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Cyprus: You Take My Self Control!

The EU and the IMF have acknowledged that Cyprus should apply capital controls, temporarily violating one pillar of the four freedoms: liberty of goods, services, people and capital. There is an ongoing debate about whether or not it breaches Article 63(1) of the Treaty on the Functioning of the European Union. I focus on the economic impact of such a move.

There are several forms of capital controls: quantitative, administrative, taxes. Their purpose is often country-specific and linked to one or several of those issues: appreciation of the currency, hot money (alters the composition of capital flows), large inflows (reduce the size of capital flows), loss of monetary authority, and risk of sudden stops in foreign inflows. For that reason, there is no unified theoretical framework and huge heterogeneities in the conclusions of empirical studies.

Controls can focus on capital inflows (a method of hindering inflows of hot money in emerging countries) or outflows, short run or long-term flows, take the form of price-tax control or quantitative control.

The official/supranational view on capital control has changed over the last decade. Since the early 2000s, capital controls have sometimes been seen as economic policy "options": they may contribute to financial stability, but generally only when "any other policy choices have been exhausted" (NYSE:IMF).

Among other things, control of outflows was implemented in Iceland in 2008 to avoid a worsening of the already dire financial meltdown. Their implementation in Cyprus also reflects the exhaustion of other options.

There are numerous critiques of capital controls:

1. Longevity: exiting capital controls are usually much more complicated than expected. In Iceland they are still in place after 5 years, and they are looking to delay lifting them for 2-3 years, or when financial conditions are substantially improved, though the current law says they will be lifted in 2013;

2. Negative impact on investment: capital controls impede foreign direct investments and are an incentive for households to keep their wealth in liquid asset (ready to exit the day controls are lifted);

3. Interest rates are distorted by a risk premium which translates into an inefficient allocation of capital;

4. Another pillar of the four freedoms is at stake: the liberty of people's movement, as travel is restricted.

Cyprus shares several of Iceland's difficulties, including a huge amount of foreign depositors. In all cases, huge withdrawals by foreign investors would weaken an already broken banking system. But while the exit of foreign depositors threatened the exchange rate of the Krona, it could cause recession and deflation in Cyprus. Another difference with Iceland was that during the 2008 crisis, all Icelandic domestic deposits were guaranteed by the government, which helped to avoid a bank run.

There is a well know monetary identity, called Fisher's equation: MV=PY

Monetary base times velocity of money equals price level times GDP. If M falls as a result of capital outflow (assuming V will remain unchanged), the country is facing the double threat of deflation and recession as the exchange rate is fixed.

Following the IMF's advice, Iceland decided to avoid a disorderly collapse of the external value of its currency. In the case of Cyprus, the key is to avoid draining an already illiquid (and insolvent) banking system and to avoid a recession/deflation.

What could be done?

It has been said that some other options could have been implemented, such as a tax on capital outflows, but this measure remains a soft version of capital controls.

As the Troika expects a sharp reduction in the size of Cyprus' banking system, and as foreign deposits made up more than 15% of its liability, those deposits that will not be swapped into equity will have to eventually exit.

One solution would be to resort to the Exceptional Liquidity Assistance (NYSE:ELA): a large amount of the exit of foreign depositors from Irish banks between 2008 and 2011 was carried out by borrowing at the central bank. This would lead to a change of the liabilities of the banking system that the ECB (through TARGET2) may not be ready to accept.

What should be done?

To quote Schauble, deposit guarantees are "as good as a state solvency," so the crisis calls for a deeper banking union and in particular its third pillar: the insurance of deposit. If Cyprus' citizen never doubted the guarantee on their deposits, the risk of capital outflows would have been much more manageable.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.