By Frances Coppola
As we have explained before, controls on inflows limit inward investment, which can restrict the availability of financing for international business’ expansion; while controls on outflows can make it difficult for international businesses to pay suppliers and repatriate funds. Capital controls also restrict free movement of people, since people will not visit a country if they cannot bring with them the means to pay for accommodation, food and entertainment while they are there.
Thus, it is hard to see how capital controls could operate within a trade bloc whose founding principles enshrine the freedom of movement of goods, services, people and capital. Yet, since 2008, capital controls have been imposed by two members of the European Union. How does this work, and what are the implications for international trade with these countries?
The heart of the Treaty on the Functioning of the European Union (TFEU) includes “four freedoms”:
Article 63 of the TFEU prohibits restrictions on movement of capital and payments not only between EU member states, but between EU member states and third countries.2 In theory, therefore, EU members should be unable to use capital controls.
But Article 65 provides a caveat. It allows member states “to take measures which are justified on grounds of public policy or public security.” This clause has twice been used to justify imposing capital controls.3
In 2012, Greece restructured its sovereign debt, imposing losses on private sector bondholders. Among those bondholders were Cyprus’ oversized and undercapitalized banks, already weakened after the financial crisis of 2008. The Greek “Private Sector Involvement” (PSI), restructuring effectively rendered the two largest banks, the Popular Bank of Cyprus (“Laiki”) and the Bank of Cyprus, insolvent.4
In March 2013, in an all-night negotiation with the European Commission, European Central Bank (ECB) and the International Monetary Fund (IMF), the Cypriot government agreed to close down Laiki Bank and restructure the Bank of Cyprus. The deeply indebted Cypriot public sector was unable to bear the cost of the restructuring, so the government agreed to impose losses on bank depositors. The original proposal was for all depositors in the Bank of Cyprus to take a small loss, including those subject to the EU’s deposit guarantee scheme.5 But the Cypriot parliament refused to allow the deposit guarantee scheme to be compromised.6 A second version of the bank bailout plan therefore restricted losses to depositors which were not subject to the guarantee scheme – households with large deposits, businesses, and institutions such as universities.7 This meant much larger losses for those depositors: they eventually lost nearly half of their holdings.8
To prevent a run on Cypriot banks, the Cypriot authorities imposed capital controls before reopening banks after a week-long enforced “bank holiday.” The Eurogroup, representing the European Union, declared that these “administrative measures” were “appropriate in view of the present unique and exceptional situation of Cyprus' financial sector and to allow for a swift reopening of the banks.”9
This sparked a debate about the legality of capital controls.10 Additionally, as Cyprus is a member of the single currency, there was considerable concern about what capital controls would mean for the euro. Restricting movements of money within the single currency area can create implied exchange rate differences between euros from different countries.11
The effect on the Cypriot economy was devastating, as businesses whose money was seized to make good on bank losses went out of business, cross-border trade diminished and international investors fled.12 Cyprus experienced a deep recession and unemployment rose to 16.1 percent. Four years on, unemployment remains in double digits and the trade balance is deeply in the red.13
But the euro remained intact. Indeed, Cyprus’ capital controls may even have helped to protect it. Since euro area countries do not issue their own currencies, cross-border bank runs can result in a country literally running out of money. In Cyprus, capital controls prevented devastating capital flight and a crippling shortage of money, which could have forced a “disorderly exit” from the euro area. In its 2014 Article IV review of Cyprus’ economy, the IMF said although controls on outflows were hampering international trade, removing them was unwise while Cyprus’ banks remained fragile.14
The Cypriot authorities started to relax capital controls one year after their imposition, and removed them completely in April 2015.15
The possibility that Greece might need capital controls was widely discussed from the time of its first bailout, in 2010.16 But Greece managed to avoid capital controls – until the renewed crisis in 2015.
Like Cyprus, Greece is a member of the euro, and therefore cannot produce its own currency. In the first half of 2015, as bailout negotiations became more difficult, depositors started to move money out of Greek banks into safer homes such as German and Swiss banks, forcing Greek banks to ask the ECB to provide them with euros.17 For some months, the ECB accommodated their requests.
