European Union policymaker hopes that the euro would
challenge the dollar as a global reserve currency have been further dented by
the Cypriot debt crisis, also raising the costs of what happens if the eurozone
breaks up, Lombard Odier Investment Managers said in a note yesterday.

“Developments in Cyprus have further dented the
euro’s fledgling status as a reserve currency... It is now clear that in stress
situations with mitigation of moral hazard an important driver, the current
rules governing the single currency area may be changed to suit the creditors,”
Salman Ahmed, strategist on the global and emerging fixed income team at
Lombard Odier Investment Managers, said in a note.

Along with a host of wealth management firms, Lombard Odier
weighed in on how to interpret measures to rescue the Cypriot economy and banking
system. The bailout has broken from three years of eurozone crisis-fighting by
penalising large bank depositors for the first time. Accounts with less
than €100,000 ($128,500) have been spared a levy. The measures have rattled
depositors such as wealthy Russians, who have been some of the heaviest users
of Cypriot bank accounts in recent years since the end of the Cold War.

The spectre of possible capital controls in Cyprus – which flies
in the face of the idea of the eurozone as a single monetary regime – has also
rattled international market sentiment. The proposed levy on bank deposits,
talk of capital controls and possible euro exodus continues to weigh on the
euro versus currencies such as the Swiss franc and dollar.

The European Central Bank decided this week to give Cypriot
banks access to emergency central bank funding. The central bank already offers
banks unlimited liquidity with loans up to three months, and reserves the
option to give them more funding certainty over a longer horizon by laying on
another three-year funding operation, as it did a year ago.

Lombard Odier’s Ahmed pointed out that in the past,
governments have created and interpreted rules to suit their needs. “According
to the EU treaty, controls that inhibit the free flow of capital within EU
borders are illegal and yet we are most likely to see draconian controls being
implemented in Cyprus,”
his note said.

“This means that [ECB head] Draghi’s now famous 'whatever it
takes' pledge is situation-dependent. Such an all-encompassing promise did not
apply when the European Central Bank threatened to pull emergency lending
assistance to Cyprus,”
he said.