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Cyprus: Small Country, Big Impact

The private sector gets ever more involved in Europe's debt crisis...

THE 1931 COLLAPSE of the small Austrian bank Creditanstalt precipitated a major financial panic, writes Satyajit Das for Dan Denning's Daily Reckoning Australia.

Cyprus, one the smallest countries in Europe with little over 1 million people and about 0.5% of the European Union economically, may prove a key inflexion point in the crisis.

Since June 2012, it has been known that Cyprus needs around €17-18 billion to recapitalize its banks (around €10 billion) and for general government operations including debt servicing (around €7-8 billion).

Cyprus' banking system is large, consistent with its status as an offshore financial center. Some suspect the scale of its financial services sector to its reputation as tax haven and money laundering center. The UK Daily Telegraph described the island as 'a sunny place for shady people'.

The required bailout of the Cypriot banks is necessitated by substantial losses on aggressive lending expansion funded by rapid growth in deposits. But the bulk of losses result from write downs to loans to the Greek government worth 160% of Cyprus' Gross Domestic Product of €18 billion. These write downs were the result of the debt restructure of Greek sovereign debt, overseen by the EU.

While small in nominal terms and well within EU's resources, the bailout required is large at around 100% of Cyprus' GDP. It is unlikely that Cyprus can repay it, in the absence of a dramatic change in its circumstances such as the mooted revenues from oil and gas reserves in the Eastern Mediterranean.

The various options considered to generate the required funding included: privatization of state assets, increases in corporate taxes (from 10% to 12.5%) and withholding taxes on capital income (to 28%) and restructuring of existing bank or sovereign debt.

Debt restructuring options included a 'bail-in' of creditors (the new fashionable term for a write off of principal). It would also entail easing terms and lengthening maturities of (up to) €30 billion in loans from Russian banks to Cypriot companies of Russian origin.

On 20 March 2013, the EU proposed a bailout package incorporating almost all of the above measures.

Most controversially, the package proposed that ordinary depositors pay a 'tax' or 'solidarity levy' on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits.

The deposit levy was 6.75% on deposits of less than €100,000 (the ceiling for European Union account insurance) and 9.9% for deposits above that amount. In return, the depositors would receive shares in the relevant banks.

In reality, the 'tax' equates to a confiscation of savings. The Kafka-esque terminology reflects the desire to avoid triggering a bank default and also avoid triggering complication with deposit guarantees.

The EU has indicated that deposit guarantees are only operative 'in the event of a bank failure'. In contrast, the tax or a deposit levy is 'a fiscal measure applied to all bank accounts' not to those in failing banks.

The unprecedented write down of bank deposits, expected to raise around €5.8 billion, was motivated by a number of factors.

Firstly, the write off of depositor's funds reduces debt and also the size of the required bailout package to Cyprus to €10 billion, consistent with the requirements of the International Monetary Fund ('IMF') and Euro-zone members like Germany. IMF participation also requires the debt level to be sustainable, a criteria which the larger amount may not have met.

Secondly, Cypriot banks have limited amounts of subordinated or senior unsecured debt. A write down of these bondholders would only raise between €1 and €2 billion, well below the required amount. This necessitated allocating losses to depositors.

Thirdly, the European Central Bank (ECB) has major exposures to Cypriot banks via its Emergency Lending Assistance (ELA) Program whereby it provides funding to Euro-Zone Central Banks.

Based on the accounts of the Cypriot central bank, the ECB may have provided as much as €10 billion, very high levels relative to the size of the Cypriot economy. As in the case of the 2012 Greek debt restructuring, the ECB and other official lenders are unwilling to take losses on their exposure, requiring the depositors to take a haircut.

Fourthly, restructuring the sovereign debt of Cyprus is risky because many of the bonds are governed by English law. Any attempt to restructure these whilst insulating official creditors from losses would invite litigation. Cypriot domestic-law sovereign debt is held by local banks. So write downs would aggravate their problems, requiring the sovereign to intervene in any case.

Fifthly, Germany, Finland and Holland are increasingly concerned about losses on bailout loans. German Chancellor Angela Merkel does not want to increase Germany's potential liability ahead of elections due in September 2013. She also does not want the ECB to take losses which might trigger the need for Germany to inject additional capital.

Sixthly, Germany wants to prevent any bailout fund flowing to Russian depositors, such as oligarchs or organized criminals who have used Cypriot banks to launder money. Carsten Schneider, a SPD politician, spoke gleefully about burning 'Russian black money'. However, the majority of affected deposits may be from Cypriots.

As of January 2013 €43 billion of the €68 billion in Cypriot bank deposits were from domestic residents, although a portion may be from overseas depositors. There are around 60,000 British retirees and 40,000 Russians living in Cyprus.

€19 billion were from the rest of the world, believed to be primarily from Russia. Based on ECB data of cross-border deposit liabilities for Cypriot banks, there is an additional amount owing with non EU banks of around €13 billion, believed to be primarily Russian banks.

The tax on depositors represents a significant expansion of the principal of PSI (private sector involvement), previously applied in the case of Greece and presented by the EU as a 'one off' measure.

