BofA: Here's What The ECB Would Have To Do If Cyprus Left The Euro

eurozone

Cypriots are not happy about the bank bailout deal being foisted upon them by their government and its EU counterparts.

The original deal included a controversial “tax” on deposits in Cypriot banks – meaning everyone with a bank account would have to hand a certain percentage of its savings over to the government in order to pay for the bailout.

The deal didn’t pass in the Cypriot parliament, and now the government is scrambling to come up with another plan to take back to the EU.

Amid all of the political chaos, chatter has resurfaced about the prospect of a country leaving the euro.

A survey this week shows why that could be something of a possibility (via Greek newspaper Kathimerini):

The survey by Prime Consulting found that 91 per cent of Cypriots backed their Parliament’s decision to reject the deposit tax.

The poll also found that 67.3 per cent of Cypriots favoured their country’s exit from the eurozone and a strengthening of relations with Russia.

Of course, euro area leaders should probably be thinking about what they can do to reduce the chances of this happening, as it sets a bad precedent.

What would happen if Cyprus did end up leaving the euro, though?

While it’s not their “base case,” BofA Merrill Lynch economists Laurence Boone and Ruben Segura-Cayuela examine the implications of such a scenario:

In this scenario, the possibility of a country exiting the euro area could revive contagion risks, only to be mitigated by much more forceful policy reactions. We could see such a scenario materialising if negotiations failed, leading to a default on private and then public debt in Cyprus. In that scenario, when banks reopened, deposit flights would likely lead to bank insolvency and the ECB would veto ELA. As a result, banks would likely default, and since the sovereign is not in a position to nationalize the banks and cover the deposit insurance, it would be likely to default as well. This would probably be followed by a strong policy response from the ECB. In that case, to contain a potential run on the peripheral banks, the ECB would likely have to use more of its unconventional tools: first, more LTRO, together with rate cuts and possibly further collateral loosening to cheapen the price of liquidity as much as possible; second, possibly bond buying if there were a sell-off of periphery bond countries.

To contain the run on sovereigns, the ECB would likely have to proceed with extensive bond buying. OMT is a tool designed for countries with temporary liquidity, which might not be perfectly suited for a rapid deterioration of several countries’ bond markets that would reflect contagion. Against that backdrop, the ECB could be forced to intervene directly, though we believe such purchases could not take place (for more than a couple of days and by a limited amount such as the SMP) without the implicit support of core countries. Given the contentious nature of sovereign bond purchases and fiscal transfers in the euro area, for markets to be fully convinced, in our view, the agreement by core countries would then have to be followed by a political process endorsing the debt mutualisation by the ECB together with a transfer of sovereignty at the euro level.

In short, it would probably be messy, and it would require a lot of compromise on the part of European officials who clearly aren’t willing to budge at the moment.

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