By William Debost. Originally published on 2013/01/28

The euro crisis has taken the form of a succession of national crises threatening the integrity of the monetary union. The response, each time, involves heads of European states meeting in Brussels or Berlin to agree on a rescue plan and hesitantly approving the necessary improvements in European governance. After Ireland, Portugal, Spain and Greece, does it even matter who’s next on the cliff’s edge?

It turns out the latest focal point in the currency area is not your run-of-the-mill European debt crisis, and involves one of the EU’s smallest members: Cyprus.

In addition to being a stunning mediterranean island, Cyprus, which joined the EU in 2004 and adopted the euro in 2008, has long been a political intrigue. Its contemporary history has been dominated by the struggle for sovereignty between Greek and Turkish Cypriots, the former having established de jure control over the island since the 1970s.

Today, against all odds, it finds itself in the spotlight of global financial news. On June 25, 2012 it became the fifth euro zone country to request an emergency bailout. Like Ireland and Spain before it, the Cypriot government faces the task of recapitalizing a collapsing financial sector. Indeed, Cypriot banks were heavily exposed to the Greek economy and held vast amounts of Greek government bonds, which were restructured last year as part of Greece’s own rescue plan. A nice, clean domino effect.

The Cypriot bailout negotiations have been dragging along ever since – surprised?

The government requires €17 billion, 10 of which would have to be injected into the country’s banks. This is a negligible amount when compared to the €500 billion European Stability Mechanism, not to mention the Euro Zone’s €10 trillion worth of annual output. However, considering that Cyprus’ GDP amounts to nearly €18 billion, this could be one of the largest bank recapitalization bills in history, relative to GDP, thus threatening to place the government in a debt overhang.

The central question in the current negotiations is over who will pay the bill: the banks’ depositors, government bondholders, or European taxpayers?

So far so good. A classic European sovereign debt crisis. But there’s more to the story.

A major obstacle in the negotiations is an ideological one. Brussels (not to say Berlin) and Nicosia aren’t on the same page when it comes to structural reforms and privatizations, which would help alleviate Cyprus’ impending deficit. It just so happens that Cyprus’ president, Dimitris Christofias, is the first and only communist leader in the European Union. A final agreement is to be reached only after the presidential election on February 17, in which Mr Christofias is not seeking re-election and will most likely be replaced by the center-right candidate.

The next complicating factor is Cyprus’ odd ties with Russia, where comrade Christofias studied in the early 1970s. In addition to receiving a low-interest loan from Russia last year, Cyprus is a well-known tax haven, in particular for Russians who reportedly hold one fifth of total bank deposits on the island.

This has serious political implications: a European-funded bailout would essentially cover the losses for Russian billionaires, a situation that European citizens and their politicians may feel somewhat uncomfortable with. In fact, the German foreign intelligence service has investigated the case and reported that the main beneficiaries of European taxpayer money would be “Russian oligarchs, businessmen and mafiosi who have invested their illegal money in Cyprus.” Germany itself is in the early stages of an election campaign – add to the “complicating factors” list – and Angela Merkel faces great political costs if she is too soft on Cyprus.

On the other hand, placing part of the burden on depositors would of course hurt ordinary Cypriot citizens as well as the Russian-held portfolios, many of which are disguised as domestic investments. In foresight it seems fair that investors who piled their money in Cyprus to escape taxes should bear part of the cost of Cyprus’ bailout. Yet targeting depositors could create a dangerous precedent and cause a bank run (with potential spillover effects) as well as a strong reaction from Moscow, turning a financial crisis into a geopolitical one.

Meeting between the European Parliament Conference of Presidents and the incoming Cypriot Presidency of the council of Ministers in Cyprus

What are the alternatives? Restructuring Cypriot government debt through haircuts would break the EU’s pledge that Greece was a unique case, and the risk of a bond market contagion would resurface. Moreover, more than half of the government bonds outstanding are held by Cypriot banks, which would merely add to the bailout tab. In addition, Cypriot bonds are governed by English law, which protects investors in such cases.

Another possibility would be to impose haircuts on bank creditors (“bailing-in” the banks). However, as an article from the Peterson Institute of International Economics points out, bonds represent only 1 percent of Cypriot bank liabilities (€1.8 billion), not to mention that many are held domestically.

What options remain? As the PIIE article suggests, the solution will have to be acceptable to the euro area, Germany, and Russia, and will most likely combine various restructuring schemes with the usual set of IMF-imposed structural reforms. The Irish bailout involved contributions from non-eurozone countries that had large stakes in the Irish financial system. Such a plan could be replicated in Cyprus, with Russia providing direct contributions to alleviate the size of a Troika bailout. The risk here is giving Russia too great a say. This would damage the eurozone’s ability to enforce its legislation within its own borders.

The amounts in question are so small in absolute terms that there should be no doubt as to whether an agreement will be reached. Any talk of a Cypriot exit from the euro is nonsense. Moreover, Cyprus is endowed with positive growth prospects.

Still, if European taxpayers are involved in the rescue plan, as they probably will be, the least Brussels should do is bring Cyprus to comply with the EU’s tax legislation and to revisit its business model. In what appears to be the most politically complex bailout package since the beginning of the euro crisis, one should hope that Brussels comes up with a bold, decisive plan. If not, the dominoes will fall and more embarrassing national crises will be on their way.

Dis­claimer: This art­icle was ori­gin­ally pub­lished as ”Of German Spies, Russian Mafiosis and a Debt Crisis“ on January 21, 2012 on The Polit­ical Bouil­lon, EST cooper­a­tion partner.

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