Cyprus Bailout: An Anomaly or a Sign of a New Polarized EU?
Cyprus Bailout: An Anomaly or a Sign of a New Polarized EU?

For twelve days in March, banks in Cyprus were closed for business. Tough capital controls meant that people, companies, and governments were unable to make deposits or remove funds from their accounts during this period. Ordinary Cypriots worried about buying gas for their cars, paying tuition bills for their school-age children, and just making ends meet.  These controls were partially lifted on March 28th, allowing customers to remove €300 per day. While life returned to a somewhat normal state, much had changed for this little island nation.

On April 3rd, the International Monetary Fund (IMF), European Central Bank (ECB), and the European Commission signed a Memorandum of Understanding (MOU) with the Cypriot government. These International Financial Institutions (IFIs) provided a $13 billion (€10 billion Euros) bailout package in return for the reform of public administration, pension system, and healthcare system.  The IFIs also wanted labor market privatization and the freezing of wages of Parliamentarians. Furthermore,  only the the Cypriot President and Speaker of the House would be allowed to fly business class (Trotman, 2013).

In addition, all bank debt and savings more than €100,000, which were held at Cyprus Popular Bank, the second largest bank in the country, would be dumped into a “bad” bank.  Savings accounts under €100,000 and most of the bank’s assets would be transferred to the Bank of Cyprus (Kremer, 2013). Bank accounts over €100,000 housed in Cyprus Popular Bank and the Bank of Cyprus willl also face a “haircut” (removal of funds by the government for debt repayment).  The final rate will be decided in September (Psyllides, 2013). Currently, all Cypriots are unable to cash checks and face caps of €25,000 for bank transactions (The resignation of Michalis Sarris may be only the beginning, 2013).

The first payments are expected in May, though the MOU must first be passed by the legislatures in 16 Eurozone countries. Cyprus will not even have the funds though to cover April salaries of its civil servants and pension payments. The country has a cash deficit of €160 million and is grasping for other lenders to help alleviate the situation (Roland, 2013).

Moscow graciously agreed to ease the terms of a €2.5 billion loan made in 2011 by reducing the interest rates on the loan (Roland, 2013). Changing the terms will cost the Russian government a ten percent loss on the loan, in addition to an estimated $31 billion loss facing Russian business and political leaders with offshore accounts in Cyprus (Russia to restructure €2.5bn loan to Cyprus, 2013). Some analysts believe that Russia might ultimately gain from this debacle as Russians might start removing funds from offshore account in Cyprus and return the funds to banks in Russia.

This news analysis examines the political, economic, and cultural factors that led to the collapse of the Cypriot banking system and potential solutions to help Cyprus recover from this ordeal.

Why did Cyprus’s Banking System Collapse?

In 2013, Cyprus’s finance sector accounted for 45 percent of the country’s GDP. Many factors over the past 40 years have led to the collapse of Cyprus’s banking system.

David Gardner of the Financial Times (2013) links the banking crisis to Cyprus’s early economic policy that created a low-tax, high-return, and lightly regulated banking center with ancillary services in auditing and law. Cyprus’s decision to focus on banking stemmed from the disintegration of Lebanon, Yugoslavia, and the Soviet Union. Beirut, Lebanon was the financial services capital in the Middle East until Lebanon’s civil war, which ended in 1990. When Lebanon was not safe, investors put their funds in Cyprus in instead. Cyprus also benefited from Yugoslavia’s break-up by providing a tax haven for former President Milosevic. Finally, Cyprus became a banking destination for Russians elites who did not want to leave their funds in Russian banks because of the political and economic uncertainty under Putin.

Others believe the banking crisis stems from culture clashes among Europeans, Greek Cypriots and Russians.  As noted by E. Wayne Merry, Senior Fellow for Europe and Eurasia at the American Foreign Policy Council in Washington, DC (2013):

The underlying problem was that Europe had accepted a non-European entity (Cyprus) into its institutions and then failed to enforce upon it Europe’s standards of financial governance. Russian money became fuel for the catastrophe, but was not itself the cause. Money laundering and bank insolvency are both deplorable but are not the same thing.