Whereas in Greece, losses were allocated to sovereign as well as junior and subordinated bank bond holders, the Cyprus measures, as originally proposed, extended burden-sharing further to ordinary small depositors.

The EU argued that depositors (and especially foreign depositors) funded the over-extension of the Cypriot banking system domestically and abroad, which reached around eight times GDP. They argued that depositors should bear losses, contributing to the bail out. The EU also argued the risk of moral hazard in bailing out depositors. They also claimed that, in reality, there was no other option.

The reasons proffered are deeply flawed.

A number of other economies have large banking systems, involving substantial levels of offshore deposits. For example, Luxembourg's bank assets are over 21 times its GDP, Great Britain and Switzerland's bank assets are over 5 times GDP and Malta's is comparable to Cyprus.

Whatever the truth of the accusations, arguments about money laundering and tax evasion may provide cover for the real reasons and smack of hypocrisy.

Cyprus has based its economy on operating as an international banking center. Strictly speaking like many other financial centers, it is a low-tax jurisdiction, not a tax haven as frequently described in the press.

Cyprus theoretically complies with OECD and EU fiscal and regulatory standards, including money laundering provisions, tax co-operation and information provisions.

Cyprus has double-taxation treaties with the EU, US, China, Russia and, Middle East countries which also comply with OECD requirements including anti-avoidance provisions and prevention of tax evasion. These factors made it an attractive place for Russian interests to invest and as a hub for business transactions.

That is not to say that all transactions undertaken in Cyprus are legitimate or the provenance of funds is pristine. Many large global corporations and wealthy individuals in developed countries use international banking centers to remain anonymous and minimize tax.

Many Western economies, including Britain, Germany and France, have benefitted from flight capital from various parts of the world, including Russia. A number of Western banks have been found to have had illegal dealings with unsavory interests including narcotics dealers and rogue states.

In addition, if problems exist then the EU cannot feign ignorance. Tighter controls over money laundering were a pre-condition to EU entry which do not appear to have been met. In addition, these problems have not prevented the ECB from offering emergency funding assistance to Cypriot banks.

The tax or levy was also bizarre in its construction, applying uniformly to all banks. Logically, only depositors in the delinquent banks should be required to bear losses. In addition, the threshold for large depositors, namely €100,000, was too low, catching small businesses.

Commentator Karl Whelan's memorably described the EU proposal to allocate part of the burden to depositors as 'a stupid idea whose time had come'.

The EU proposal affected countries other than Cyprus.

British military personnel and government officials based in Cyprus, who are believed to have over €1.5 billion in local bank accounts, were affected by the tax. The UK government have announced that they would be compensated, although other UK depositors would not be eligible for assistance. The unexpected cost in a fiscally challenged era and the approach to the bailout will increase divisions between Britain and Euro-Zone.

The plan affected Russians interests. Its citizens may faces losses of around €2 billion. In addition, Russian banks have significant exposure to Cyprus. In 2011, Russia lent Cyprus €2.5 billion.

In July 2012, Russia refused a request for a further €5 billion loan, stating that it was the EU's responsibility to come up with a comprehensive solution to Cyprus' problems. Russian President Vladimir Putin criticized the plan as 'unfair, unprofessional and dangerous'.

Given that the extension of Russian loans is one element of the package, the desire to target Russian interests was a curious way to obtain Moscow's co-operation. Russia has already stated that, 'The EU took action to levy a tax on deposits without consulting Russia, and for this reason we will further consider the issue of our participation from the point of view of restructuring the earlier loan.'

The EU might have been trying to use the proposal to elicit Russian concessions and further contribution to the Cypriot bailout. But as a major trading partner and major supplier of gas to Europe, the Russians have significant leverage in any discussions.

Initially, the newly elected Cyprus government of Prime Minister Nicos Anastasiades failed to pass the necessary enabling legislation in his first attempt, with nobody voting in favor of the package.

Cyprus explored alternative strategies including confiscation of pensions, additional taxes and other sources of funding. Unsuccessful discussions were held with Russia for a financing package which would secure Cyprus' position and protect the interests of the Russian state, its citizens and banks who have substantial exposures.

With no other source of funding available and the ECB threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse. Businesses would face bankruptcy. Banks would fail, with most Cypriots probably losing their savings.

Under duress, Cyprus agreed to an amended plan on 25 March 2013. Whilst maintaining most of the original elements, the plan appears to amend the deposit levy.

'Small' depositors (below €100,000) will be protected, being exempted from the levy.

A major restructuring of the two largest banks will take place. The troubled Laiki Bank will be divided into a good bank (including small depositors and emergency ECB funding) to be absorbed into the Bank of Cyprus and a bad bank which will be liquidated over time.

Shareholders, bondholders and ultimately larger depositors in Laiki Bank will have to absorb losses, the size of which is uncertain. There are some suggestions that losses may be capped at 40%. Shareholders, bondholders, and large depositors in Bank of Cyprus will then be written down so that the bank achieves a capital ratio of 9%.

