Cyprus, Russia and the Future of the Euro Zone

2013-04-01 by Dr. Harald Malmgren

The Troika (EU Commission, ECB, and IMF) enthusiastically declared “success” in the late March bailout of Cyprus banks.

Early this year European finance ministers grew increasingly worried that Cyprus banks would default. The total assets of these banks stood at 7 to8 times the total GDP of Cyprus, threatening collapse of the government as well as the economy. One concern of the Troika was that Cyprus might become the first Eurozone nation to exit the Euro, renewing market fears of a chain reaction collapse of confidence in banks across Europe.

But preventing cracks in the Euro was not the only worry.

Politicians were aware that the huge size of Cyprus banks relative to GDP was that they had become a tax haven for citizens of other European nations and in particular the primary parking place for Russian “black money.”

How could political leaders in the rest of Europe explain to their voters that taxpayer money might have to be used to bail out tax evaders and alleged mafia wealth? 

The political challenge was to find a way to impose large losses on “foreign” depositors, greedy Cypriot bankers and a government that had long tolerated, and even encouraged, black money to find a home in Cyprus.

If Cyprus continues to falter and the deposit base weakens, economic and financial implosion may ultimately result in exit from the Euro. In that event, Russia would likely step in to, in effect, acquire Cyprus. Credit Image: Bigstock

The Troika decided that Eurozone aid to Cypriot banks would not be politically tolerable, and that losses must be imposed not only on investors but also on depositors, because more than half the assets of these banks were “foreign” deposits (i.e. tax haven and black money from Russia and elsewhere).

A “lesson” had to be taught in the form of harsh treatment of the banking system.

The initial agreement negotiated between the Troika and the Cypriot government was that all depositors must take losses, with smaller depositors taking a smaller hit and larger depositors a relatively larger hit. This action would be a breach of the widely recognized Eurozone principle that depositors should be protected, or at the very least depositors under €100,000 should be exempted from any confiscatory action.

The Cypriot parliament promptly rejected the initial agreement and opened talks with the Russian leadership for possible aid. Moscow angrily refused to help, and the negotiators had to go back to the idea that only “large” depositors would take a hit, exact size to be determined.

During deliberations between the Troika and Cypriot officials, the banks were closed and only nominal withdrawals permitted. The bank closure lasted almost two weeks, and both the Troika and Cyprus government politicians thought that the “foreign” deposits had been captured. Unfortunately, branches and subsidiaries of Cyprus banks in London and Moscow remained operational. Throughout February the “foreigners” had already been making withdrawals in expectation of a crisis and during the bank closure in March, large withdrawals continued through these banking channels outside Cyprus.

The Troika-Cyprus agreement involved a breakup of large banking into a “good bank” and a “bad bank”, with depositors and investors in the bad bank taking a substantial hit, the percentage unknown until an audit of what had not escaped from Cyprus was determined. To execute this agreement, and help to prevent an uncontrolled mass exodus of deposits, it was agreed that capital controls would have to be imposed, with explicit provision for conduct of “legitimate business.” This “nationalization” of the major segments of the Cyprus banking system was carried out administratively, avoiding another parliamentary vote.

Once agreement had been reached, the new chairman of the Eurogroup Finance Ministers, Jergen Dijsselbloem of the Netherlands, proclaimed that this solution provided a template for other Eurozone bank failures in the future. 

From now on, investors and depositors should take primary responsibility for restructuring in the event of bank failure.

By the end of March the banks were reopened, and markets throughout the world seemed to shrug off what had taken place. Last year markets had become complacent that the Eurozone banking crisis had been resolved by the pledge of ECB President Draghi that the ECB “would do whatever it takes to save the Euro.”

We warned in January that the Eurozone financial marketplace was still faltering, with continuing Spanish reluctance to yield sovereignty to Eurocrats in Brussels and Frankfurt in exchange for Troika aid, election of a hung parliament in Italy, deterioration in France’s budget and its national economy, growing scale of Greek borrowing needs and imminent threat to Cyprus banking.

Markets should take note of a number of lessons implicit in the March, 2013 resolution of the Cyprus bank crisis:

The first lesson is that the German, Dutch, Austrian, and Finnish governments wanted harsh treatment of the “foreign” bank shelter, and were eager to impose losses on depositors, or at least on these “foreigners.”

