Fisher Investments Editorial Staff
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Cyprus Bailout Blues

By, 03/19/2013

A team of European surveyors in Cyprus, circa 1878. These days, official European visitors likely get a frostier welcome. (Photo by Topical Press Agency/Hulton Archive/Getty Images.)

Until now, eurozone bailouts have spared bank depositors. Banks’ and governments’ private-sector investors have taken losses, but savings have been sacrosanct.

Saturday morning, that may have changed. The EU/IMF/ECB “troika” and Cyprus’s government agreed to a €16 billion rescue package—€10 billion from the ESM, and nearly €6 billion from a one-time tax on Cypriot bank deposits. While Cyprus is likely too small to have much lasting global impact, the move is effectively a seizure of private wealth—in our view, a terrible idea.

Officially, the tax is a swap. Depositors will pay 6.75% on deposits up to €100,000 and 9.9% on accounts above that threshold and receive the equivalent amount in bank-issued bonds backed by state-owned natural gas reserves. Problem is, those reserves are undeveloped and unproven. They may not generate revenue for years, if ever. So savers must trade up to 10% of their money—which they’d probably assumed was parked risk-free—for risky assets. (It’s also swapping liquid for illiquid.) That’s a dangerous precedent for private property rights. It also tests EU law, which guarantees bank deposits up to €100,000.

Another problem: The tax all very likely drives a run on Cypriot banks (tax something, and you get less of it). Cyprus called a temporary bank holiday (as we write, banks are closed till Thursday), but customers have reportedly drained ATMs, and once banks open, expect deposit flight to intensify. Banks may have to tap capital reserves, exacerbating their problems and, potentially, requiring more bailout cash.

So why would the troika do this?

In their view, Cyprus is different than the PIIGS. With its favorable tax regime and light regulations, it’s a safe haven for foreign money. About 40% (€27 billion) of Cyprus’s €68 billion in bank deposits is foreign, and Russian authorities say €15 billion is Russian (analysts believe the true figure is higher). Most assume that includes a hefty chunk of laundered money. In Germany (where Chancellor Angela Merkel soon faces re-election) and other core eurozone nations, using taxpayer money to (in their mind) guarantee ill-gotten Russian money would be politically untenable. Hence the tax, to make alleged Russian criminals pay their fair share.

But that assumption isn’t proven. Yes, some Russian deposits may be ill-gotten. But they could also be legitimate. Many Russians likely lack faith in their financial system—in Russia, corruption reigns, the rule of law is weak and private assets are vulnerable. Cyprus is geographically close, tax-friendly and has a strong rule of law backed by EU treaties, making it a logical place to deposit savings. Plus, not all foreign money is Russian—about €2 billion is British, mostly belonging to folks who retired in Cyprus’s sunny climate. They don’t fancy paying for their banks’ Greek debt writedowns (the root cause of Cyprus’s banking crisis).

Thankfully, this plan isn’t yet set in stone. Cyprus’s parliament must approve it, and the ruling party has a one-seat majority, making easy passage seem unlikely—especially with citizens protesting en masse. President Nicos Anastasiades—elected on February 24 after vowing depositors wouldn’t fund a bailout—has delayed the vote till Tuesday afternoon and, in the meantime, reopened troika negotiations. But the troika isn’t bending yet: In a late-Monday conference call, eurozone finance ministers agreed only to a new version with “more progressivity.” However, if the global outrage to what many see as an abhorrent violation of private property rights continues, officials have more incentive to consider alternate approaches.

In our view, that’s the more desirable outcome. Beyond its assault on private property rights, the tax has myriad consequences. It deters foreign capital from Cyprus, potentially hollowing out the banking sector and robbing the economy of a key input. This could hinder Cyprus’s growth for decades. It also calls into question deposit safety in other member-states. Spain’s bank rescue has thus far spared depositors, but if Cyprus’s tax goes through, savers could flee just in case. Ditto for Portugal, where fears of a second bailout persist. And Italy, still mired in political uncertainty.

The tax also fuels anti-euro sentiment. It’s easy to envision Beppe Grillo, leader of Italy’s anti-establishment Five Star Movement (FSM), rallying Italian voters with fears of the troika stealing their hard-earned money. This could increase FSM’s presence in Parliament if Italy holds another election—not what eurozone officials want. And it likely fuels euroskepticism in potential eurozone members like Latvia—which just applied for membership—and Lithuania. They might think twice about adopting the currency. It could even deter prospective EU nations like Macedonia, Albania and Turkey (EU treaties require all members except UK and Denmark to adopt the euro). That would call the long-term viability of EU officials’ “European project” into question—the opposite of their aim to strengthen the union.

Looking ahead, it’s unclear how this saga plays out, and markets could very well remain volatile as things unfold. Cyprus could even vote to reject the bailout and leave the eurozone, which would likely prompt some market jitters. But breaking that taboo likely won’t break the eurozone. Several leaks from Brussels suggest officials have already come to terms with Cyprus’s possible departure. In fact, if they believed keeping Cyprus in the fold was essential, they’d likely have offered much more favorable terms. 

And financially, the global fallout from a Cypriot exit and bankruptcy seems limited. Counterparty risk appears small, and eurozone backstops should help any banks with Cypriot exposure. While Cyprus itself would feel the pain of default for some time, its economy is a tiny €18 billion—0.5% of eurozone GDP and 0.1% of global GDP. Growth elsewhere would likely easily offset the global economic impact. (And with private property rights upheld, Cyprus might remain attractive to foreign investors over time, perhaps aiding its recovery.)

Cyprus absolutely bears watching, and the outcome may prove a landmark for eurozone law. But for now, Cyprus’s situation doesn’t seem likely to raise the risk of the currency union’s disorderly collapse.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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