Cyprus is on the verge of an unprecedented financial experiment:imposing controls on money transfers in an economy that doesn'thave its own currency.

Countries from Argentina to Iceland have used similar measuresin the past to defend against devaluation. Being part of the eurozone may make it harder for the Mediterranean island to enforcerestrictions, as any money that leaves the banking system can betaken out of Cyprus without losing value.

That also may make it more difficult to meet the goal setyesterday by Finance Minister Michael Sarris to lift any controlsin “a matter of weeks.” When economies in Asia and Latin Americatried to stem the outflow of money in the 1980s and 1990s, theyended up keeping the measures in effect for six months to twoyears. Iceland, another island nation with an outsize bankingsystem, still has capital controls five years after its bankscollapsed in 2008.

“Thanks to political mismanagement, we now have a first: capitalcontrols in the euro zone,” said Nicolas Veron, a senior fellow atBruegel in Brussels and a visiting fellow at the Peterson Institutefor International Economics in Washington. “How long is temporary?It could turn out like Iceland, extending to many years.”

Cyprus may announce what types of controls it plans to implementtoday, before its banks are scheduled to reopen tomorrow. Thecountry's leaders are seeking to prevent the flight of money fromthe island's lenders, which have been closed for almost two weeks.Russian holdings in Cypriot banks are estimated by Moody'sInvestors Service to be $31 billion, or about a quarter of totaldeposits.

Parliament last week gave wide-ranging powers to the centralbank governor, Panicos Demetriades, and Finance Minister Sarris,including the ability to limit daily withdrawals and force therenewal of time deposits upon maturity. The two officials also canrestrict the opening of new accounts, credit- or debit-card use,wire transfers among the branches of the same bank and non-cashtransactions.

“They're going to need some serious controls to make sure themoney doesn't leave the country,” said Nikolaos Panigirtzoglou, aLondon-based strategist at JPMorgan Chase & Co. “Otherwise, Ican't see how any of this money with a high propensity to leavewill stay voluntarily.”

ECB Financing

A rush of money out of Cyprus would shift more financingresponsibility to the European Central Bank, which provides about10 billion euros of emergency loans to the country's lenders. After30 billion euros, the ECB would have to lower its standards for thecollateral it demands from Cypriot banks, Panigirtzoglou said. Withdeposit flight and rising loan losses in Cyprus and Greece, the ECBcould lose money on the funds it lends.

The island's lenders have been closed since a plan by theEuropean Union to force losses on depositors in exchange for a 10billion-euro bailout touched off a political upheaval. Parliamentrejected the deal, which would have taxed all bank accounts,including those under the 100,000-euro deposit- insurance limit. Anew agreement shuts Cyprus Popular Bank Pcl, the nation'ssecond-largest lender. Uninsured depositors of that institution andthe Bank of Cyprus Plc, the biggest, will share losses, whileinsured deposits in all the banks are spared.

When Iceland imposed capital controls after a property bubbleburst and its banks collapsed, political leaders said they would betemporary, too.

Financial firms, with assets 11 times the national economy atthe peak, were too big to save. So Iceland let them fail, splittingthem into good and bad banks. Bondholders bore most of the losses.Iceland's krona dropped by more than half.

Restrictions on the movement of capital out of the country wereintended to stabilize the currency. They mostly related to theconversion of the krona to other currencies and targeted legacyforeign investments in the nation's securities.

Even with such a limited reach, the Icelandic capital controlshave had a negative impact on the economy, according to PallHardarson, president of Nasdaq OMX Group Inc.'s Iceland unit.They've discouraged outsiders from investing and made it harder forIcelandic companies to sell bonds overseas, he said. After doublingevery year for five years, foreign direct investment in the islandcollapsed in 2008 and has remained about 25 percent below thepre-crisis level.

“Ultimately we need to create confidence in the economy, andwith these controls it's hard to do so,” said Hardarson.“Officially they only apply to legacy investments, but neverthelessthey send a signal that things aren't the way they're supposed tobe.”

Two Euros

Krona-denominated bonds left from the boom era cannot beconverted to foreign currency when they mature. The proceeds needto be reinvested in krona assets. That has created twoforeign-exchange rates for the island's currency — an official onetraded domestically and one offshore.

