Streetwise Professor

March 18, 2013

Cyprus: The Essence of FUBAR

Filed under: Economics,Financial Crisis II,Politics — The Professor @ 7:50 pm

If you’ve been waiting your entire life to witness the pure, un-adulturated, distilled essence of FUBAR, your dreams have been answered: for behold Cyprus!

For in one fell swoop, the with their monster mash of a bailout-bail-in of Cyprus, the Eurotards have succeeded in: gutting the rule of law and due process; riding roughshod over democratic institutions; increasing the risk of a catastrophic bank run in the event any Eurozone country (e.g., Spain) is believed to need to seek assistance; and sparking a huge diplomatic row with Russia.  Well played! Well played, indeed!

For those dwelling under a rock: as part of a 10 billion euro bailout for Cyprus, the Euros (meaning primarily Germany) required the imposition of a tax on deposits in Cypriot banks: a 6.75 percent tax on deposits below 100,000 euros, and 9.99 percent on deposits above 100K euros.

The bail-in essentially guts deposit insurance, which allegedly protects deposits below 100K.  A run on Cypriot banks is almost inevitable, because who is to say that this haircut is the last?  What’s worse, depositors in other peripheral banks have to take seriously the prospect that they will be similarly expropriated, in the event that their banks and/or sovereigns (to the extent this distinction has any meaning) require a Eurozone bailout.  This makes them much more likely to run at the first hint of trouble.  And of course, these things can be self-fulfilling.  If, say, Spanish depositors become more worried about the financial condition of the country’s banks, fearing having some of their deposits confiscated they might start to pull their funds from the banks; in the event, unable to fund themselves, the banks-and the Spanish government-may be forced to throw themselves to the tender mercies of the Germans, et al, leading to the imposition of the dreaded deposit tax.

The dynamics in these situations are always complicated, and highly dependent on beliefs, but it cannot be gainsaid that the actions in Cyprus increase appreciably the odds of a destabilizing run somewhere in the Eurozone, especially on the periphery.  Therefore, it is worthwhile to keep an eye on deposits at peripheral banks for any evidence of the beginnings of a run.  Relatedly, keep an eye on Target2 balances; an uptick in German Target2 assets could indicate attempts by peripheral depositors to move their funds to core banks.

The best-only?-hope of avoiding such an outcome is that Spaniards, Greeks, Italians, etc., believe that Cyprus is truly an exceptional, one-off case as the Eurocrats claim.  Which leads to the question: what differentiates Cyprus to such an extent that events in Cyprus do not cause depositors in Spain, etc., to update their beliefs regarding the probability they will be similarly expropriated in the event of a bailout of their countries’ banks?

There is one obvious answer: Russia.  Or, more properly, Russian money.

Cyprus has been the most popular destination for Russian funds leaving the country, and most notably dirty money: much of the money stolen in the Hermitage/Magnitsky fraud, for instance, went to Cyprus initially.  Germany’s intelligence service, the BND, said in a leaked report that a Euro bailout of Cypriot banks would largely benefit Russian depositors whose money has dubious origins.

This became a huge political issue in Germany.  The Social Democrats made a bailout of Cypriot banks political poison for Merkel: No bailout of Russian thieves!  She is ramping up for an election campaign, and in no way could be seen as bailing out dirty Russian money.

Supposedly she (and the IMF) wanted to force uninsured depositors (including many of the Russian depositors) to bear the entire burden of the bail-in, but Cyprus’s government refused.  Hence sharing the pain with smaller depositors.  But that has unleashed a furious reaction in Cyprus, and it is likely that the deal will be redone so as to put more of the burden on the uninsured (read-Russian) deposits and less on the insured deposits.

Which will only infuriate the Russians more.  And they are already plenty furious.  Putin just about lost his sh*t today, calling the original deal “unjust, unprofessional, and dangerous.”  And that’s before any adjustment of the deal to the further detriment of Russian depositors.