But in June 2015, negotiations failed and Greek Prime Minister Alexis Tsipras called a referendum on the conditions the EU wished to impose on Greece’s latest bailout. As deposit flight from Greek banks intensified due to the uncertainty created by the referendum, the ECB imposed a limit on the quantity of euros it would provide.18 Faced with the real possibility of Greek banks literally running out of euros, and unable to provide them with any money, the Greek government closed the banks and imposed capital controls that impacted international trade.19
Although capital controls were effective at slowing deposit flight,20 there were reports that Greek and international businesses were suffering: businesses could not pay suppliers and consumer spending slumped.21 Many businesses froze investment.22 But although capital controls still remain in place,23 data from the OECD shows little evidence that capital controls have been as bad as many expected. The country dropped briefly into recession but has since recovered;24 investment is gradually returning25; and unemployment is slowly falling.26
How much of Cyprus’ economic collapse was due to capital controls impeding international trade, and how much arose from the combination of a major bank bailout and an IMF program, remains unclear. But for Greece, there is little doubt. Although Greece’s strict capital controls have hampered international trade to some degree, capital controls were the “lesser of two evils.” Without them, Greece would have been forced into a disorderly exit from the euro, with devastating impact on international businesses and international trade. In a financial crisis, using capital controls within the single currency area, far from breaking the euro, may be necessary to preserve it.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Treaty of Rome (EEC),” European Commission; http://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=LEGISSUM:xy0023&from=EN
2. “Consolidated versions of the Treaty on European Union and the Treaty on the Functioning of the European Union,” European Commission; http://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:12016ME/TXT&from=EN
4. “Beware of German gifts near their elections: How Cyprus got here and why it is currently more out than in the Eurozone,” Alexander Apostolides, European University of Cyprus; http://www.sharingperspectivesfoundation.com/wp-content/uploads/Beware-of-German-gifts.pdf
5. “Sowing the wind,” Coppola Comment; http://www.coppolacomment.com/2013/03/sowing-wind.html
6. “Cypriot parliament rejects levy on bank deposits,” China Daily; http://www.chinadaily.com.cn/world/2013-03/20/content_16323827.htm
7. “Cyprus agrees €10bn bail-out deal with eurozone,” Telegraph; http://www.telegraph.co.uk/finance/financialcrisis/9951680/Cyprus-agrees-10bn-bail-out-deal-with-eurozone.html
8. “Bank of Cyprus deposit haircut is 47.5 percent, says central bank,” Reuters; http://www.ekathimerini.com/152610/article/ekathimerini/business/bank-of-cyprus-deposit-haircut-is-475-percent-says-central-bank
9. “Eurogroup Statement on Cyprus,” Eurogroup; http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/136487.pdf
10. “Legal debate over Cyprus capital controls,” Financial Times; https://www.ft.com/content/a723d6e4-955a-11e2-a151-00144feabdc0
11. “The broken Euro,” Coppola Comment; http://www.coppolacomment.com/2013/03/the-broken-euro.html
12. “As Cyprus recovers from banking crisis, deep scars remain,” NY Times; https://www.nytimes.com/2015/03/17/business/international/as-cyprus-recovers-from-banking-crisis-deep-scars-remain.html
13. “Cyprus: Solid growth accompanied by fiscal loosening ahead,” European Commission; https://ec.europa.eu/info/sites/info/files/ecfin_forecast_spring_110517_cy_en.pdf
14. “Cyprus : Staff Report for the 2014 Article IV Consultation, International Monetary Fund; https://www.imf.org/external/pubs/cat/longres.aspx?sk=42406.0
15. “Capital punishment,” The Economist; http://www.economist.com/blogs/freeexchange/2015/07/cyprus-and-capital-controls
16. “Effects of capital controls on Greece,” Financial Times; https://www.ft.com/content/48a216de-a42a-11e1-84b1-00144feabdc0
17. “Greek deposit flight forces banks to apply for emergency support,” Telegraph; http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/11350042/Greek-deposit-flight-forces-banks-to-apply-for-emergency-support.html
18. “ELA to Greek banks maintained at its current level,” European Central Bank; http://www.ecb.europa.eu/press/pr/date/2015/html/pr150628.en.html
19. “The Day The Euro Died,” Forbes; https://www.forbes.com/sites/francescoppola/2015/06/29/the-day-the-euro-died/2/%2326c0ed07a302
20. “Greek bank deposit flight slowed in July amid capital controls,” Reuters; http://in.reuters.com/article/eurozone-greece-deposits-idINA8N10L00L20150827
21. “Effect of Greece’s capital controls one year on,” Anadolu Agency; http://aa.com.tr/en/anadolu-post/effect-of-greeces-capital-controls-one-year-on/606613
22. “Capital controls still hurting the Greek economy,” ekathimerini.com; http://www.ekathimerini.com/214757/article/ekathimerini/business/capital-controls-still-hurting-the-greek-economy
23. “Capital controls to stay in effect until end of 2018 at least,” Greek Reporter; http://greece.greekreporter.com/2017/05/10/capital-controls-to-stay-in-effect-until-end-of-2018-at-least/
24. “Greece real GDP growth,” Organization for Economic Co-operation and Development; https://data.oecd.org/gdp/real-gdp-forecast.htm%23indicator-chart
25. “Greece investment (GFCF),” Organization for Economic Co-operation and Development; https://data.oecd.org/gdp/investment-gfcf.htm%23indicator-chart
26. “Unemployment statistics” (accessed May 2017), Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/Unemployment_statistics