A little more on the confusion that is Cyprus
Analysis
Cypriots formed long lines at bank cash machines this week to withdraw their money due to a tax on bank accounts proposed as part of an EU-IMF economic bailout package and fears of bank failures. (PAT R ICK BAZ/AFP/Getty Images)
March 21, 2013
| Economics
| Europe, R ussia and Central Asia
Summary
SITUATION R EPO R T
As the Cypriot government clambers for a solution to a banking crisis that is rattling Europe, it now appears increasingly likely that it will have to depend on loans from R ussia to avoid a default. With options universally bleak for the stricken island nation, Cypriot Finance Minister Michael Sarris vowed yesterday to remain in R ussia until a loan agreement could be reached. But accepting loans from R ussia would be a bitter pill for Cyprus to swallow, as LIGNET explains.
On March 18, Cyprus ordered its banks to close as part of an initiative to renegotiate the terms of an iron-fisted bailout proposal that would have taxed bank savings within the low-tax country. This appeared to be a miscalculation by the European Central Bank (ECB), the International Monetary Fund (IMF) and a host of European leaders. As a result, European leaders are now worried about R ussia bailing out Cyprus given the increased influence this could give Moscow in Europe , especially in the energy sector.
Background
Shockwaves reverberated across financial markets this week in response to unprecedented taxes on bank accounts that the EU and the IMF attempted to force upon Cyprus . The bank taxes were intended to raise 5.8 billion euro s in exchange for a 10 billion euro bailout package. Under this plan, Cypriot authorities were to impose a 6.75 percent tax on all deposits under 100,000 euro s and a 9.9 percent tax on accounts over 100,000 euro s.
The Cypriot economy is in dire shape largely due to its exposure to the Greek debt crisis. Cypriot government debt is currently about 15.3 billion euro s. The Cypriot government lost $5.9 billion from the second Greek bailout last year that wrote off part of Greece ’s sovereign debt.
The purpose of taxes on Cypriot bank accounts is clear: the island nation is a well-known tax haven with about 40 billion euro s ($51.6 billion) in deposits, a figure that greatly exceeds its 2012 GDP of 29 billion euro s ($22.4 billion). About half of this money is foreign; $31 billion belongs to R ussian businesses, banks and individuals, according to the credit rating agency Moody's. EU officials have been strongly critical of low Cypriot taxes to attract foreigners to its banks, a situation that German Chancellor Angela Merkel recently said is “not sustainable.”
Cyprus is also widely viewed as an international money laundering center. The new bailout plan requires the Cypriot government to enact more stringent regulations to halt this illegal activity.
News of taxes on Cypriot bank accounts have triggered panic in the country and long lines at cash machines. Cypriot banks are closed until at least March 26 and there are fears of bank runs when they re-open. Cypriot authorities reportedly are considering implementing capital controls to stop their citizens from taking their savings out of the country once banks reopen.
Due to the popular outcry over bank taxes, the Cypriot government rejected the latest bailout deal. The ECB announced today that Cyprus has until March 25 to sign a new agreement that will still require the government to raise 5.8 billion euro s. After March 25, the ECB said it would not continue low-interest loans that are keeping Cyprus ’ banks afloat unless the government signs a new bailout agreement.
A new Cypriot government “Plan B” to raise the 5.8 billion euro s reportedly could include a smaller bank tax, nationalizing pension funds of government corporations, and issuing bonds written against the country’s potential offshore gas reserves. There also have been reports that the Laiki bank, the second largest in Cyprus , may need to close.
The New York Times reported today that under the government’s new austerity plan, bank deposits of up to 100,000 euro s would be hit by an immediate one-time tax of 2 percent. Deposits above that threshold would be subject to a 5 percent levy. However, other press reports today said bank taxes are off the table.
The Church of Cyprus this week offered to put up its properties as collateral so the government could issue bonds to raise funds.
It is unclear whether the government’s Plan B would be approved by the Cypriot parliament or the country’s international lenders.
Cyprus’ economic turmoil has raised the possibility that the government may turn to unlikely sources for the bailout loans it desperately needs. R ussian President Vladimir Putin was quick to decry the proposed bank tax in Cyprus , where an estimated 30,000 R ussians claim residence and many have bank accounts.
The R ussian Finance Ministry said on March 18 that the Cypriot government asked for a 5 billion euro loan, although Cypriot officials denied this. R ussian officials reportedly also have raised the idea of possibly restructuring their existing loans to Cyprus . Moscow gave Cyprus a 2.5 billion euro loan in 2011.
Russian energy giant Gazprom reportedly proposed to provide Cyprus with bailout loans in exchange for exclusive rights to offshore gas production in Cypriot waters. Cyprus ’ offshore energy reserves could total 8 trillion cubic feet of gas worth almost $390 billion. However, these offshore reserves are still unproven and production is not expected to begin before 2019. Gazprom on March 19 disputed press reports that it made such an offer to the Cypriot government.
Such moves would be derided in Europe , keeping alive the possibility that the ECB and IMF could cut off all aid to the country. The ECB has sought to calm investors by maintaining that the Cyprus bailout would not be repeated in larger economies.
Analysis
The proposed taxes on Cypriot bank accounts appear to have been handled very badly, given the outrage they have caused inside and outside of Cyprus and the likelihood that they could spur a run on Cypriot banks. This idea has attracted international outrage because of the appearance that the EU and the IMF are trying to seize funds from insured bank accounts ahead of other assets in the country.
Whatever the government agrees to with its international lenders, strict banking measures will be necessary when banks re-open to prevent a run on bank run that could cause a collapse of the economy. Such moves could include an extended bank holiday, restricting the amounts that Cypriots can withdraw from their accounts, and converting short-term accounts to longer term debt. If the bank tax is small or is taken off the table, the risk of a bank run will go down and the banks may be able to slowly resume normal operations.
More drastic measures include exiting the euro zone and converting euro bank accounts into Cypriot pounds as part of a devaluation. This idea does not seem to be likely at this time.
There are signs that that foreign stakeholders recognized that they may have overstepped the mark in advocating the tax on Cypriot bank accounts. Several governments, including Germany , have sought to distance themselves from this idea, while French President Hollande has engaged in talks with Cypriot leaders over the past few days.
European states are concerned about R ussia exploiting Cyprus’ economic woes since this would not only increase R ussia’s regional economic presence, it would also add to R ussia’s dominance of natural gas sales to Europe by giving it effective control over what may be huge gas reserves in Cypriot waters.
Russia is likely to press hard for a loan deal with Cyprus , but its terms will be harsh – probably involving R ussia gaining control of hard assets like a Cypriot bank or offshore gas reserves. A deal with R ussia would also poison Cyprus ’ relations with the EU and possibly undermine the Cypriot government’s efforts to use the EU to counter efforts by its major adversary, Turkey , from gaining EU membership. For these reasons, LIGNET believes the Cypriot government’s interest in a R ussian loan deal is probably mostly a ploy to force better bailout terms from the EU and the IMF.
As in all of the recent European debt crises, Cyprus and the EU are likely to reach a deal that will avert this crisis. A short-term emergency EU-IMF loan might be needed to reassure Cypriot bank depositors while the terms of a comprehensive agreement are negotiated. It is also possible that a least one Cypriot bank may be allowed to fail.
While a small bank tax is possible – possibly limited to large accounts – the outrage this idea caused probably means it is an initiative that will not be attempted again as part of future euro zone bailouts.