Any initial schadenfreud should be stifled: yes, the Russians are the masters of unjust expropriation, but two wrongs don’t make a right.  If some Russian money in Cyprus is dirty, being laundered, etc., the right way to handle it is to investigate and provide protections of due process to ensure that the guilty are identified and punished, and the innocent are spared: the Eurotard approach is Red Queen justice: “Sentence first! Trial later!”  The innocent are swept up with the guilty.  This is why the Euro approach guts the rule of law, with all of the pernicious effects that inevitably accompany such actions.

In some respects, Putin’s reaction is a surprise.  Given his declamations against tax evasion and the off-shoring of Russian money, there are some benefits to closing down an offshore bolt-hole for Russian money that Putin would prefer to remain in Russia.  But the unilateral Euro action no doubt rankles deeply, and no doubt strikes very close to home for Putin and some of his cronies.

It is very interesting to note that Russian stocks and the ruble took a far bigger hit from the Cyprus news than did Eurozone stocks.  The loss (about 2 percent on the major Russian indices, MICEX and RTS, and a .7 percent decline in the ruble, as compared to less than 1 pct declines in European stocks) cannot be explained by the direct effect of the expropriation.  Estimates are that there are about 30 billion euros in Russian deposits in Cyprus: 10 percent of that is only 3 billion euros, far less than the decline in Russian market capitalization.  Meaning that there is some indirect channel by which the expropriation is hitting Russian corporations: I am still trying to think through what that channel might be, but haven’t arrived at any opinions yet.

Whatever the reason, the market reaction demonstrates just how important the Cyprus issue is to Russian interests.  It will further stoke Russian paranoia-an amazing accomplishment.  It could cause a major diplomatic fallout between Germany and Russia, which would have substantial geopolitical implications.

All in all, it is hard to imagine how the Eurocrats could have played this any worse.  They didn’t really solve Cyprus’s debt problem.  They made it all the harder to deal with debt and banking problems outside of Cyprus.  They committed a major foreign policy blunder.  A truly amazing trifecta.

One final thought.  This points out the absurdity of the Euro project.  If tiny Cyprus is too big to fail, if the effects of its default would be so horrible that the Euro mandarins feel it necessary to take such a desperate and dangerous measure to prevent it, how can the Euro be anything but an absurdity?

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15 Comments »

  1. Spot on, Prof! Add one other fact here: With the exception of England, citizens of every country in Europe have been sold out by their governments and bureaucrats since 1789. There is no history of institutional accountability in any of these countries, save England, where, thank the Maker, there is a history of holding public officials accountable, and reforming institutions that fail their constituents. The history of exploitation in Europe — citizens being betrayed as a matter of course — is why they’re heading for another series of violent revolutions. Horrific.

    Comment by markets.aurelius — March 18, 2013 @ 8:22 pm

  2. Malta here I come :)

    Comment by MJ — March 18, 2013 @ 10:39 pm

  3. There exists a huge misconception about “Dirty Russian Money” in Cyprus, fed in part by lazy stereotyping and facile interpretation of simple business facts. The vast bulk of Russian deposits in Cyprus are simply Russian investment capital that has been “booked” in Cyprus before round-tripping back to Russia as “loans” and “ foreign equity” investment. This is largely due to the historically favourable double taxation treaty between Cyprus and Russia and the low tax rates in Cyprus – think of Cyprus as corporate Russia’s Ireland or Hong Kong. Add to this the perceived benefits of security of a EU country, a legacy British legal system, favourable location, time zone and cultural affinity. Why would any rational investor in Russia (Russian or foreign) choose to invest directly in Russia and deal with the tender mercies of the Russian legal, regulatory, monetary and banking system if he could route the very same investment through Cyprus and enjoy at least a modicum of perceived security and potential legal recourse? Naturally, the Russian investment market will suffer greatly if the Cyprus investment platform is destroyed, demonized and “harmonized” by a bureaucratic EU “witch hunt” targeting supposed “evil Russian oligarchs”.

    If one condemns Cyprus for trying to emulate (if somewhat poorly) the historical successful growth models of Ireland and Hong Kong, and claim its banks are only “repositories of stolen oligarch cash” one should likewise condemn Ireland as a “bolthole of bootlegger and IRA cash” and Hong Kong as a hive of “triad and communist party corruption loot”. Better to ignore the hyperbole and do a bit of actual research before hauling out the old tired stereotypes.

