Analysis: ECB prepared to let Cyprus go, protect others

FRANKFURT Wed Mar 20, 2013 12:35pm EDT

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012. REUTERS/Alex Domanski

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012.

Credit: Reuters/Alex Domanski

FRANKFURT (Reuters) - The European Central Bank is prepared to cut off funding to Cyprus and let the Mediterranean island succumb to financial meltdown if it has to, confident it has unlimited firepower to protect the rest of the euro zone.

Cyprus propelled the 17-nation bloc into uncharted waters on Tuesday by rejecting a proposed levy on bank deposits as a condition of a 10 billion euro ($12.9 billion) EU bailout.

Without the aid, much of it to recapitalize Cypriot banks, the ECB says they will be insolvent, and it requires banks to be solvent for them to receive central bank support.

Denied these funds, Cyprus would be left staring into a financial abyss.

For the rest of the euro zone, the ECB has a suite of policy tools at its disposal to prevent contagion - with bond purchases and unlimited liquidity offers to the fore.

ECB chief Mario Draghi has his ability to create new policy tools constrained by resistance in Germany, where business newspaper Handelsblatt last week ran a front-page picture of him under the headline: "The poisoned gift: how ECB President Mario Draghi is saving the euro and ruining savers".

Bundesbank chief Jens Weidmann opposed Draghi's bond-buy plan - he sees it as simply financing governments - but he is open in principle to funding measures like the so-called LTRO the ECB used a year ago to funnel banks 1 trillion euros of cheap money.

Given that, the ECB probably has no need to dream up new crisis measures and before it even deploys its existing ones, it will try to work with governments to reassure bank depositors.

"The contagion risk is a run on banks in other countries," said Andrew Bosomworth, senior portfolio manager at Pimco, the world's largest bond fund.

"Verbal intervention from the ECB and governments can help, such as a commitment that guaranteed deposits are sacrosanct. Operationally, it also means keeping the ATMs full."

Draghi calmed markets last July by promising "within our mandate, the ECB is ready to do whatever it takes to preserve the euro". He backed up that vow by unveiling a plan to buy countries' bonds if they met certain conditions.

Now, a reassuring message to depositors needs to be supported with efforts to make sure the euro zone financial system is lubricated properly.

The ECB is already offering banks unlimited liquidity with loans up to 3 months, and reserves the option to provide them with more funding certainty over a longer horizon by laying on another 3-year funding operation, as it did a year ago.


In a statement issued late on Tuesday, the ECB underlined its position: "The ECB reaffirms its commitment to provide liquidity as needed within the existing rules."

Draghi has also deployed his lieutenants to reassure depositors, with ECB policymaker Joerg Asmussen saying no other euro zone country has a banking sector like Cyprus.

Deutsche Bank economist Gilles Moec said the ECB commitment to provide liquidity, combined with Asmussen stressing that Cyprus's banking sector is unique, showed it was ready to support healthy banks in the rest of the euro zone.

"The subtext is 'we reaffirm that we cannot fund a bank that is insolvent'. You can also read it as: 'as long as a bank is solvent, we will continue to provide liquidity'," Moec said.

So far, there have been no signs of bank customers getting worried elsewhere in the euro zone, part of a worst-case scenario that could also see a spike in government bond yields.

To guard against a bank run, euro zone national central banks must make sure bank notes are available to stock up cash machines - though the ECB and euro zone policymakers will be hoping Cyprus can still agree a rescue and no such scenario comes to pass.

For a spike in bond yields, the ECB could use its new bond-purchase plan - dubbed Outright Monetary Transactions (OMT) - to buy potentially unlimited amounts of a country's bonds and push down its borrowing costs.

The catch is that a country must first agree to an aid plan of reforms and austerity measures. The Cyprus case has highlighted just how difficult agreeing such a program can be.

"Even if the principle of OMT is still there and valid, all the drama about Cyprus may remind people that the bar to get OMT is actually higher than they probably think," said Moec.


By stressing that it stands ready to provide liquidity "within the existing rules", the ECB is standing firm.

The central bank is not ready to bend for Cyprus.

As its governing council gathered for a mid-month meeting on Wednesday, Asmussen pressed Cyprus to agree to an aid plan:

"We can provide emergency liquidity only to solvent banks and ... the solvency of Cypriot banks cannot be assumed if an aid program is not agreed on soon, which would allow for a quick recapitalization of the banking sector.

With Cyprus sovereign bonds ineligible for use as collateral for ECB refinancing operations due to their low credit ratings, the Cypriot central bank is providing banks with Emergency Liquidity Assistance (ELA).

These emergency loans are more easily available, but the ECB's Governing Council must approve provision of ELA. It reviews banks' eligibility every two weeks and needs a two thirds majority to stop these funds.

"If really need be, the euro zone would likely choose to let small Cyprus go and focus on containing the damage instead of softening the conditions to such an extent that much bigger countries than Cyprus could be encouraged to reject their own current bailout terms," said Berenberg Bank's Holger Schmieding.

(Writing by Paul Carrel, editing by Mike Peacock)

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Comments (5)
Willvp wrote:
There is only 1 problem:

Who in their right mind can still believe the ECB, especially in connection with DEPOSITS at banks.

Trust is gone, boys. More lies will not help.

Mar 20, 2013 12:56pm EDT  --  Report as abuse
n.stravelakis wrote:
Geopolitics are entering the current crisis resolution in the most absurd manner. The ECB issued a statement following the Cyprus parliament vote stating that liquidity will be provided “under the current terms”. Does this statement hold? If yes what is the purpose of these roumours? If not they should make this clear. Sorry but banking especially central banking is not children playground like Brussels and Frankfurt. I hope that both my country and Cyprus will shortly leave the Euro. Otherwise it is pain without gain.

Mar 20, 2013 5:31pm EDT  --  Report as abuse
TommyPaine wrote:
Apparently the author of this article is oblivious to the irony of the idea that ECB bond buying is going to “protect” other economies. The very premise of the OMT bond-buying program is that a country must formally apply for a bailout before its bonds are eligible for purchase. Thus anyone who holds the sovereign bonds of such country has to worry whether they will take a “haircut” in such a bailout. If such a haircut takes place, perhaps the economy may be protected, but – as bank depositors in Cyprus learned — investors will not be.

The lesson of Cyprus applies to the rest of the Eurozone’s troubled economies: investors must be prepared for Public Sector Involvement (PSI) to save those economies. If they refuse to go along (or if their governments refuse, on their behalf), they will find no ECB or Eurzone savior.

In retrospect we now see why Spain’s PM Rajoy has been wise to resist the calls for Spain to apply for a bailout. He has correctly gauged that any such bailout is going to be quite painful for Spain’s investors.

Mar 21, 2013 2:34am EDT  --  Report as abuse
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