This motivation was particularly strong in Germany, where national elections would be held in September, and voters showed increasing unhappiness with bailouts of their neighbors, with underlying sharp criticism of Russian “black money” as the source of excesses in Cyprus banking.

Last year political leaders had agreed in principle that the banking system of the Eurozone had to be unified under a common regulatory framework with common resources made available to shore up troubled banks. That agreement was eroded by German objections to inclusion of all banks, rather than only the “biggest” banks, and objections to using taxpayer money to bail out banks directly.

Instead, with the Germans in the lead, it was agreed that such governments would have to accept Eurogroup oversight in exchange for aid to them to assist their own banks, in essence yielding sovereignty to non-elected Eurocrats in Brussels, Frankfurt and possibly other Continental cities. 

Thus, for the foreseeable future, bank crises in the Eurozone look likely to have negative impact on all bank stakeholders, including at least large depositors. For foreign corporations and investors, the lesson is that only an absolute minimum of deposits to manage daily transactions should be held in Eurozone banks.

Deposits are no longer safe from emergency confiscation.

This lesson should be reviewed by U.S. money market funds (MMFs) which had pulled back from holding Eurozone bank paper but in 2012 had begun again to increase exposure to higher yielding Eurozone short-term debt.

The second lesson is that the IMF had agreed that losses should be imposed on depositors, especially the “foreigners.” The IMF is subject to US Treasury acquiescence, so IMF approval of hitting depositors implies that the US Treasury did not object to the principle of confiscating deposits.

Probably no one in the present U.S. Treasury gave much thought to the consequences of permitting breach of protection of depositors, but the principle having been breached, the idea of hitting at least some depositors in banks could be applicable to non-Eurozone countries as well – including the U.S. itself.

Can banking really function well if the sanctity of deposits is even slightly impaired? 

The third lesson is that capital controls can be permitted within the Eurozone.

This means that a Cyprus-issued Euro (with identifiable serial numbers on bank notes) is not equivalent to Euros elsewhere in Europe, as it is essentially not negotiable outside the capital controls of Cyprus.

In effect, there is a differentiated Cyprus Euro, which the market may price differently than a non-Cyprus Euro so long as capital controls continue.

The question then arises: how long will capital controls be viable, or will collapse of Cyprus financial services for foreign investors and foreign tourists bring about collapse of the economy and exit from the Euro? 

A fourth lesson seems to be that the ECB’s promise to do “whatever it takes” includes stealing deposits, but does not yet seem to have any other meaning inasmuch as it is still unable to prop up the Eurozone banks, except for support of relatively short-term liquidity needs.

Is this sufficient reason to instill confidence in sovereign debt issuance of Eurozone government? 

Doubts seem already to be resurfacing as yields are once again dilating against Bunds for the debt of a number of Eurozone member governments.

Yet another lesson is that the number of troubled banks is likely to grow, as recession and fiscal austerity gradually drain away the strength of banks in additional countries, including even France. It appears that a vigorous battle erupted in Paris in recent weeks over the German-dominated “rescue” of Cyprus. The Germans did not consult the French about German objectives in the Cyprus “rescue.”

Politicians, bankers, and experienced bureaucrats were at war with one another over the potential negative consequences for French banks if the Cyprus formula was to prevail, and a Eurozone bank union and deposit guarantee system was postponed well into the future (as is likely). 

As for the Troika itself, its credibility is being dramatically eroded as improvised rescues in the Eurozone continue to deteriorate while recession and growing capital requirements eat away at assets of Eurozone banks as assets are sold off and loans increasingly restricted.

The IMF will soon find itself facing internal controversy over its implicit involvement in the politics of Germany and Eurozone economic and regulatory dynamics. 

As for the angry Russian response to the Troika-Cyprus accord, it should be kept in mind that many influential Russians, possibly including some officials in the present government, have had significant interests in Cyprus. Moreover, Russia is at risk of losing its influence in Syria, and potentially with it the use of a Russian naval base in that country.

Most likely Russian leadership would have preferred a Cyprus exit from the Euro, in which case Russia would have likely stood ready to assist Cyprus and its own Russian interests, including its interests in gas exploration in neighboring waters, and the potential for an alternative naval base in Cyprus which is so close to Syria.

If Cyprus continues to falter and the deposit base weakens, economic and financial implosion may ultimately result in exit from the Euro.

In that event, Russia would likely step in to “acquire” Cyprus.

"If everyone is thinking alike, someone isn’t thinking."

—General George Patton Jr.

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