One clear winner from Cyprus’s imposition of capital controls is the US dollar, which stands to benefit from public and private flows after another round of damage to the euro’s reserve currency status.
The euro fell to its lowest against the US dollar in four months on Wednesday, falling below $1.28 after Cyprus moved to limit the flow of money out of the country in the aftermath of a bank bailout which singed foreign bank lenders and depositors alike. The dollar was just below its 52 week high against a trade-weighted basket of currencies, indicating that its strength was broad-based.
Following a bailout package that includes a substantial hit to uninsured deposits, many of them Russian, Cyprus imposed a limit of 300 euros per day on account withdrawals and set a limit of 5000 euros per month on credit and debit cards used abroad.
This should surprise absolutely no-one. Whacking depositors was probably the right thing to do, but it is a policy with substantial costs, and not just to Cyprus.
The introduction of capital controls actually will mark the effective debut of a new currency, the “Cyprus euro.” As a euro held in Cyprus is no longer a unit of value with free movement, it will no longer be worth as much as a euro held in France or under a mattress in Moscow.
That in itself is a blow to the euro’s status as an international reserve currency which has already been damaged by the terms imposed on foreign depositors and the ongoing risks to the euro project itself.
Since its conception, one of the hopes for the euro was that it would develop into a reserve currency to rival the US dollar. Reserve currencies are those held in reserves by governments and institutions and they also tend to be used for pricing and exchange of commodities, as the dollar is for oil.
Reserve managers, and the private parties who follow in their footsteps, look for stable stores of value which are easily convertible in highly liquid markets. That is simply less true of the euro than a month ago, and will be still less true tomorrow when Cyprus banks reopen in what may prove to be a long era of capital controls.
Moody’s Investors Service estimates that Russian companies and individuals have, or had, at least $30 billion in Cyprus banks, while some $135 billion is estimated to have flown from Russia to the island between 2007 and 2011.
Many Russian companies priced goods and services in euros and transacted much of their business through Cyprus-based accounts. That phenomenon, of people using a currency when they don’t strictly have to, is what happens when a currency becomes a reserve currency. While the euro won’t stop being used internationally, far from it, there are now new risks and restrictions which will tend to retard its use.
In fact, we were already seeing this, according to the latest IMF data, based on the third quarter of 2012 which showed the euro’s share of global reserve holdings falling to 24.1 percent, down from 24.9 percent at the end of 2011. This move away from the euro was particularly marked among emerging market central banks, which cut their holdings on a valuation-based level to the lowest since late 2002, according to estimates from Nomura.
Given that Japan is about to embark on a still more radical round of easing to try and create inflation and stoke economic growth, the attractions of the US and the dollar are markedly stronger than they were six months or a year ago.
Of course, being a reserve currency is not all good. A weakening euro, whatever the reason, is precisely what the continent needs to help to ease the pain of trying to adjust the weaker economies without recourse to separate official exchange rates.
The flip side is that the larger you are as a reserve currency the cheaper it becomes to borrow, a cost that will make supporting current levels of debt in the euro zone marginally more difficult.
Add to this all the real risk that the “Cyprus euro” eventually is replaced by the Cyprus pound if the country leaves the currency union and we have yet another reason for reserve managers to shave their exposure.
That process won’t be quick. The euro’s share of reserves grew by about 50 percent in the decade to 2009, but with global currency reserves of more than $10 trillion, the dollar will get substantial help for a long time. [Reuters]