Cyprus Crisis Likely Won’t Spread, but Has Big Implications

The tiny Mediterranean nation of Cyprus is in suspended animation.  The island whose population of 1.1 million is comprised three-quarters of residents of Greek origin, while the rest are of Turkish heritage (and who fought each other for years) is now the staging ground for the Euro zone’s latest crisis.

Cyprus’s parliament rejected unanimously a plan worked out by the European Union and the International Monetary Fund to recapitalize its deeply insolvent banks by imposing a “tax” on all the banks’ depositors—deposits which are technically insured up to €100,000.

In fact, it was an act of confiscation that had the veneer of progressivity but would undoubtedly have fallen hardest on pensioners and small savers.

Now, as European finance ministers offered €10 billion and not a euro more to bail out the failing banks, the Cypriot government needs to raise maybe €7 billion more, somehow. The total package would just about match Cyprus’s GDP.  Banks will be shut until next Tuesday while politicians scramble for some “solution” to a problem that’s, well, too big to solve.

Cyprus has become the Cayman Islands of the Mediterranean. Its lax banking laws have attracted tax dodgers, money launderers and members of the Russian mafia. Assets of the island’s major banks grew to eight times Cyprus’s GDP (US banking assets are about equal to GDP), and foreigners hold nearly half of banking deposits.

But those banks had lots of money invested in Greece, so when bondholders in Greek debt had to take haircuts, it put a huge hole in Cyprus banks’ balance sheets, as the real estate crash in Ireland decimated Irish banks. And just as Ireland made taxpayers foot the bill for rescuing its banks, the EU and IMF tried to make Cypriot depositors carry the freight for saving theirs.

Cyprus's president and other officials celebrate the country's entrance into the Euro zone in 2008. Photo: Flickr/European Commission in Cyprus.

Cyprus’s president and other officials celebrate the country’s entrance into the Euro zone in 2008. Photo: Flickr/European Commission in Cyprus.

Now, as we wait, I have several observations:

  1. I don’t think there’s much chance for contagion here—especially to Spain and Italy—but it sets a bad precedent. It shows once again that Eurocrats are willing to do anything—even if it’s undemocratic and confiscatory—to bail out big banks that made stupid investments.
  2. That may be because European banks did not follow their US counterparts and recapitalize in 2009 using private capital, even though the price here may have been that US banking criminals got away scot-free.
  3. Since Cyprus entered the euro zone in 2008, it—like Greece, Ireland, and Portugal—can’t get out of this crisis in part by devaluing its currency.
  4. German politics is playing a big role here. “Chancellor Angela Merkel does not want concern about actual cash losses to German taxpayers to affect her prospects in September 2013 elections,” wrote the estimable Satyajit Das. “She also does not want the [European Central Bank] to take losses which might trigger the need for Germany to inject additional capital.”

Russia may play a big role as well. Does anyone really expect Vladimir Putin to sit by while his friends and cronies lose billions? That’s why there’s lots of talk about Russia possibly lending money to Cypriot banks as part of a rescue package.

But that might come at a steep price—drilling rights in Cyprus’s offshore gas fields and maybe even a base or access to a port on the Mediterranean, to replace the one Russia’s likely to lose in Syria.

Would the US, the EU or NATO allow that? Probably not. But it shows that as the Euro zone’s debt problems take new and hybrid forms, its impact has spread well beyond banks’ balance sheets and finance ministers’ palaver into the real world.

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