By SIMON NIXON
The euro zone is used to brinkmanship. But since the Cypriot parliament refused to sanction a tax on bank deposits, a vital condition of its proposed €10 billion ($13 billion) bailout, the currency bloc is in uncharted territory. What happens next depends on the response of the European Central Bank. The Cypriot parliament is gambling that the ECB is bluffing when it says it will withdraw Emergency Liquidity Assistance from the country's banks, thereby precipitating their likely financial collapse.
That looks like a reckless gamble. True, the ECB has blinked before. It had originally threatened to withdraw permission for the Central Bank of Cyprus to provide ELA on Jan. 21. But it backed down because it believed there was a realistic prospect of a bailout deal that would recapitalize the country's broken banking system once the presidential election was out of the way in February. At that point, it said it would review its decision after two months, a deadline that expires this Thursday.
During Friday's marathon negotiations over the current bailout proposal, ECB executive board member Jörg Asmussen made clear to President Nicos Anastasiades that failure to agree on a deal that weekend would make it impossible for the ECB to provide a further extension of ELA since ECB rules don't allow national central banks to lend to insolvent banks. But any actual decision to withdraw ELA is a matter for the ECB's Governing Council and requires two-thirds of the council's members to vote in favor.
The Cypriot parliament may be calculating that it can count on enough Governing Council members to block any move to withdraw ELA. After all, the ECB's rules say it can only withdraw a national central bank's right to provide ELA to protect the monetary integrity of the euro zone. If Governing Council members were looking for reasons not to withdraw ELA—which would be understandable given the intensely political nature of such a decision—they could argue that a possible Cypriot euro exit would do more damage to euro-zone monetary integrity than keeping the banks alive. Besides, even if ELA ended up replacing the entire €70 billion of Cypriot deposits, it would make little difference to overall euro-zone money supply.
But this is complacent. Even if Cyprus is small, the ECB needs to consider the precedent it would create if it allowed the Central Bank of Cyprus to continue providing ELA in the absence of a deal. Besides, failure to reach a deal is certain to lead to an immediate nationwide bank run: The CBC would, anyway, not be able to meet the demand for euros unless the ECB allowed it to drastically widen the pool of eligible collateral, which seems highly unlikely given concerns over the quality of Cypriot bank assets.
Cyprus's best hope is that the ECB makes any extension in ELA beyond Thursday dependent on two conditions: first, that it receives credible assurances that there is a realistic prospect of an alternative deal, and second, that the banks remain shut until that deal is concluded to minimize the low-level bank run already under way as Cypriots continue to empty automatic cash machines.
But whether Cyprus can meet even these conditions is an open question. Any deal will still require Cyprus to find €6 billion from its own citizens to help pay for the bank recapitalizations. That must be done to keep the cost of the euro-zone bailout below €10 billion and the government's debt sustainable—an essential condition for International Monetary Fund involvement which is, in turn, an essential condition for the German government and parliament to agree to a deal.
So the banks will have to stay shut and the Cypriot parliament keep voting until it comes up with the "right" answer or decides to quit the euro. Sound familiar?
Write to Simon Nixon at simon.nixon@wsj.com
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