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Bumbling and Stumbling in Cyprus

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 Burning Down the House

anastasiadesOn Saturday, March 16th, EU Finance Ministers and IMF representatives announced that a deal had been reached with representatives of Cypriot President Nikos Anastasiades’ government to provide assistance to that nation’s beleaguered banks[1]. That was the good news. The “Men in Black” then disclosed the details of the agreement: Cyprus would receive €10bn of the €17bn it required from the European Stability Fund, but the country would need to come up with the other €7bn by itself. How was this to be achieved? By imposing an unprecedented “one-time” tax on all deposits held in Cypriot banks.

Mr. Anastasiades has been President for all of 16 days.

This “one-time” levy would assess a 6.75% tax on all deposits under 100,000 euros, while charging 9.9% on deposits over 100,000 euros. No deposits would be exempted: domestic and foreign depositors would be treated the same as private and business deposits. Cyprus would also have to increase its corporate tax rate from 10% to 12.5%, which is still low by European standards, and sell off some state-held assets. However, the deal does not require the sorts of massive cuts to government employee salaries and pensions which have characterized previous bail-outs. Banks were closed on Monday for a regularly scheduled holiday, but the Parliament immediately extended the bank holiday until Wednesday or Thursday in order to allow time for a vote.

euministersEuropean Finance Ministers have defended the requirement imposed on Nicosia. Dutch Finance Minister Jeroen Dijsselbloem said that it seemed “just” to ask for a contribution from Cypriot depositors for the financial stability of their banks[2]. French Minister Pierre Moscovici echoed this sentiment and said, “we did what we had to[3].” Angela Merkel went so far as to say: “We all know that banks that take risks, banks that operate on the wrong model, are a threat not just for the home country but a threat for all[4].” These incredible piece of bald-faced hypocrisy contrasts strangely with previous interventions: no Dutch depositor was touched when the ABN Amro was bailed out; the French government didn’t insist on seizing the deposits of Dexia, when Paris ponied up half of the bail-out funds for that bank; and somehow the fact that Commerzbank almost brought down the entire German financial system before Berlin stepped in didn’t lead to anyone talking about the “wrong model.” Apparently, wrong models only exist south of the Alps.

What’s the big deal? Why shouldn’t depositors give up a little money in order to save the rest from a banking collapse? There are a number of very good reasons:

  • The measure strikes directly at the heart of almost a hundred years of deposit insurance. Financial crises were caused by the failure of a single institution – when it suspended payments, nervous depositors in other banks began to withdraw their funds, just in case. This caused other institutions to fail as customer demands exceed bank capital, which led to more withdrawals and failures in a vicious circle. After the Great Depression, governments everywhere moved to insure the deposits of ordinary people in order to forestall runs on banks. These measures have been extremely successful: during the 2008 Great Recession and throughout the Euro crisis, no bank has failed because of a run by depositors. No one would believe this to be a “one off” measure – if it could be imposed once, it could be imposed again and again and again. The whole miserable history of the Euro crisis has been one of confident pronouncements of “this will never happened” followed rapidly by backtracking and the imposition of the very solution that was deemed impossible (remember when a Greek haircut was declared “impossible” by no less than Angela Merkel?);

 

  • If deposits are now fair game for government confiscation, the cycle of trust is broken. At the end of the bank holiday in Cyprus, what is to stop depositors from withdrawing their funds en masse, leading to the very collapse of the system that the levy was supposed to prevent? Only by imposing a “corralito” i.e. withdrawal limits and capital controls, could the Cypriot government prevent massive capital flight. That would violate both the regulations of the Single Euro Payments Area as well as the treaty commitments to free movement of capital within the Euro zone. Of course the various Eurozone treaties give governments significant leeway in dealing with crisis situations, but the precedent it would set is important. A corralito in Cyprus could very well be replicated in Greece, or in Spain, or in any other crisis country and depositors would be led to hedge their bets by moving funds to less risky accounts in Germany, or even outside the Eurozone;

 

  • The proposed measure also violates the usual and well-established hierarchy of protection that is associated with bank liquidations. The usual order of imposed losses is: equity and shareholders are first wiped out; then subordinated debt; then senior creditors and deposits above the government backstop. If the European Union is prepared to throw this orderly progression out the window along with its guarantee to depositors, it could have a major impact on the relative pricing of bank debt and equity as well as on the willingness of people to leave their money in European banks. After all, the reason that senior bonds are priced lower than subordinate bonds is precisely because there is supposed to be less risk. There is nothing that markets hate worse than uncertainty: between Greek private sector haircuts, Spanish preferred shares and now Cypriot deposits, no one has any idea which assets classes are relatively safer, or how they should be priced.

