The Cyprus crisis is about principle, but at what cost?

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This weekend, the tiny and divided island-nation of Cyprus landed at the center of the latest eurozone crisis. Its banking system, like in much of Europe, is in bad shape. We have been writing about how the European banking system is the area’s Achilles heel for a long time, and Cyprus proves the case. Cypriot banks’ assets amount to a staggering 7 times the nation’s GDP, all but guaranteeing that a systemic crisis would happen sooner or later.

The Greek debacle hit Cypriot banks badly because they had been big investors in Greek bonds. When those bonds were restructured, local banks suffered big losses and Cyprus has found itself short of money to save them and pay the country's bills.

Since Cyprus is part of the eurozone, the crisis set in motion the area’s bail-out mechanisms. Unexpectedly, the “troika” of the IMF, the European Commission and the European Central Bank announced this weekend that as a condition for a rescue they were demanding participation from the bank’s depositors. Accounts larger and smaller than €100,000 would be subject to a 9.9% and a 6.7% “tax” respectively.

The outcry was swift and virtually unanimous, not just from depositors but also from analysts, observers, reporters and many politicians. The complaint was that going after depositors while sparing banks’ investors and bondholders upended the normal chain of claims. Depositors had always been granted first claim on a bank’s assets, followed by senior and junior bondholders and, lastly, by shareholders. Going to depositors first not only violated the spirit of deposit guarantees but also probably the letter of existing law.

Why these extraordinary, unprecedented demands?

The knee-jerk reaction has been to blame European policymakers as inept, bumbling bureaucrats coming up with one bad idea after another in complete ignorance of market repercussions. Indeed, stocks in Europe and elsewhere took a hit on the following day as this action was seen as setting a dangerous precedent on other countries beset by banking problems, such as Spain or Greece. Why would anyone keep money in a weak country’s banks? Everyone was spooked by the specter of bank runs in peripheral nations.

But there is more than meets the eye.

In a little-noticed interview last January, German Finance Minister Wolfgang Schauble expressed concerns that the Cypriot banks were instrumental in laundering Russian money. According to Bloomberg, he said that “suspicion arises – and it’s plain to see –because Russian investment in Cyprus is so high and at the same time Cypriot investment in Russia is high. You may ask why Cyprus is the second-largest foreign investor in Russia and we need clear answers to that.”  

Bloomberg also added that “a German secret service report on Cyprus that was sent in November to federal lawmakers said Russians deposited 26 billion euros ($34.6 billion) – more than the size of Cyprus’s economy – in Cypriot banks over an unspecified timeframe, according to Priska Hinz, a Green party lawmaker, who read the secret report.” Meanwhile, another high-ranking German politician added that Cyprus needed to “play by the rules we have on money laundering in Europe.”

One reason for going after depositors was that Cypriot banks had barely issued any bonds, so there were no bondholders to assist in the bail-out. Also, the main shareholder is the state itself. That left the troika with a simple choice: force eurozone taxpayers to pay the $17bn price tag to save a banking system that was perceived to be a money launderer for Russia, or have depositors – Russians, in great measure – foot the bill.

This was an easy choice to make for European authorities whose passion for European integration had been steadily evaporating. The days of admitting Greece into the eurozone with fake numbers or to overlook missed budget deficit goals for the sake of uniting Europe under a big tent are quickly receding into a quaint past.

Germany, for instance, recently passed a budget that calls for an elimination of its structural deficit by 2014. While this may be a virtuous goal, it blatantly ignores the impact that a deceleration of the eurozone’s largest economy will have on struggling peripheral nations. Germany argues that it is only fair to subject itself to the same austerity that it demands from everyone else. The medicine, however, has done little to improve the health of peripheral Europe.

Peripheral Europe Debt as % of GDP

As a percentage of GDP, debt has increased substantially in Greece, Portugal, Spain and Italy because economic activity has declined. That Germany doesn’t see this as a problem and insists on further fiscal tightening is worrisome for the future of the eurozone.

Throwing Cyprus under the bus appears to some as further proof that Germany and its Finnish and Dutch acolytes, for all the lip service they pay to the integration of Europe, care far more about themselves than about their southern neighbors. It’s an election year in Germany, after all. And this gloomy change in sentiment only reflects the irritation of northern taxpayers. The caricature of peripheral Europe as an irresponsible, corrupt, undeserving bunch, whether fair or unfair, has been reinforced by the debacle in Cyprus. The willingness of the European core to bail out a banking system portrayed as a money launderer for the Russian mafia, not surprisingly, is nonexistent.

Russia has been pulled into the fray and this complicates matters. The Kremlin has already expressed its displeasure at what they ironically see as a “soviet” confiscation of private property. The latest news suggests that smaller depositors will be let off the hook, therefore increasing the levy on the largest depositors, likely to be mostly Russians. Chances that the Russians will meekly take the hit are slim.

This “Cyprus moment” does not seem to be about money – the amount is small by any standard – but ultimately about principle. European integration at all costs has morphed from a vision of the future to a morally suspect undertaking. And this time politicians do not seem to be delegating to technocrats to call the shots, but they are assuming the task themselves.

This is dangerous because politicians rarely find any upside in moderation, especially if abdicating to the demands of the market or of Russia ends up being perceived as admission of defeat. In some sense they have painted themselves into a corner. Preventing the Cyprus crisis from turning into something uglier could turn out to be more difficult than they anticipated.

What now?

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