Cyprus's High-Stakes ECB Gamble

A Mediterranean Jonestown

By SIMON NIXON

The euro zone is used to brinkmanship. But since the Cypriot parliament refused to sanction a tax on bank deposits, a vital condition of its proposed €10 billion ($13 billion) bailout, the currency bloc is in uncharted territory.

What happens next depends on the response of the European Central Bank. The Cypriot parliament is gambling that the ECB is bluffing when it says it will withdraw Emergency Liquidity Assistance from the country's banks, thereby precipitating their likely financial collapse.

True, the ECB has blinked before. It had originally threatened to withdraw permission for the Central Bank of Cyprus to provide ELA on Jan. 21. But it backed down because it believed that there was the prospect of a bailout deal that would recapitalize the country's broken banking system once the presidential election was out of the way in February. At that point, it said it would review its decision after two months, a deadline that expires this Thursday.

During Friday's marathon negotiations over the current bailout proposal, ECB executive board member Jörg Asmussen made clear to President Nicos Anastasiades that failure to agree on a deal that weekend would make it impossible for the ECB to provide a further extension of ELA. After all, ECB rules don't allow national central banks to lend to insolvent banks.

But any actual decision to withdraw ELA is a matter for the ECB's Governing Council, and that needs two-thirds of the council's members to vote in favor.

The Cypriot parliament may be calculating that it can count on enough Governing Council members to block any move to withdraw ELA. After all, the ECB's rules say it can only withdraw a national central bank's right to provide ELA to protect the monetary integrity of the euro zone.

If Governing Council members wanted reasons not to withdraw ELA, they could always argue that a possible Cypriot euro exit would do more damage to euro-zone monetary integrity than keeping its banks alive. Besides, even if ELA eventually replaced the entire €70 billion of Cypriot deposits, it would make little difference to overall euro-zone money supply.

But this is complacent. Even if Cyprus is small, the ECB must consider the precedent it would create if it allowed the Central Bank of Cyprus to continue providing ELA in the absence of a deal.

The more likely outcome is that the liquidity provision continues beyond Thursday, dependent on two conditions: First, that it receives credible assurances that there is a realistic prospect of an alternative deal. Second, that the banks remain shut until that deal is concluded to minimize the low-level bank run that is already under way as Cypriots continue to empty automatic cash machines.

Whether Cyprus can meet these conditions is an open question. Any deal will require Cyprus to find €6 billion from its citizens to help pay for the bank recapitalizations. That must be done to keep the cost of the euro-zone bailout below €10 billion and the government's debt sustainable—an essential condition for International Monetary Fund involvement, which is, in turn, an essential condition for the German government and parliament to agree to a deal.

So the banks will have to stay shut and the Cypriot parliament keep voting until it comes up with the "right" answer or decides to quit the euro. Sound familiar?