Saturday 23 March 2013

Destroying Cyprus to Save It

German Chancellor Angela Merkel said, “Right now the banking sector isn’t sustainable and has come under enormous difficulties because of its business model. It’s our obligation, if we want to provide ESM assistance, that we make sure there is a permanent solution.” Photographer: Johannes Eisele/AFP/Getty Images (c) Bloomberg BusinessWeek

The Eurozone insistence on a Cyprus bank deposit confiscation has almost nothing to do with a desire to “save” Cyprus, and everything to do with its destruction.

The surprise plan forced through on Saturday, 16 March called for a 6.75% "levy" on deposits up to EUR 100,000, and 9.99% on deposits over EUR 100,000. Although part of this “levy”, which is more appropriately called a confiscation, would have been offset by the issue of bank bonds, the Eurozone finance ministers departed from all previous best practise and EU law.

Specifically nearly all bank recapitalisations and restructurings protect depositors and impose losses on bondholders. Moreover, deposits up to EUR 100,000 in the EU are insured to their full value. No losses on bondholders were proposed, although these would not have been sufficient in any case. And the Eurozone tried to twist reality, explaining that this was a “levy”, or tax, on deposits, not an outright confiscation.

But at the heart of the issue is a dramatic refusal by the Eurozone finance ministers to understand basic financial reality. By embarking on this step, they dramatically undermine faith in the European banking system. Although they claim that this is a “unique instance” (the same term used for the Greek government bond haircuts), it is only a question of time before the hyper-indebted governments of Spain, Italy, Belgium and perhaps France follow suit.

The Eurozone has had over a year to prepare for this crisis, but sprang the idea of a levy at the last minute as a fait accompli. This is where I am led to believe that there is both a deep misunderstanding of modern finance, as well as a deliberate intent to “make an example” of a small country. 

This latter attempt was already tried in Greece, but apparently there is no satisfying the appetite of the German political class for “making examples” of hapless countries, particularly if they are smaller ones.

How do I come to this conclusion? Through a very simple assessment of the public statements of German officials, which have changed so many times in the last week.

The Russian Money Laundering Thesis

The German position building up over the past year is that Cyprus is a haven for Russian money laundering. WolfgangSchauble led the offensive as quoted by Bloomberg:

“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,” Schaeuble said today on Germany’s ARD television 2+Leif program. “You may ask why Cyprus is the second-largest foreign investor in Russia and we need clear answers to that.”

In fact, transactions between Russia and Cyprus are governed by a double tax treaty, which together with the English-language business culture, Cyprus' 10% tax for non-resident companies, and the ease of registering and operating companies has made Cyprus an attractive location for Russian companies.

Cyprus is regulated by European law and by the OECD’s Financial Action Task Force (FATF), and cooperates fully with the EU MONEYVAL. The latest MONEYVALevaluation report can be seen here.

So the first logical fallacy is that Cyprus must be punished for a crime it hasn’t committed: being an attractive location for Russian investments.

Let’s assume that this “crime” is true: that Cyprus is a hub of Russian money laundering. What is the solution? Is the solution to destroy the country’s banking system, which is what the current Eurozone solution is doing?

Or is the solution to tighten EU rules on money laundering, pricing transfers and tax avoidance schemes, affecting not only Cyprus, but jurisdictions such as The Netherlands, Luxembourg, Lichtenstein, London, Jersey, Guernsey, Ireland, Isle of Man, Malta and others?

Germany certainly tried to destroy the Irish economic model as well: it failed. But in Cyprus, a country of just 860,000 residents, was “non-systemically relevant”, and had no choice.

Holy German Money and Evil Russian Depositors

This fallacy of economic destruction to avoid money-laundering was actually launched by the SPD. The SPD is in the middle of a failing election campaign, and is casting about for any straw with which to beat Angela Merkel’s CDU. AsSpiegel reports, the SPD specifically linked a Cyprus bailout to “illegalRussian money”:

Germany's opposition, center-left Social Democratic Party says it will only accept a rescue package for Cyprus if certain conditions are met. "Before the SPD can approve loan assistance for Cyprus the country's business model must be addressed," SPD lawmaker Carsten Schneider told SPIEGEL. "We can't use German taxpayers' money to guarantee deposits of illegal Russian money in Cypriot banks."

As seen here, the fallacy is alive and well: All Russian money in Cyprus is illegal. Therefore, German taxpayer money will not be used to bail-out Cypriot banks.

