Central banks in the developed world have taken on outsize influence since the collapse of Lehman Brothers in 2008. The U.S. Federal Reserve has made massive asset purchases and recently established a target unemployment rate, and the Bank of Japan has committed to engineering higher prices to “reflate” the country’s economy.
Throughout Europe’s three-year-old financial 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 — and arguably kept the currency zone intact.
But the ECB has also shown the limits of its patience, most notably when it undercut the government of Italy’s Silvio Berlusconi after the then-leader tried to back out of budget cuts that ECB members felt were important to the country’s financial rehabilitation.
Cyprus’s finances are in such disarray that its banks don’t qualify for the standard ECB loans that euro-zone financial institutions depend on. The alternative, an ECB program called Emergency Liquidity Assistance, is reserved for banks 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 ECB concluded that it must leave the tiny island to fend for itself.
After meeting in Frankfurt, the 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’s 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.
European leaders on Thursday were openly discussing the possibility of Cyprus leaving the 17-nation currency union, 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 money. 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 Europe. Nations such as Greece that are struggling to remain in the euro zone’s good graces might see a template for the pros, cons and practicalities of a euro-zone exit. Countries such as Poland that are considering whether to adopt the currency would see powerful evidence of the sweep and authority of the central bank they would be joining.
There are no formal procedures in the euro zone’s treaty for countries to leave or be pushed out of the bloc. But the withdrawal of ECB support would probably be the beginning of the end — leaving the country’s banks without the flow of money needed to operate, isolating them from the world financial system and perhaps leaving Cyprus little choice but to reestablish a national currency.