Cyprus's Dangerous, Necessary Capital Controls

Picture not being able to cash a check, transfer money electronically or withdraw more than $385 a day from your bank. Or imagine being searched by airport gendarmes making sure you aren't taking more than $3,800 of your own money out of the country.

These are the indignities Cypriots must endure after the country's $13 billion bank rescue. For the first time in the history of the single currency, a euro country is imposing capital controls, even for transfers within the union. It's as if California barred residents from moving their savings to banks in Oregon.

The unfortunate rule of thumb on capital controls is that they are easy to impose, difficult to enforce and almost impossible to lift. Iceland, whose banks ran into similar trouble as Cyprus's, adopted emergency controls in 2008. Five years later, they're still in place.

At first, Cypriot officials pledged that the controls would last about a week, but quickly revised that to about a month. Hardly anyone believes even that timeframe. The minute Cyprus lifts its controls, money will fly to safer havens. Even insured deposits -- the ones that were protected by the European Union's bail-in, which required all other creditors to take losses -- will probably flee.

Cypriot Euros

In imposing capital controls, Cyprus has detached itself from Europe's monetary union. A euro deposited in a bank in Cyprus is no longer worth the same as one deposited in France or Germany. It can't be easily withdrawn, spent or converted, and is therefore a second-class euro. The consequences are going to be harsh, with some economists now warning of Greek-like shrinkage of Cyprus's gross domestic product. As long as capital controls are in force, no one is going to buy Cypriot government or corporate debt, or make direct investments in Cypriot businesses.

It's too late to suggest that Cyprus should have been more prudent. It isn't too late, though, to warn other countries away from the practices that caused this debacle. The biggest lesson is obvious, but worth stating clearly: Don't let your banks get too big to save.

Both Iceland and Cyprus buckled under the weight of an overblown banking sector. Iceland's was 10 times the size of its economy; Cyprus's was eight times, bloated by deposits that came mostly from wealthy Russians avoiding taxes. But Iceland, at least, had its own currency which, once devalued, helped soften the blow.

Another lesson: Beware hot money. Trillions of dollars circumnavigate the globe in search of yields that well- regulated, well-capitalized banks simply can't -- and shouldn't -- offer. Once hot money flows into a country's banking system, it must be invested to deliver the returns that attracted it in the first place.

Cypriot banks, flush with about $20 billion from Russians, put much of that money to work in Greek government bonds. When those bonds were written down because of the 2011 Greek debt restructuring, the three largest publicly traded Cypriot banks lost 6.5 billion euros, sealing their fate.

Luxembourg and Malta, two euro-area countries whose banking sectors dwarf their national economies, should take heed. Luxembourg's financial industry assets are 22 times the size of its annual output. Bank assets in Malta, which hopes to replace Cyprus as Europe's newest offshore money haven, are about eight times the size of its economy.

Resolution Powers

The euro area also needs authority to shut down banks -- a power similar to what the U.S. Federal Deposit Insurance Corp. possesses. The FDIC is adept at taking over troubled banks, shutting them down or merging them with healthy banks, and then reopening them so smoothly that retail depositors hardly even notice.

The EU's plans to create a banking union initially recognized the need for a single resolution authority, but governments now seem to be retreating from the idea, citing "bailout fatigue." If they want to avoid another Cyprus, they should think again.

The euro area shouldn't kid itself: Cyprus's capital controls, while necessary to prevent the island's banks from collapsing, are a break from the principle that a euro is a euro, no matter which of the 17 currency-union countries you live, work or travel in. If depositors in other countries start worrying that their money may one day be similarly trapped in their domestic banking systems, then the whole single-currency project will be in jeopardy.

Goay Joe Lie

Director of Joe Lie Beauty And Cosmetics