Even if we ignored these solid economic and financial reasons, the question still remains: why is it fair or just for depositors to pay for the financial difficulties of their banks? Some argue that Cypress is a haven for laundering money from Russia’s oligarchs and mafia. German, Dutch and Finnish governments were unwilling to be seen as using their taxpayers’ money to bail out Russian billionaires and criminals. One German economist has gone so far as to recommend differential levies on foreign accounts over a certain amount – i.e. the Oligarch’s Tax[5]. However, striking down the innocent with the guilty and letting God sort them out is neither good economics nor good politics.

Streets of Rage

EU leaders seem to have underestimated the reaction of ordinary Cypriots to the deal. Indeed, EU leaders don’t seem to have thought through anything at all to have come up with a measure of such monumental stupidity.

cypriotsOrdinary Cypriots immediately took to the streets in protest. Although the demonstrations started small, due to many people having left the capital to take advantage of the long weekend, they grew in size and vehemence. There was no violence, as there was last year in Greece, but Cypriot parliamentarians got the message from their voters loud and clear. President Anastasiades backtracked so quickly on Saturday’s deal that it is surprising he didn’t hurt himself. He immediately claimed that he was “blackmailed” into agreeing to the deposit scheme and promptly flew off to Moscow to commiserate with Russian President Vladimir Putin. Cypriot legislators also made it clear that the deal stood little chance of surviving the Tuesday vote.

Of course the Germans protested their innocence. Wolfgang Schäuble, the German Finance Minister, said that the proposal to “bail-in” bondholders – i.e. a haircut – was rejected by the Cypriots, and that the decision to tax deposits under 100,000 euros was also made by the Cypriots. Not content with slamming the Cypriots, Mr. Schäuble continued to throw the dirt far and wide: “those who did not want a bail-in were the Cypriot government, also the European Commission and the ECB, they decided on this solution and they now must explain this to the Cypriot people.”[6] Perhaps…but the Germans showed remarkable insensitivity to the public perception of their increasingly unpopular role in managing the Euro crisis and were promptly excoriated as Nazis.

putinThe Russians were also furious at what they perceived – rightly – as a blatant and unjustified discriminatory measure against their citizens and business. President Putin described the deal as “unfair, unprofessional and dangerous[7]”. More to the point, the Russian Finance Minister Anton Siluanov said menacingly that Russia might not restructure its short-term loan to Cyprus of €2.5 billion, which had saved the island nation in 2011 from requesting a bail-out at that time. Siluanov said that the loan had been extended under an agreement with the EU to consult with Russia and agree jointly on any future actions[8]. He was visibly upset with EU ministers whom he accused of not consulting Russia at all and thus breaching the agreement.

Malignant Stupidity

After a few banal days of finger-pointing, mudslinging, denials of responsibility and more volte faces than even Benedict Arnold could stomach, this Greek tragedy played itself out. The Cypriot Parliament overwhelmingly voted against the deposit levy: the President absented himself, the other 19 members of his ruling party abstained and every single opposition lawmaker rejected the deal. Some went so far as to suggest repudiating any bail-out from the EU and to appeal to Russia or China for additional funds[9].

This is not as far-fetched as it seems. The amount of money Cyprus needs (€17 billion) is not significant compared to the size of Russia’s foreign currency reserves (€415 billion)[10] or especially China’s (€2,550 billion)[11]. Not only does Russia have strong financial ties with Cyprus, there is a history of political and religious affinity as well[12]. There are even more compelling reasons than those of sentiment: for one, Cyprus is sitting on potentially substantial natural gas deposits in the seabed surrounding the island and the Russian energy giant Gazprom wants them. In fact, Gazprom unofficially offered to bail-out the Cypriot banks in return for a concession to these deposits, but the offer was rejected[13]. Additionally, Russia seeks to maintain influence in the Mediterranean – currently that is accomplished through her alliance with Syria and the use of the naval base in Tartus. With the Assad regime on the ropes and Russia’s future in Syria seriously in doubt, Mr. Putin may see an opportunity to acquire port rights to the Cypriot naval base near Zygi[14].