    Comment by ramblarou — March 18, 2013 @ 10:39 pm

  4. In fairness to Germans, tax on deposits below 100K Euros was not a German (or Eurolander) idea, but Cypriot goverment’s, and in fact made many in the EU furious. Cypriots propably thought that by making everybody pay would keep some of the bigger inverstors in the island. They might also have held some hope that speculative effect could force EU to soften conditions. Not gonna happen, but I very much doubt under 100K deporsitors will have to pay, because EU law guarantees deposits up to a minimum of 100K.

    Comment by Harold — March 19, 2013 @ 12:17 am

  5. I’m not so sure in infuriating the Russians is a foreing policy blunder. Because, let’s face it, in so many ways Russia is the only problem that Europe has. For two decades now Europe has tried to engage Russia but results are nowhere to be seen. Many in Europe have began to think that it is time for the Russians to taste their own brand of foreign policy – direct confrontation.

    Comment by Harold — March 19, 2013 @ 12:41 am

  6. @Harold. I know that the <100K tax was not a German idea, and I state that explicitly in the post, i.e., I say Germany wanted the uninsured to get whacked, but Cyprus pushed back.

    If you follow the blog you know I’m hardly shy about advocating standing up to the Russians, for precisely the reasons you mention. But this is a gratuitous affront, and the Russians actually have the moral high ground.

    @ramblarou-I know a lot of the money in Cyprus isn’t dirty, which is exactly why I objected to the meat cleaver approach. I say “if *some* Russian money is dirty . . .” then prove it in a way that respects due process and the rule of law.

    The ProfessorComment by The Professor — March 19, 2013 @ 8:58 am

  7. Due Process – Perfesser, what has the European Project been but a desperate attempt by the bunglecrats to avoid any responsibility for their actions? Representative democracy subverted, with pay and perks for the “representatives”: does anyone remember the riotous video of MEPs showing up at 9 am on Fridays to collect their Friday per diems so they could take off early and still get paid? Legislation and management by Directive have been the order of the day for the last 25 years.
    The European Project need not have been ridiculous, if it was in fact a European Project. Instead it devolved into a bureaucratic coup d’état. Among the many things that is causing this to come unstuck is that these guys (neuter gender) have lived in a sound chamber based on near religious faith as opposed to analysis: My cousin had a story about how when applying for or reporting on any EU funded project (he was a plant biologist / geneticist) there would have to be a homily attached or made as to how this would help Europe become more integrated, prosperous, etc. Actually these projects almost always had the opposite effect, worsening surpluses in the CAP, migrating to 3rd world nations and increasing production. The Eurocrats knew this, the scientists knew it, but they all chorused along – sort of like a toothless version of a Party Congress under Joe Stalin.
    Magical thinking and mindless repetition doesn’t work too well when it runs into reality. Barzzini in the Italians said that disaster occurred for Mussolini when the show of power ran into the real thing. Cyprus is too big to fail not because it is too big to fail economically, but because any failure undermines the ”faith” or con that is Europe. Riding roughshod over rights is not material – when have these people given a rat’s ass as to rights in any real non PC way? What it is, is evidence of panic and in panics stupidity usually follows. I don’t think they could have come up with a stupider way of doing this if they sat on both hands for a fortnight.
    It has all the markings of being just fudge – in this case toadying to the Krauts and demonizing “Outsiders” (dirty Ruskies) to keep the ball in play for a little bit longer. Let Putin squawk, that is just “corroborated detail that added verisimilitude to an otherwise bald and improbable tale,” (Pooh-Bah, the Mikado). Utterly despicable and predictable.

    Comment by Sotos — March 19, 2013 @ 10:49 am

  8. @The Professor

    I do see your point. Still, I can’t help myself but enjoying Putin’s troubles. On the one hand, he is ordering Russian officials to repatriate their money back to the Motherland, but at the same time he is trying to defend their money in Cyprus. If he is successfull, then who in the elite would obey his orders anymore? If he is not successfull, the who in the elite would obey his orders anymore?

