By the Blouin News Business staff

Cyprus breaks new ground with capital controls

by in Europe.

Cyprus bank ATM

Photo Credit: Getty Images/Milos Bicanski

Throwing up the ramparts of capital controls isn’t a new defense for troubled economies against devaluation of their currencies. What is unique is that Cyprus is attempting to do so for a currency that is not its own.

A euro that slips away off the island should be worth the same anywhere in the euro zone as one that stays. Yet there is already talk that a ‘Cyprus euro‘ may acquire a different value to every other euro, not what is supposed to happen to a single currency. Prices on the island are likely to be the adjustment mechanism.

What that means, whether Cyprus will be able to keep the word of its finance minister that its capital controls will last only a matter of weeks, is anyone’s guess. In the Asian and Latin American debt crises in the 1980s and 1990s, capital controls lasted from six months to two years. Iceland’s capital controls put in place when its banks collapsed in 2008 are still there.

Cyprus’s intent is to prevent a run on its banks when they reopen Thursday having been closed for two weeks, while the island’s bailout was so contentiously negotiated with international lenders. The controls it is introducing are severe and will apply to both payments and capital transfers for at least the first seven days, after which controls on payments would likely be reviewed.

Restricting Cyprus’s euros from being used to pay for goods and services elsewhere in the euro zone, even by credit or debit card, would be disruptive of Europe’s internal market. The E.U.’s treaty prohibits such restrictions for just that reason, although there is a public security loophole that Cyprus is able to wiggle through and so acquire the dubious distinction of becoming the first euro zone country to impose capital controls.

The E.U. doesn’t want them to last any longer than necessary. Michel Barnier, the E.U. commissioner responsible for the single market, has urged them to be lifted after a few days. The longer they are in place, the more likely it is that the resolution would be for the island to chalk up another first, leaving the euro.

Allowing payments would inevitably provide a backdoor for capital transfers, though a bit of judicious red tape could slow down the pace of the outflow. In the short term, however, the island has little choice; it is capital controls, however imperfect and with all the risks of the liquidity crunch Argentina experienced, or an untrammeled exodus of cash, taking what will be left of the local economy with it.