Merry agrees with Gardner theory that Beirut’s dissolution as a financial capital was a pivotal historical event that helped Cyprus become a banking-based economy. He also points out the role that Cyprus played in laundering and housing Russian government funds and, later, funds from the oligarchs. These were not the main causes of the collapse of the banking system, but these factors magnified the impact. He concluded:

But on Cyprus, financial insolvency resulted from irresponsible investment decisions by major banks (Laiki to the fore), the downgrading of Greek sovereign debt, plus systemic failures of financial governance in Nicosia and by Brussels/Frankfurt. The Russian and other foreign money scaled up the problem, but Greek Cypriot bankers and authorities caused it. (Wayne, 2013)

Russian-owned banks, such as VTB, are not at risk because Russian bank holders are able to get financial support from the Russian state-owned bank, VEB (Inozemtsev, 2013). Cyprus Popular Bank, on the other hand, is being liquidated to the Bank of Cyprus.

Cyprus Popular Bank was responsible for most of the illegal laundering in the country. The culture of Cyprus Popular Bank changed in 2006 when it was taken over by a Greek company, Marfin Investment Group (MIG). MIG took a conservative bank and began investing aggressively, including a failed €700 million loan to a Greek shipping company (Kremer, 2013). These murky loans were accompanied by large company removals of funds in the days leading to the agreement, as well as loan-write-offs by prominent politicians (Kremer, 2013). In June 2012, the government of Cyprus took an 84 percent stake in the bank and was unable to stem the bank’s collapse (Kremer, 2013).

Where can Cyprus Go from Here?

Most analysts point to two possible paths for Cyprus: leaving the European Union or staying in the Union and carrying out the terms of the MOU. Nicos Anastasiades, Cyprus’s President and Cyprus’s new finance minister both declared that the country will not abandon the Euro.

If Cyprus keeps the Euro it and implements austerity measures and the called-for banking reforms, its economy may contract 13 percent or even more in 2013 (Chan, 2013). The country will be able to raise funds from increased corporate tax rates (from 10 percent to 12.5 percent). Also positive, the deal allows Cyprus to retain control of valuable offshore deposits of natural gas. The jobs of contract teachers and 500 civil servants were saved as well. Furthermore, dividends will not be taxed either (Kanter, 2013). These are small consolations though to many Cypriots.

The Communist Party, currently in the opposition, favors abandoning the Euro for the Cypriot pound. In a New York Times article (2013), Hugh Dixon outlines the potential consequences of Cyprus’s exit from the Euro.  If Cyprus abandoned the Euro there would be increased inflation, decreased wealth for its citizens and companies, and a major default of its loans to creditors. The losses from the bailout would amount to a 60 percent loss to GDP.

Furthermore, Dixon (2013) believes that the value of the pound is uncertain as Cyprus would wisely need to peg its value to another major currency, which would mean the country would have to keep interest rate high and curb deficits. Inflation would occur because the country is dependent on imports and low-cost immigrant labor, whose costs would rise if a local currency was used. Local industry that relies on imports would suffer and the country would lose its hard currency reserves. Finally, exiting the Eurozone would cut Cyprus off from its key trading partners, as its relations with its neighbors are not strong, particularly with Turkey.

Slavoj Žižek (2013), a Slovenian scholar, worries that if Cyprus stays part of the Eurozone then there will be a divided Europe that mimics current North-South relations. Southern Europe would house a cheap labor force that would live outside the safety net enjoyed by the North. Companies would go to this region for labor (instead of perhaps China) and for tourism. In an article in The Guardian (2013), Žižek points out the Cyprus will be unable to pay off its debt and that eventually the EU will no longer want to provide bailout funds. According to Žižek, “The Cyprus crisis is not a storm in the teacup of a small marginal country, it is a symptom of what is wrong with the entire EU system.” He proposes that a radical change is needed to banking in the EU. Banking should have social controls, become streamlined and become thoroughly regulated.

Conclusion

Mario Draghi, President of the European Central Bank tried to assuage fears stating that Cyrpus is not a template for future Eurozone bailouts. Draghi wants to calms investors who fear bank runs across weaker Eurozone countries (Chan, 2013). Many fear contagion will spread to Eastern Europe, which is also dependent on foreign capital flows, easy access to credit markets, and export markets. Eastern European banking markets though differ from Cyprus because they do not rely on massive volumes of large deposits. Nonetheless, some banks in Slovenia are quite worried since the country faces increasing amounts of debts resulting from bad loans associated with the collapse of its construction industry (Lovasz, 2013)

Eastern European countries are not the only EU countries at risk. Luxembourg and Malta both serve as tax havens for big global corporations. Assets of these banks are more than eight times (Malta) and twenty-two times (Luxembourg) the size of these country’s economies. While banks at these countries are healthy for the moment, the IMF fears it would have to step in to save these banks if trouble occurred. A New York Times editorial (2013) argues that the Eurozone needs to quickly complete a banking union that would be supervised by the ECB instead of at the national level. A banking union could also calm investors who fear strict capital controls as a response to a bank bailout.