    Comment by Harold — March 19, 2013 @ 1:09 pm

  9. @Harold. I agree with you on the hypocrisy re “off-shoring” Russian money. He is truly on the horns of a dilemma.

    Knowing Putin, there are two classes of people. The enemies he hates and wants to prevent from taking their money off-shore, and his cronies who he wants to protect. The problem with the Cypriot action (in his eyes) is that it is so indiscriminate. It hits friend and foe alike. He probably figures he has other ways of dealing with the foes, but he is totally pissed that this hits his friends.

    I’ve written for years that the key to Putin’s survival is his ability to distribute rents to keep the powerful happy. Loss of access, or reduced access, to foreign financial black holes sharply constrains his ability to do that.

    Thus, ironically, this could destabilize Putinism. Which is probably the real reason he lost his sh*t.

    The ProfessorComment by The Professor — March 19, 2013 @ 2:01 pm

  10. Representative democracy subverted, with pay and perks for the “representatives”: does anyone remember the riotous video of MEPs showing up at 9 am on Fridays to collect their Friday per diems so they could take off early and still get paid?

    I remember getting angry at that video. These days, I’d be asking myself what else I expected.

    Comment by Tim Newman — March 20, 2013 @ 1:10 am

  11. The opposition parties in the UK – one of whom, amusingly, is also in the government; aren’t coalitions grand? – will be watching the Cyprus grab with interest.

    Two of the parties are committed to a “mansion tax” on individual properties worth more than £2 million pounds. This describes a number of family houses in the London suburbs bought 40-odd years ago, such as my parents’.

    The idea is to tax the owners of such houses, because they’re rich bastards on account of what others will bid for their houses. Leaving aside all the obvious problems with this, the cost of this tax is much more than just the cost of this tax. If you’re liable for it but can’t afford it – because you paid a hundredth of that price for your house 40 years ago, say, and you’re now retired on a pension – then you must sell that house and buy a smaller one. This will cost you so much in transaction costs that we’re looking at a percentage expropriation close to what the government has in mind in Cyprus.

    Probably the best thing the people of Cyprus could do today, to ensure future peace and harmony in Europe, would be to riot, set a few government buildings on fire, and pitchcap (look it up on wikipedia, it’s a laugh) a few local politicians. All of them, perhaps.

    Depressingly, I am actually serious.

    Comment by Green ad Grass — March 20, 2013 @ 6:10 am

  12. I don’t think Putin or Russia have problems with it. The Parliament of Cyprus voted it down. However, one can say the psychological damage is already done. But the Minister of Finance of Cyprus is in Russia now trying to fix things. And he may very well be bailed out by Russia. Furthermore, today, Jersey, Cayman Islands, the Island of Man and Luxemburg were courting the Russian businessmen and government in the spirit of “please get setup with us.”

    Comment by MJ — March 20, 2013 @ 8:34 am

  13. @ramblarou, can you explain in more detail why Russians like Cyprus? if there is a tax advantage, then I understand why Russian citizens would like Cyprus over Russian banks, but then why is Putin sympathetic to Cyprus? Further, why don’t Russians park their money in Switzerland, or Jersey where the rule of law is much clearer than Cyprus. There must be some siren song on the island, and inquiring minds want to know. “Any” commercial activity in Russian is suspect to me, so I don’t care about money laundering and unknown sources like the Germans, I simply want to understand the attraction of an unalluring island in the Mediterranean sea, Compared to Iceland, it is a basket case.

    Comment by scott — March 20, 2013 @ 2:01 pm

  14. […] SWP, 18 March 2013: “Cyprus: The Essence of FUBAR.” […]

    Pingback by Streetwise Professor » Coincidence? Merton’s Theory of Multiples? Theft? — March 21, 2013 @ 9:13 pm

  15. Good article. The Euros proposed to Cypriots to close their entire banking industry. Were they surprised when the Cypriots rejected this “offer”?

    Comment by Vlad Rutenburg — March 21, 2013 @ 11:23 pm

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