Here I have to ask some simple questions:

a.  Did the SPD conduct an audit of depositors in Greek, Irish, Spanish or Portuguese banks before agreeing to their bailouts?

b.  When the European Central Bank extended EUR 1.1 trillion in lost-cost loans to European banks under LTRO, did it differentiate between banks with Russian deposits and those without?

c.  When US multinationals such as Google, Yahoo and Starbucks use a “Dutchsandwich” to avoid billions of dollars in EU taxes, did the SPD investigate whether these companies should operate in Germany or anywhere else in the EU? 

The answer to these three questions is, of course, a resounding “no”. The SPD is making a pathetic election year issue out of Cyprus. And the fact that Cyprus is the EU’s third-smallest country, while Germany is the largest, is decisive.

The Banks are too Large – They Must be Destroyed for their Own Good

Following the Cyprus Parliament’s rejection of the first Eurozone “offer”, German comments about the deposit confiscation changed. Realising that they had over-reached in forcing a deposit confiscation, they attempted to cast the confiscationas being in the best interests of the Cypriot banking system:

"Cyprus has a banking sector that is way too big and they are insolvent with that model and no one outside of Cyprus is at fault for that," Schaeuble said. "This business model is not sustainable, there is no alternative."

This is one of the greatest fallacies of all, and flies in the face of established EU law and international banking practise. The EU has adopted the Basle II and III banking regulation and capital requirements. Basel II and III regulations, which make detailed provisions for the ratio of bank core capital to deposits and loans.

But nowhere is there a requirement, or even a definition, that a country’s banking sector must shrink to a certain proportion of GDP. This is confirmed both by the absence of any such indicator in EU or international law or standards. It is also confirmed by the fact that no such condition was raised in the Irish or Spanish bail-outs.

It is, as with so many other decisions, a statement tossed out with the air of authority, which unfortunately no one has challenged, and which bears no relation to legal or financial reality.

The Myth of Debt Sustainability

"But investors above 100,000 euros should make a contribution to the Cypriot banking landscape being stabilized," Merkel said, stressing that she still believes "the banking sector must make a contribution to Cypriot debt being sustainable." "Cyprus is our partner in the euro area and so we are obliged to find a solution together," Merkel said.

If debt sustainability in Cyprus is the key, then Germany should have recommended three alternative solutions to dealing with the bank component of the bail-out:

a.  Creating a state-owned “bad bank” and transferring non-performing loans from Bank of Cyprus and Laiki to this bank. This would remove at least EUR 4-8 billion from the loan books of these two banks, and made their recapitalization and restructuring easier.

b.  Force the divestment, over time, of the international banking network of BOC/Laiki, particularly loss-making Greek, Russian and Ukrainian operations.

c.  Use the European Stability Mechanism funds to lend directly to banks, avoiding the sovereign. This solution is not yet technically ready, but the two banks could have maintained operations under an ECB ELA-funded restructuring until ESM is fully ready.

But there was no attempt to do so. In fact, the hysteria over the Eurogroup’s decision was reinforced by the typically veiled threats that Cyprus would collapse and leave the Euro, and by the ECB’sunnecessary decision to stop ELA assistance to BOC and Laiki by Monday.

Cyprus is Immoral

And finally, we come to the same statement deployed against Greece: Cyprus deserves to fail, because it is immoral. This was couched in different terms by Wolfgang Schauble on March 19th:

"Whoever deposits their money in a country because it will be taxed less and controlled less runs a risks when the banks in these countries are no longer solvent. That is what happened in Iceland and in Ireland some years ago. European taxpayers should not be made responsible for this risk," said Schaeuble.

This viewpoint ignores a number of specific issues in Cyprus:

a.  The 2011 Mari explosion damagedCypriot energy generation and cost at least EUR 1 billion (in an economy of EUR 17 billion)

b.  BOC and Laiki suffered write-downs of EUR 4 billion on the Greek government bond PSI, with further losses from non-performing loans in Greece and Cyprus. This has nothing to do with Russian deposits or the “size of the banking sector”.

c.  When Cyprus participated in the bail-outs of Greece, Ireland, Portugal and Spain, Germany was happy to make Cypriot taxpayers responsible for these risks. Only now has Germany turned against a country that is “taxed less and controlled less.”

d.  There has been absolutely no agreement on what “taxed less” means: The Netherlands has a much lower effective tax rate on international transfer pricing transactions than Cyprus does. And if the issue is “controlled less”, then there are obviously other solutions for this.


