currency turmoil.
We’ll put the full note in the usual place — it includes a summary of the whole mess, a discussion of the counterfactuals (depression and hyperinflation), whether Cyprus is in fact a template (yes and no — the liability structure of the Cypriot banks was extraordinary), the chances of future bailouts, the state of banking union including the single resolution restructuring and recapitalisation mechanism, the legality of capital controls (basically, yes as the Treaty is a trickster), the idea that a Cyprus euroexit is quite plausible and sundry other things.