As the United States addresses the issue of “too big to fail,” Europe too must address this ever increasing challenge. The globalization of banking has made many countries and individuals quite prominent, though the cost is unfortunately being felt by the masses on both sides of the Atlantic.

Works Cited
Chan, S.P. (2013, April 4). Cyprus ‘no template’ for future bail-outs, says Mario Draghi. The Telegraph. Retrieved from: http://www.telegraph.co.uk/finance/financialcrisis/9971992/Cyprus-no-template-for-future-bail-outs-says-Mario-Draghi.html

Cyprus was not an exception (2013, April 1). The New York Times. Retrieved from: http://www.nytimes.com/2013/04/02/opinion/cyprus-is-not-an-exception.html

Dixon, H. (2013, April 7). Quitting the Euro wouldn’t be a good choice for Cyprus. The New York Times. Retrieved from: http://www.nytimes.com/2013/04/08/business/global/quitting-the-euro-wouldnt-be-a-good-choice-for-cyprus.html?_r=0

Gardner, D. (2013, April 7). Cyprus reaches end of a long and sleazy road. The Financial Times. Retrieved from: http://www.ft.com/intl/cms/s/0/39748f8a-9e01-11e2-bea1-00144feabdc0.html

Inozemtsev, V.L. (2013, April 4). Cyprus: a blessing for Russia, in disguise?. The New York Times. Retrieved from: http://www.nytimes.com/2013/04/04/opinion/cyprus-a-blessing-for-russia-in-disguise.html?pagewanted=all

Kanter, J. (2013, April 5). I.M.F. and Europe set tough terms for Cyprus bailout. The New York Times. Retrieved from: http://www.nytimes.com/2013/04/04/business/global/imf-to-contribute-1-billion-euros-to-cyprus-bailout.html

Kremer, W. (2013, April 5). Laiki Bank: the Cyprus bank staff hit worst of all. Retrieved from: http://www.bbc.co.uk/news/magazine-22042727

Lovasz,A. (2013, April 8). Cyprus woes threaten East Europe GDP, Development Bank says. Bloomberg. Retrieved from: http://www.bloomberg.com/news/2013-04-07/cyprus-woes-threaten-east-europe-growth-development-bank-says.html

Merry, E. W. (2013, April 8). The Cyprus-Crisis culture clash. National Interest. Retrieved from: http://nationalinterest.org/commentary/the-cyprus-crisis-culture-clash-8321

Psyllides, G. (2013, April 9). ‘Haircut exemptions only lead to bigger cuts for others.’ Cyprus Mail. Retrieved from: http://www.cyprus-mail.com/central-bank-governor/haircut-exemptions-only-lead-bigger-cuts-others/20130409

Roland, D. (2013, April 8). Cyprus needs €75m before bailout. The Telegraph. Retrieved from: http://www.telegraph.co.uk/finance/financialcrisis/9979806/Cyprus-needs-75m-before-bailout.html

Russia to restructure €2.5bn loan to Cyprus (2013, April 8). RT.com. Retrieved from: http://rt.com/business/restructure-loan-russia-cyprus-503/

The resignation of Michalis Sarris may be only the beginning (2013, April 6). The Economist. Retrieved from: http://www.economist.com/news/europe/21575791-resignation-michalis-sarris-may-be-only-beginning-blame-game

Trotman, A. (2013, April 2). Only Cypriot President and Speaker allowed to fly business class under bailout rules. The Telegraph. Retrieved from: http://www.telegraph.co.uk/finance/financialcrisis/9967911/Only-Cypriot-President-and-Speaker-allowed-to-fly-business-class-under-bailout-rules.html

Žižek, S. (2013, April 8). The Cyprus crisis is a symptom of what is rotten in the EU. The Guardian. Retrieved from: http://www.guardian.co.uk/commentisfree/2013/apr/08/cyprus-crisis-symptom-rotten-eu

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