By Paul Carrel
FRANKFURT (Reuters) - Cyprus's plan to impose capital controls threatens to test the ties that bind Europe's monetary union and could see euros on the Mediterranean island valued differently to those in the rest of the bloc.
The capital controls, being imposed to avert a run on banks after an EU bailout, will limit foreign transactions and capital outflows but not movements of money within the country itself, the head of the Cyprus chamber of commerce said on Wednesday after meeting government officials.
The finance minister has said the controls could be in place for a few weeks although the experience of other countries, such as Iceland, suggest it may take much longer. Banks, shut since nearly two weeks, are due to reopen on Thursday.
The impact the restrictions have on the Cypriot economy depends on their exact nature and whether they are applied to payments as well as capital transfers. A report from Greek newspaper Kathimerini suggested there would be restrictions to both, and that these would initially last for seven days.
Restrictions on payments would be a far bigger incursion into the functioning of Europe's internal market than controls on capital transfers, as euros held in banks in Cyprus could not be used to pay for goods and services elsewhere in the bloc.
By definition, that would make them less liquid than French or German euros and de facto, worth less.
"If you were to impose restrictions equally on capital transfers and payments, then economically a Cyprus euro would be a different currency vis-a-vis a non-Cyprus euro," said Kai Schaffelhuber, partner at Allen & Overy law firm in Frankfurt.
"You would have to buy non-Cyprus euros to pay for goods and services in other countries," he said. "With the rules of supply and demand, the Cyprus euro could then take on a different exchange rate."
If capital controls are relatively short-lived, that situation would be reversible. The longer it goes on, the more it would question Cyprus's place in the euro zone.
But with the alternative likely to be massive capital outflow, Nicosia has little choice.
A Reuters poll of economists found 38 out of 46 said capital controls were appropriate, with the alternative being an uncontrolled exodus of cash. Thirty of 46 said controls would last months, while 13 expected they would endure a matter of weeks. Three said they could last years.
"You can't have Cyprus in capital control limbo," said Sassan Ghahramani, CEO of U.S.-based SGH Macro Advisors, which advises hedge funds. "I think it's a question of weeks, at most. If it gets into months it's going to be really problematic."
The chapter on capital and payments in the Treaty on the Functioning of the European Union begins by prohibiting restrictions both on the movement of capital and on payments between European Union member states, and 'third countries'.
But a subsequent article allows countries "to lay down procedures for the declaration of capital movements for purposes of administrative or statistical information, or to take measures which are justified on grounds of public policy or public security".
This gives governments sufficient wiggle room to impose restrictions both on capital transfers and payments.
Nonetheless, Cyprus's plan to impose capital controls will mark a first for the 17-country euro zone.
The experience of Argentina's 'corralito' a decade ago, when authorities restricted withdrawals to prevent bank runs, offers a recent precedent but the Cyprus case breaks new ground.
"What you've got is a monetary and banking system which is not supposed to impose capital controls. What they are doing is creating a sub-set of rules to create a new economic area, which is unprecedented," said David Brown at New View Economics.
Michel Barnier, the European Commissioner responsible for the 27-member European Union's single market, wants the controls to be brief. He said on Monday they should only last a few days.
Restricting capital transfers - movements of money or securities - to other countries but not payments could open up myriad 'work around' options for people trying to get their money out of Cyprus.
One could be to buy goods in another euro zone country, shifting funds out of the island to pay for them.
To counter such scenarios, the Cypriot government could introduce limits on such payments or require them to be approved by a licensing authority - red tape that will impede business and slow turnover.
Kathimerini said the controls will allow Cypriot businesses to pay for imports if they provide the necessary documentation.
This hit could be recovered if the controls are brief.
"But the longer this lasts the more it will hurt the economy, the more likely it is that businesses run out of liquidity and have to default. Then we really get into trouble," said Berenberg bank economist Christian Schulz.
Having threatened to cut off funding to Cyprus's banks if its government did not agree a bailout, the ECB decided on Monday to give them access to emergency central bank funds - a step that will avoid an immediate meltdown in the country's bloated banking sector.
Argentina's 'corralito' resulted in a liquidity crunch.
The bailout plan aims to shore up Cyprus's financial sector, winding down the largely state-owned Cyprus Popular Bank
But the system is bound to come under more stain.
"The ECB is now on the hook for funding what's left of the banking system of Cyprus, which remember is multiples of the GDP of the country," said Ghahramani at SGH Macro.
Such pressure sits uneasily with some ECB policymakers.
"As opposed to Argentina and other instances of domestic capital controls, you would have an entire country and banking system remain in a grey area while the ECB and by extension the euro zone keep funding it," said Ghahramani. "These controls should have to come off in a matter of days if possible, not weeks, and certainly not months."
(Writing by Paul Carrel, editing by Mike Peacock)