Other measures include 'temporary, proportionate and non-discriminatory' capital controls to prevent funds being taken out of Cyprus. There will also be a reduction in the size of Cyprus' financial sector to the EU average by 2018.

Two aspects of the agreed package are noteworthy. The bailout package (€10 billion) cannot be used to re-capitalize banks, which limits its utility.

The plan does not need Cypriot parliamentary approval as it is no longer a 'tax'. The transfer of losses on large depositors takes place under recently adopted bank restructuring laws passed at Brussels' insistence.

The measures stave off the risk of immediate collapse and Cyprus having to leave the Euro. But the plan does not address Cyprus' problem.

As in Greece and Portugal, privatisation proceeds and the revenue from increased taxes may not reach targets.

The bank restructuring plan may not raise sufficient funds. It will encourage remaining deposits to flee Cyprus when capital controls are eased, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance, entailing further write-offs in depositor's fund.

The proposed restructuring effectively cripples the Cypriot banking industry, which is a major part of the economy and employs over 50% of workers. The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations.

Russian businesses are unlikely to continue to patronise Cyprus. Press reports quoted one Russian businessman's wry observation that the EU had killed Cyprus in one day. 'When the Russians leave who is going to stay at the Four Seasons for $500 a night? Angela Merkel?'

Economic activity in Cyprus is expected to contract by between 15-25% over the next few years. Unemployment will also rise. The slowdown will reduce Cyprus' capacity to pay back its creditors.

Whatever the case for or against the Cyprus package, it has significant side effects.

Firstly, the transfer of losses to depositors creates a dangerous precedent. In 147 banking crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses.

The Cyprus measures derogates from the general principal of protecting depositors. These principles were strictly adhered to in the US and UK bank bailouts.

Depositors in weak banks in weak countries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain, based on depositor concerns about loss of capital in any future debt restructuring.

Europe has total bank deposits of around €8 trillion, including around €6 trillion in retail deposits. Around €1.5-2 trillion of these deposits are in banks in peripheral countries.

In the period leading up to July 2012, banks in these peripheral countries lost between 10% and 20% of their deposits. This only abated when the ECB made its announcement in July 2013 that it would do whatever it takes to safeguard the Euro.

If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have to intervene, funding affected banks and potentially restricting withdrawals, electronic funds transfers and imposing cross-border capital controls.

Banks runs and capital flights are difficult to control once they commence. As former Bank of England Governor Sir Mervyn King argued, it is not rational to start a bank run but it is rational to participate in one under way.

Secondly, the Cyprus bail-in provision will make it increasingly difficult for European banks, especially in vulnerable countries, to raise new deposits or issue bonds. There will be increasing concern about the risk of loss and subordination of investor claims to official lenders. The ECB, national central banks and governments will have to cover any funding shortfalls.

Thirdly, the Cyprus arrangements undermine the credibility of the ECB and EU and measures announced last year to combat the crisis, which have underpinned the recent relative stability.

The ECB's OMT (Outright Monetary Transactions) facility allows it to purchase sovereign bonds to assist nations to finance and lower their cost of borrowing. The facility, which is yet to be used, requires the affected country to apply for assistance.

After Cyprus, it will be politically difficult for countries like Italy and Spain to ask for assistance if required, knowing that if a future debt restructuring is necessary then domestic taxpayers face a loss on their bank deposits.

Cyprus highlights the shortcomings of the EU's much vaunted 'banking union'. The arrangements did not provide sufficient funds to undertake any required re-capitalisation of banks, an alternative to the levy on deposits.

Cyprus also highlights the lack of a Euro-Zone wide consistent deposit protection scheme, backed by EU funds.

Fourthly, the Cyprus package highlights the increasing reluctance of countries like Germany, Finland and the Netherlands to support weaker Euro-Zone members. Domestic political consideration and popular resistance to commitment of further taxpayer funds to such bailouts make such assistance increasingly problematic.

Fifthly, the negotiations surrounding the Cyprus bailout revealed policy makers' lack of understanding of the problems and the effects of policies. It also revealed significant differences between Euro-Zone members and also between Europe and the IMF

Sixthly, the EU, by agreeing to potentially indefinite capital controls, has effectively created a two tier Euro, undermining the single currency in the long term.

Debt crises, especially on the current scale, cannot be dealt with other than by financial repression.

To date, it has taken the form of higher taxes, interest rates below the rate of inflation, directed investment and increased government intervention in the economy. Cyprus marks a new phase of financial repression, shifting the burden increasingly onto savers directly by confiscating savings.

In any debt crisis, there are several possible methods of allocating losses. The borrower bears the losses, either through austerity or bankruptcy. The lenders bear the losses. Some rich relative (in Europe read: Germany) bails out the indebted borrower.

Another option is to just to ignore issues, fudge the numbers, and hope that fortunate events will remedy the problems. Europe has now tried all of the above.

Unfortunately, in each attempt at resolution, as shown by the proposed Cyprus package, the measures have become the problem rather than a solution.

Time to buy gold?...

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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