gazprom 

Nothing is going to happen for the moment. Cyprus is not going to leave the euro, allow her banks to collapse or default on her loans. The ECB has already stated that it will continue to provide limited amounts of liquidity to the teetering – but not quite yet insolvent – Cypriot banks.[15] And why not? The ECB has already accepted billions in highly dubious collateral to extend liquidity assistance to Spain (€ billion) and Italy (€ billion). What is truly baffling is why the ECB didn’t simply do this in the first place, rather than run the risk of destabilizing the whole European house of cards with a negative precedent of this magnitude.

Neither will there be any immediate run on banks in the periphery. I stress the word “immediate”. Unfortunately for Europe, like the powers in Pandora’s Box, once the spectre of deposit confiscation is out, you can’t put it back in. If Greece goes into meltdown again; if the Italian government falls; if the Spanish property black hole yawns wider – then both investors and depositors will know that any negotiation of assistance may include a “Cypriot Tax” provision. The bland and unbelievable denials of the Faceless Finance Minister du jour are not going to satisfy them and they are not going to wait to find out.

The next Euro flare up will undoubtedly be worse than the last, thanks to the gross stupidity of everyone involved in this fiasco. In the wake of Cyprus’ slap in the face, and still reeling from the almost universal condemnation of the global financial community, European leaders struggled to define what had just happened and began yet another round of finger-pointing that has only succeeded in making all of the involved parties look grossly incompetent and petty: starting with the EU leaders who insisted on inflicting the maximum pain on Cyprus, continuing with the Cypriot government that suggested penalizing small depositors, and finally the ECB and IMF “experts” who gave their consent to the deal, there is blame enough to go around. All of Europe’s frailties and failings were present in this farce, but especially the lack of a single authority with public legitimacy to call the shots.

Cyprus is insignificant to Europe. It is 1 million people out of 505 million and its economy is 0.5% of the EU’s €13.5 trillion, a flea on the tail of a dog. Yet, thanks to the failures of European institutions and the incredible failure of European leaders to learn from past crises (or a really shocking degree of election year cynicism), today, the tail is wagging the dog.



Sources and Notes

 [1] Thomson, Roderick, “Europe Announces Stunning Bailout For Cyprus – Bank Depositors To Get Instant 10% Tax Before Banks Reopen This Week,” Business Insider, 16 March 2013
[2] Ibid.
[3] Ibid.
[4] Neuger, James, “Europe Plays I-Didn’t-Do-It Blame Game on Cyprus Bank Tax,” Bloomberg, 20 March 2013
[5] Schultz, Stefan, “German Economist: ‘Europe’s Citizens Now Have to Fear for their Money’,” Der Spiegel Online, 18 March 2013
[6] Donahue, Patrick and Bensasson, Marcus, “Euro Officials Signal Flexibility on Cypriot Bank Levy,” Bloomberg, 18 March 2013
[7] Ibid.
[8] “Cyprus Bail-out: Russia threatens to pull aid,” The Telegraph, 19 March 2013
[9] Alderman, Liz, “Rejection of Deposit Tax Scuttles Deal on Bailout for Cyprus,” The New York Times, 19 March 2013
[10] As of 31 December 2012. Central Bank of the Russian Federation. Denominated in dollars and converted to euros at an exchange rate of 1.3:1.
[11] “Bloomberg China Monthly Foreign Exchange Reserves”, Bloomberg. Denominated in dollars and converted to euros at an exchange rate of 1.3:1.
[12] Both Russians and Greeks are Orthodox Christians. Russia also supported the Greek Communist Party for decades during the Cold War and Mr. Putin as an ex-KGB man undoube are still ties.
[13] Kramer, Andrew, “Protecting Their Own, Russians Offer An Alternative To Cypriot Bank Tax,” The New York Times, 19 March 2013
[14] Kravchenko, Stepan and Orphanides, Stelios, “Cyprus Says Russia Is Benefactor, Denies Naval Base Offer,” Bloomberg, 25 July 2012
[15] Charlton, Emma, “Euro Climbs as ECB Buys Cyprus Time To Renegotiate,” Bloomberg, 20 March 2013

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