The pros and cons of capital controls

The Greek government’s decision to hold a July 5 referendum on a proposal put forth by international creditors triggered an acceleration of deposit outflows, leading to a bank run over the weekend. The outflows, amounting to several hundred million euros, combined with the freeze of the emergency liquidity mechanism (ELA) by the ECB on Sunday, renders capital controls likely to protect the liquidity of the banking system. In this respect, the paradigm of Cyprus, without the bail-in, may be useful but the economic consequences will be unavoidable.

Prime Minister Alexis Tsipras called for the referendum because he obviously believes he is being asked by the international lenders to go too far in crossing the so-called leftist SYRIZA party’s red lines, that is, rolling back his electoral promises. In this referendum – assuming it is held on Sunday, as there have been claims that this will be impossible due to technical reasons – people will be called upon to state whether they reject the creditors’ proposal by voting disapprove/no or agree with the proposal by voting approve/yes.

Although the referendum is a democratic way for people to express their view on a subject, it is generally seen as a high-risk political strategy with serious economic and social consequences for the country at this point. Many analysts and others say the referendum has no practical use after the lenders withdrew their proposal. It would have made more sense, they argue, if the referendum had been held a few months earlier, possibly paving the way for a successful conclusion of the negotiations. This way it could have reduced uncertainty and helped the economy return to an upward path.

They also add that the timing of the referendum, just a few days before the expiration of the adjustment program and the deadline for a 1.6-billion-euro payment to the IMF, complicates things for two reasons. First, it increases the risk of a default on the IMF and the ECB freezing ELA loans at current levels. Second, it increases the likelihood of a haircut on collateral submitted to ELA.

Of course, ECB chief Mario Draghi has said that the European Central Bank will continue to authorize ELA funding as long as the Greek banks are solvent and have available, eligible collateral. But things could take a turn for the worse after June 30. This is because Greece may miss the payment to the IMF and be left without a program, calling into question the solvency of its banks. In addition, the apparent increase in the country risk could lead to a bigger haircut, meaning banks will have to provide more collateral for the same amount of ELA liquidity.

Undoubtedly, the ECB’s decision on Sunday to keep the limit on ELA unchanged put pressure on the Greek government to impose capital controls to protect the liquidity of the banking system. The limit stands reportedly at 89 billion euros, but the liquidity buffer should have been reduced, following the acceleration of deposit outflows over the weekend. In general, the liquidity buffer was kept around 3 billion euros but should be less than 2 billion and even 1.5 billion euros by now, according to some pundits.

If outflows continue on Monday, the liquidity of the banking system will be strained further, making the imposition of capital controls imperative. The latter are expected to be restricted to the banking sector to deal with a potential run on the banks. They could be comprised of daily and weekly limits on deposit withdrawals and cross-border transfers. If the outcome of the referendum next Sunday is in favor of the lenders’ proposal, these limits can be gradually raised and eventually be phased out. However, if the No vote prevails in the referendum, these limits could become more severe and ELA loans are expected to be frozen or even reduced.

It is reminded that in the case of Cyprus, capital controls consisted of a cash withdrawal limit of 9,000 euros per month and a limit of 2,000 euros in bank notes per journey. In addition, use of credit cards abroad was limited to 5,000 euros per person per month and the cashing of cheques was prohibited. Wire transfers of businesses exceeding 300,000 euros domestically and 20,000 euros cross-border required approval by the authorities. Companies could transfer up to 50,000 euros to another domestic bank and individuals could do the same for 3,000 euros. No new bank accounts were allowed and time term deposits were extended. Capital controls were preceded by a long bank holiday.

In any case, the likely imposition of capital controls will hurt the economy. This is more because the Greek economy is cash-based. In this regard, transactions between businesses and individuals should drop considerably, hurting consumption and investment spending as all try to hoard cash. Tourism should also feel the pain as bookings drop because of the negative advertisement and tourists’ fears of running out of cash. Imports and exports of goods will also suffer because of the limits in bank transfers and counterparties’ refusal to assume the Greek risk. The latter has already been happening. Some large companies may also have difficulties to service their foreign debt.

Analysts are saying the success of capital controls to protect the liquidity of the banking sector in Cyprus was due to the fact that they were part of a bigger plan supported by international bailout funds. This may not be the case in Greece if there is no new agreement with the lenders in place after June 30. Undoubtedly, capital controls is not good news for the economy. However, they may be inevitable for the protection of the banking sector.