What happens when you refuse an offer you can’t refuse?

But seriously, if you are not following the Cyprus story, you need to start.

So, Cyprus kept delaying the vote (and extending the bank holiday). Finally, today, they voted on the measure…

…and voted “no”.

From here, things should get interesting. First, when the news broke, the Dow immediately dropped 150 points or so. Then around an hour later, the ECB released a brief statement:

The ECB takes note of the decision of the Cypriot parliament and is in contact with its Troika partners. The ECB reaffirms its commitment to provide liquidity as needed within the existing rules.

And the Dow immediately rallied 100 points.

This is not how things were supposed to go down. In last week’s thrilling closed-doors meeting, Jörg Asmussen threatened, on behalf of the ECB, to terminate all liquidity support for Cyprus’s banks unless Cyprus agreed to haircut its depositors.

You see, the ECB is a central bank. Central banks were invented to keep bank runs from bringing down banking systems. They are supposed to do this by “lending freely at a high rate against good collateral”. Lending freely? Check. High rate? Well, everything is relative, I suppose. Good collateral? Er… um…

The ECB’s “Emergency Liquidity Assistance” (ELA) program — or “programme” — is a mechanism by which commercial banks, pretending to be solvent, can borrow Euros from their national central bank against the value of their loans as carried on their books. The central bank of Cyprus is a bit behind on its financial statements, but as of January they had €9,099,745,000 in “Other claims on euro area credit institutions”. This includes more than just ELA because it’s complicated, but it is a good first approximation.

It is the ELA that the ECB was threatening to cut off, which would instantly collapse Cyprus’s banking system and thereby its economy.

Here is what was supposed to happen. Eurozone lends €10 billion to Cyprus. Cyprus extracts €5.8 billion from its depositor base. Net effect would be that the government and banks would be solvent for real, not just for pretend, at least for a while. Of course, every depositor in Cyprus would withdraw all of their money the instant the banks reopened, but that would be OK because (a) the ECB would provide unlimited support via ELA, and (b) the system really would be more-or-less solvent. So the panic would eventually subside and everyone could move on.

That was the plan. Now here we are, one week later, and nothing has changed… Except every depositor in Cyprus is still going to withdraw every single Euro the instant the banks reopen. But the system is not solvent, and the pretending is just about over.

There is no longer any technical reason to keep the banks closed since the ECB has “reaffirmed its commitment to provide liquidity”. But once the bank run starts, the ELA could easily grow to tens of billions of Euros just to satisfy withdrawal requests. That is, the ECB — via the Central Bank of Cyprus — would be putting tens of billions of Euros at increasingly greater risk.

I wonder when those banks will reopen?

EU Said to Discuss Cyprus Capital Controls, Longer Bank Holiday

Ah, right.

Now, given this situation, a rather obvious proposal presents itself. You can get the gist from a couple of tweets by Alea (1 2), or full details from Team Macro Man. But the basic idea is that Cypriots could simply “take the money and run”. They owe €9 billion to the ECB already, soon to be more — possibly tens of billions more — once their banks reopen. For reference, the entire GDP of Cyprus is €20.5 billion.

Or, in my own words:

#Cyprus should just default on the ECB and come out tens of billions ahead. What are the Germans going to do? Invade?

(It isn’t your grandparents’ Germany.)

This would almost certainly precipitate an exit from the Eurozone for Cyprus, which is an increasingly likely outcome in any case. But it could be quite a profitable one. This assumes the ELA actually lasts past the end of the bank holiday. I am not sure that can happen unless something else happens first. I am not sure what…

Related: New UI for Cyprus ATMs