Central bank board's ultimatum could lead to island becoming first to exit the eurozone

Cyprus scrambles as ECB readies ax

The Washington Post, AP

The eurozone, a centerpiece of Europe’s efforts to knit its far-flung nations into a coherent whole, edged toward rupture Thursday as the European Central Bank said it was ready to pull the plug on Cyprus.

The stark ultimatum came in a terse statement Thursday from the governing board of the ECB, which said that it would cut off the flow of euros to Cyprus’ struggling banks Monday unless the country’s leaders reach agreement with the International Monetary Fund and other eurozone nations on the terms of a $20.5 billion bailout to avert a financial disaster.

The Central Bank of Cyprus warned that one large lender, the Cyprus Popular Bank, commonly known as Laiki, would probably have to shut its doors Tuesday morning if nothing is done.

The deadline sent Cypriot leaders scrambling to come up with fixes, and by Thursday night they were discussing restructuring the nation’s worst-off bank and imposing capital controls that would sharply restrict depositors’ ability to withdraw money to prevent bank runs.

Because Cyprus is a small economy and its banks aren’t so wired into the international financial system, a failure isn’t likely to trigger the kinds of global problems feared if Greece or another eurozone nation were to leave the single currency union.

But Cyprus’ departure from the eurozone would still be a stunning blow to the crowning achievement of Europe’s post-World War II efforts to unify its warring nations. The euro was intended to be so ironclad that there are no procedures for countries to back out of the currency bloc. But leaders fear that if one country leaves, pressure could increase on others to follow suit, quickly destabilizing the entire project.

The IMF and other eurozone member countries have offered to lend Cyprus about $13 billion, but they expect the country to come up with $7.5 billion on its own through taxes, government spending cuts and other measures to help restart a banking system that is essentially broke. A plan to raise the money by taxing bank deposits — including tens of billions of dollars held by Russians and other foreign investors — collapsed this week in the Cypriot Parliament.

The prospect of an exit by Cyprus fueled an intense hunt for options — from a nationwide bank restructuring that would put the country’s largest banks out of business to more unusual proposals, such as mortgaging the property of the Orthodox Church, selling off natural gas rights or simply asking for donations.

Central Bank of Cyprus Gov. Panicos Demetriades called on lawmakers Thursday to vote immediately on a legal framework to rehabilitate the local banking sector.

The government will also create an Investment Solidarity Fund, which is intended to appeal to “the patriotism of Cypriots” and draw on contributions from ordinary citizens, businessmen and foreign investors.

Those details, however, were overshadowed by the larger issues of the ECB flexing its muscle over a nation’s leaders and of the possibility that the eurozone, after years of insisting otherwise, may finally have to admit that membership is not sacrosanct.

Central banks in the developed world have taken on outsize influence since the collapse of Lehman Brothers in 2008.

Throughout Europe’s 3-year-old sovereign debt crisis, the ECB has proved an aggressive arbiter in a currency union that remains a political work in progress. At key points, its willingness to venture into uncharted waters by buying government bonds or taking other extraordinary steps has give political leaders time and financial leeway to make tough economic choices, arguably keeping the eurozone intact.

But the central bank has also shown the limits of its patience, most notably when it undercut the government of Italy’s Silvio Berlusconi after the prime minister tried to back out of budget cuts that ECB members felt were important to the country’s financial rehabilitation.

Cyprus’ finances are in such disarray that its banks don’t qualify for the standard ECB loans that eurozone financial institutions depend on. The alternative, an ECB program called Emergency Liquidity Assistance, is reserved for lenders that have a cash-flow crisis but are fundamentally solvent.

The ECB has funneled billions of dollars into Cyprus under that program. But with no rescue plan in sight and a massive deposit run likely once the country’s banks reopen, the bank concluded that it must leave the tiny island to fend for itself.

After meeting in Frankfurt, the ECB board said it would consider lending more to Cyprus only “if an EU/IMF program is in place that would ensure the solvency of the concerned banks.”

Cyprus’ bank deposits are more than seven times the size of the local economy. The IMF, in particular, is pushing for a program that will not just keep the country afloat but will dramatically scale back the size of a financial system inflated with tens of billions of dollars from offshore investors.

European leaders Thursday were openly discussing the possibility of Cyprus leaving the 17-nation eurozone — an unprecedented step.

On a practical level, a new Cypriot currency would probably drop sharply in value relative to the euro, wiping out the purchasing power of Cypriots, whose banks would be obliged to do business in the new currency. Existing contracts would have to be repriced, touching off complicated rounds of litigation between Cypriot businesses and their international clients and customers.

There could be ramifications for the global economy if a pullout reignited broader concerns about the currency bloc. Ailing nations such as Greece that are struggling to remain in the eurozone’s good graces might see a template for the pros, cons and practicalities of quitting the currency union. And countries such as Poland that are considering whether to adopt the euro would see powerful evidence of the sweep and authority of the central bank they would be joining.