Draghi Wins Cyprus Chicken Game in Bailouts Test RunJeff Black
Mario Draghi’s brinkmanship has worked -- for now.
The European Central Bank’s ultimatum to Cyprus to commit to a 10 billion-euro ($12.9 billion) rescue showed Draghi playing a harder and more public game than in any bailout before. While that’s easy enough with a country like Cyprus, officials may shirk from such tactics with bigger nations, said economists from Citigroup Inc. to ABN Amro Bank NV.
“The ECB does want to lay down the law and pressure countries into doing what the international lenders expect of them,” said Nick Kounis, head of macro research at ABN Amro in Amsterdam. “That said, playing chicken with Cyprus is a lot easier than doing it with Spain or Italy.”
President Draghi drew a line in the sand for Cyprus by defining what it needed to do to keep its banks afloat and, effectively, stay in the euro. The choice of being just as tough or more flexible may present itself again if political instability in Italy or the struggle to curb deficits in Spain test the financial-market lull that has prevailed since last year.
The Cyprus episode reveals the extent of the Frankfurt-based ECB’s leverage in bailouts. As finance ministers haggle over adjustment plans and bank rescues, the ECB controls the so-called Emergency Liquidity Assistance that can keep financial systems afloat. Cyprus’s ELA lending stands at about 10 billion euros, equal to about 56 percent of annual output.
Liquidity assistance is formally the responsibility of national central banks and must be guaranteed by governments rather the 17 euro-area central banks. The ECB’s Governing Council can object if that lending becomes too large or appears to prop up banks with no hope of becoming liquid or staying solvent.
Yesterday, the ECB used that power to renew its life support for Cyprus after the country succumbed to creditors’ demands to shrink its banking system in exchange for aid. That followed a week of political brinkmanship between Nicosia on one side and euro policy makers on the other.
As German Chancellor Angela Merkel expressed her irritation with Cyprus, the ECB played its part by delivering Cyprus an ultimatum on March 21 that gave it four days to come up with a deal acceptable to the European Union and the International Monetary Fund. Otherwise the ECB would cut off funds to its banks.
“In the end, the ECB made it clear the capitulation had to be on the other side,” said Ken Wattret, chief European economist at BNP Paribas SA in London. “It certainly raised the stakes, but it also galvanized the politicians into action.”
What to the outside looked like the ECB hurrying up a necessary process actually represented European bullying of a small country, according to Christopher Pissarides, a Nobel laureate and head of Cyprus’s economic policy council.
“The behavior of the Eurogroup wasn’t one that would give you the impression, if not convince you, that here was a single unit of 17 partners trying to do the best for their continent and their currency,” he said in an interview with Bloomberg Television yesterday. “It was more like: here is a little guy who has misbehaved, and we’ll put him down.”
Throwing down ultimatums has proved to be an effective, if high-risk, strategy elsewhere in the euro crisis. On Oct. 31, 2011, then-Greek Prime Minister George Papandreou roiled the euro’s leaders by declaring he was planning to hold a referendum on the latest bailout package facing his nation.
Fearing weeks of turmoil, Merkel and then-French President Nicolas Sarkozy raised the stakes by saying that any plebiscite should be an in-out vote on Greece’s euro membership. Within three days, Papandreou had backed down.
The Cyprus approach isn’t likely to be replicated if a country like Spain, the fourth-largest euro economy, needs to tap a bailout and apply for use of the ECB’s Outright Monetary Transactions bond-buying program, said Juergen Michels, chief euro-area economist at Citigroup in London. Spanish Prime Minister Mariano Rajoy is struggling to curb a deficit worsened by the cost of servicing the nation’s swelling debt load.
“I’m not so sure the ECB would act in the same way as it did in Cyprus,” Michels said. “They have to make sure that the whole system works, so there’s always an element of doubt” that they’ll insist on the rules.
While Draghi and ECB officials like Joerg Asmussen, who took the lead in Cypriot negotiations, have consistently emphasized the “strict conditionality” of the as-yet-untested OMT program, the central bank will have to be more flexible if such a scenario arises, Michels said.
The ECB faces a similar quandary with the prospect of a populist or euro-skeptic leadership in Italy. Inconclusive elections on Feb. 25 prompted the biggest bond-market slide in 14 months and may result in former prime minister Silvio Berlusconi becoming the kingmaker of a new government.
An opponent of austerity, Berlusconi could calculate that the ECB wouldn’t be able to turn its back on a country as big as Italy. That could still pile pressure on the ECB to soften its conditions for bond-market aid to stop contagion spreading throughout the euro area, said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London.
“It has been politically useful for the ECB to be seen to have meant it when it threatened Cyprus,” Barwell said. “In game theory, only the credible threat counts. Without that, they’d have zero plausibility when it came to Spain or Italy.”