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ECB ready to let Cyprus sink in to chaos

Wednesday, March 20 16:38:25

The European Central Bank is prepared to cut off funding to Cyprus and let the Mediterranean island succumb to financial meltdown if it has to, confident it has unlimited firepower to protect the rest of the euro zone.

Cyprus propelled the 17-nation bloc into uncharted waters on Tuesday by rejecting a proposed levy on bank deposits as a condition of a 10 billion euro EU bailout.

Without the aid, much of it to recapitalise Cypriot banks, the ECB says they will be insolvent, and it requires banks to be solvent for them to receive central bank support.

Denied these funds, Cyprus would be left staring into a financial abyss.

For the rest of the euro zone, the ECB has a suite of policy tools at its disposal to prevent contagion - with bond purchases and unlimited liquidity offers to the fore.

ECB chief Mario Draghi has his ability to create new policy tools constrained by resistance in Germany, where business newspaper Handelsblatt last week ran a front-page picture of him under the headline: "The poisoned gift: how ECB President Mario Draghi is saving the euro and ruining savers".

Bundesbank chief Jens Weidmann opposed Draghi's bond-buy plan - he sees it as simply financing governments - but he is open in principle to funding measures like the so-called LTRO the ECB used a year ago to funnel banks 1 trillion euros of cheap money.

Given that, the ECB probably has no need to dream up new crisis measures and before it even deploys its existing ones, it will try to work with governments to reassure bank depositors.

"The contagion risk is a run on banks in other countries," said Andrew Bosomworth, senior portfolio manager at Pimco, the world's largest bond fund.

"Verbal intervention from the ECB and governments can help, such as a commitment that guaranteed deposits are sacrosanct. Operationally, it also means keeping the ATMs full."

Draghi calmed markets last July by promising "within our mandate, the ECB is ready to do whatever it takes to preserve the euro". He backed up that vow by unveiling a plan to buy countries' bonds if they met certain conditions.

Now, a reassuring message to depositors needs to be supported with efforts to make sure the euro zone financial system is lubricated properly.

The ECB is already offering banks unlimited liquidity with loans up to 3 months, and reserves the option to provide them with more funding certainty over a longer horizon by laying on another 3-year funding operation, as it did a year ago. Reuters