Looking back at this extraordinary week, the most charitable thing one could say is that the European Union’s crisis management and decision-making function is perhaps permanently dysfunctional. But this is obviously not enough.

I find it difficult to understand how a relatively simple EUR 17.5 billion sovereign and bank bailout can be so badly managed, particularly by Germany.

The undercurrent of hysteria, logical fallacy, finger-pointing and false morality one sees resurface time and time again among German political leadership and press is not a harbinger of good times in the present or the future.

The sight of a country with 82 million inhabitants and a EUR 2.6 trillion GDP ganging up so obviously on Cyprus, a country of 860,000 and a EUR 18 billion GDP, is deeply unedifying.

The constant and escalating stream of threats, deliberate misstatements, and omissions from Wolfgang Schauble, Angela Merkel and others is deeply worrying.

The refusal to consider a rational bank recap and restructuring over a period of 3-5 years, and to provide a calm framework for negotiations without false deadlines and threats, is inconceivable, particularly if one compares this to how Germany’sgovernment has treated German bank recapitalisations.

The fact that the German Parliament has to approve the Cypriot bail-out makes this bail-out, and any other one, prey to the lowest political instinct of the German political class and its accompanying yellow press. It’s something we have seen before in the case of Greece, but it’s surprising that nothing has changed.

Absent in this debate is the fact that ESM/EFSF resources and capital exist: no new capital raising is required, and that Germany is not the only contributor to ESM/EFSF. Ironically, Cyprus is a contributor.

Even more worrying is the fact that there was not a single report of a dissenting voice at the Eurozone summit which led to the insane bank deposit confiscation in the first place.

Do any of these “finance ministers” understand the basics of finance?

What will Europe do when confronted by a real crisis, not a EUR 17.5 billion rounding error?

How many rule-books will they destroy? How many foreign investors and key suppliers like Russia will they offend and alienate? How many more Eurozone banks will they destroy?


I believe the following scenario will unfold over this weekend and next week:

a.  Cyprus will accept a face-saving “levy”, which will be 0-1% tax for deposits on EUR 20,000, 5-6% for deposits up to EUR 100,000, and 12-15% on deposits over EUR 100,000. This will allow the Eurogroup and Cyprus the false satisfaction of having reached a compromise.

b.  Capital flight will commence in Cyprus immediately. Russia multinationals such as ITERA, Nikoil, Gazprom, Mecel, Rosneft, Sintez and others will lift their deposits as soon as they are able, most likely to London and Switzerland, avoiding the Eurozone. Cypriot and British depositors will follow suit.

c.  Cyprus will have to introduce capital controls to avoid deposit flight – thus worsening the need for Cypriot bank recapitalization that the Eurozone’s “solution” purported to avoid. A second Cypriot bank recap will be needed.

d.  The Cypriot GDP will fall, probably by 5-6%, and unemployment will rise to 15-18% by the end of 2013, with a negative track going into 2014. Cyprus will be in for a 3-4 year depression, the end of which will only be signaled by hydrocarbon investment. Cypriot emmigration follows. 

e.  The Cypriot project to develop hydrocarbons will also be set back. On the one hand, the Cyprus credit rating will mean years of higher interest rates and a lack of capital availability. On the other hand, Russia will withdraw its political and economic cover. On the other hand, it is clear that rather than being the vaunted engine of geopolitical and economic stability the European Union claims, it is actually an engine of destruction in the case of Cyprus.  This means that Cyprus will meet renewed Turkish hostility and interference, quite beyond its illegal occupation of northern Cyprus.

I sincerely doubt we have heard the last of deposit confiscation. Italy, France, Spain and Belgium are mismanaging their national budgets and will likely follow the Cypriot example at some point in the future. Having taxed financial transactions, the inevitable next step is to tax savings, rather than “only” the interest on savings.

The democratic deficit within the European Union has been clearly indicated beyond a shadow of a doubt, as has the role of Germany and its satellite countries. I expect these tendencies of continue in the future, to the detriment of the people of a continent that are daily confronted with declining economic competitiveness, adverse demographics, absurd taxation, an anti-entrepreneurial culture and cut-throat international competition.

Once can only wonder what Europe will do in the face of a real crisis.

© Philip Ammerman, 2013

1 comment:

  1. Thanks Philip for a particularly well reasoned article on the Cyprus crisis.

    P.S. I'm assuming you're somehow related to "Chip" Ammerman. Right?