The offshore krona trades lower than the official one because itreflects the difficulty exchanging them for dollars or euros,according to Hardarson. One euro was worth 159.54 kronur onofficial markets yesterday and 220 kronur offshore, according toKeldan.com, an Icelandic data provider.

The same is going to be true for the euro now that a membercountry is walled off from the rest, said Raoul Ruparel, chiefeconomist at Open Europe, a London-based research group.

“Now there are two euros, one in Cyprus, one elsewhere,” saidRuparel. “The whole point about a single currency is that money isfungible, it can cross borders without any restrictions. Thecapital controls in one member basically ends thatarrangement.”

To be effective, controls in Cyprus will have to be stricterthan those in Iceland, Ruparel said. Iceland's importers andexporters have been exempted from currency- conversion restrictionsas long as they can show the exchange is for trade purposes. If asimilar exemption were to be made in Cyprus, Russian companies onthe island could use the loophole to take their money out swiftly,Ruparel estimated.

Cyprus-based Russian companies, taking advantage of the island'slower tax rates, are the largest source of foreign directinvestment in Russia, according to central bank data.

Most efforts to restrict capital flows out of a banking systemor a country have failed to protect the currency they were intendedto prop up, according to separate papers by Sebastian Edwards, aneconomics professor at the of University of California at LosAngeles, and Graciela Kaminsky, an economics professor at GeorgeWashington University.

Argentina Restrictions

Argentina restricted bank withdrawals in 2001, when it was facedwith a banking crisis following the government's debt default.Three months later the country had to abandon its currency peg tothe dollar, which it had maintained for a decade. The governmentimposed losses on deposits through forced conversion of dollarsavings to pesos at unfavorable rates.

Being a member of the euro zone is similar to maintaining a pegto another currency at a fixed-exchange rate. When the localcurrency is overvalued as a result of inflation, countries withpegs eventually end the fixed regime and devalue, as Argentina did.Cyprus might do the same, faced with dire economic prospects, OpenEurope's Ruparel said.

“Stuck with an overvalued euro, Cyprus loses out on tourism, oneof its two main economic activities,” he said. “The other one,banking, is dead with capital controls. So what advantage doesCyprus get from being in the euro now?”

Cyprus's 18 billion-euro economy is the third smallest in the17-nation euro area. Before the bailout, which was coupled with anausterity package, the European Commission predicted a contractionof 3.5 percent in 2013. Economists said afterward that the damagewill be greater.

The decision to burn depositors with more than 100,000 euros andrestrict money movements will hurt confidence in other weakeconomies and banking systems of the euro zone, according to areport yesterday by DBRS Inc., a Toronto-based rating firm.

“During the current period of low to no growth in Europe, it iscertainly possible that a run on Cypriot deposits could spread, inspite of existing or future controls on capital,” wrote FergusMcCormick, head of sovereign ratings at DBRS.

A total of 378 billion euros was pulled from banks in Ireland,Spain, Portugal, Greece and Italy in the 13 months through August,according to data compiled by Bloomberg. The flight was reversedonly after the ECB pledged to buy government bonds of thosecountries, calming investors.

Greek Ties

Cyprus's three biggest publicly traded banks had a total of 6.5billion euros of losses in 2011 after writing down the value oftheir Greek bond holdings. They have also been bleeding on theirloans to companies and individuals in Greece, which is in its fifthyear of a contracting economy.

At least 1,600 Greek shipping, trade and tourism companiesheadquartered in Cyprus are threatened with closure, according toNational Confederation of Hellenic Commerce. Greek firms that helddeposits in Cyprus were unable to meet a deadline this week forpaying taxes in Greece, the Athens-based organization said.

The divided island's internationally recognized southern part isethnically Greek and has close ties to the financially troubledcountry. The northern part is controlled by a breakaway governmentbacked by Turkey.

Russian companies with banking ties to Cyprus will face the samehurdles as their Greek counterparts, though the impact on theRussian economy will be less significant. Russian economic output,which expanded by about 4 percent last year, is almost 10 times asmuch as Greece's.

The biggest losers may be Cypriots themselves. Unemploymentcould double to 30 percent as a result of the planned bankrestructurings, estimates Hari Tsoukas, a professor at WarwickBusiness School in Coventry, England.

“Life will be difficult for people living in Cyprus,” Tsoukassaid. “The country will be another version of Ireland and Greece,with a tough austerity program. In another decade, we can lookforward to another recovery.”

Bloomberg News

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