The financial bailout deal enforced last week on Cyprus is truly a case where size does not matter. It not only sets a dangerous precedent, but its implications are far more than merely financial. It is also political, and plays into the already volatile eastern Mediterranean geopolitical arena.
Cyprus, with a population of about 1.1-million, accounts for only 0.2% of the total European Union (EU) economy and its bank assets total €68 billion, which is minute in global terms. The importance of events around this tiny island, however, is much greater than these statistics would suggest.
In dealing with the European financial crisis, the guiding principle since the days of the so-called ‘bank runs’ of the 1930s – that bank deposits are sacrosanct – has gone out the window. Part of the money held by depositors in Cypriot banks is being confiscated to help bail out banks.
In the words of George Friedman of Stratfor Global Intelligence: “The proposal ... undermines a formerly sacred principle of banking in most industrial nations, the security of deposits – setting a new and possibly destabilising precedent in Europe.”
The role played by Russia in the drama that unfolded around the Cyprus bailout deal in the latter part of March, is much more significant than the much-highlighted presence of huge Russian deposits in Cypriot banks. The fact that there are substantial natural gas reserves in the maritime economic zone of Cyprus, and that Russia seems doomed to soon lose its only military base in the eastern Mediterranean region due to the conflict in Syria, underpins the strategic importance of the island to Russia.
It further explains why Russia in recent years has cultivated a good relationship and involvement in the economy of Cyprus.
In a recent analysis titled, “Trouble in the Eastern Mediterranean Sea: The Coming Dash for Gas”, the magazine Foreign Affairs of the American Council on Foreign Affairs wrote about Russia: “The country holds about a quarter of the world’s total proven gas reserves (at 1 680 trillion cubic feet) and accounts for, on average, 71% of gas imports in central and eastern Europe. Future production in the eastern Mediterranean would be too marginal to offset Russia’s dominant market position.
“Nevertheless, the state-owned gas monopoly, Gazprom, is seeking a financial stake in the development of local resources. It has actively pursued licences for production in Israeli and Cypriot fields and has offered to help develop liquefied natural gas (LNG) infrastructure.”
Small wonder that one commentator, referring to the targeting of Russian deposits in Cyprus – according to the same Foreign Affairs article – remarked: “The talk among a lot of locals is that Germany has engineered this deliberately to scare off the Russians and so that they can get their hands on the LNG deposits. That way, we will be forced to turn to Germany as our next sugar daddy. We have been forced to slap the Russians in the face, even though we didn’t want to.”
The article further noted the local view on Cyprus’ position: “We have always been important strategically, from the time of the Venetians, the Ottomans and the British. We are slap bang in the middle of Africa, Asia Minor and Europe. The gas reserves make us even more important.”
Implications for the financial system
After the final deal, which excluded smaller depositors, the president of the European group and Dutch minister of finance, Jeroen Dijsselbloem, badly spooked markets with his remark that the Cyprus case is a “template” for future bailouts. He later stepped back somewhat and said that Cyprus is "a specific case with exceptional challenges" and that "no models or templates are used".
But the damage has been done and, as Friedman remarked: “The question, of course, is whether foreign depositors in European banks will accept that Cyprus was one of a kind. If they decide that it isn't obvious, then foreign corporations – and even European corporations – could start pulling at least part of their cash out of European banks and putting it elsewhere.
“They can minimise the amount of cash on hand in Europe by shifting to non-European banks and transferring it as needed. Those withdrawals, if they occur, could create a massive liquidity crisis in Europe. At the very least, every reasonable CFO (chief financial officer) will now assume that the risk in Europe has risen and that an eye needs to be kept on the financial health of institutions where they have deposits. In Europe, depositing money in a bank is no longer a no-brainer.”
He points out that more than just “Russian money” will be caught up in the Cypriot bailout deal. “Moreover, the point of the global banking system is that money is safe wherever it is deposited. Europe has other money centres, like Luxembourg, where the financial system outstrips gross domestic product (GDP). There are no problems there right now but, as we have learnt, the European Union is an uncertain place. If Russian deposits can be seized in Nicosia, why not American deposits in Luxembourg?”
And at the heart of the Cypriot crisis is the fact that by 2011, according to an International Monetary Fund (IMF) report, the assets of Cypriot banks were equivalent to 835% of annual national income.
This situation might have been sustainable, but Cyprus’ two largest banks made loans to the Greek government worth 160% of the Cypriot GDP. And then, under another bailout deal, the value of the debts owed by Greece was cut by 75%, which was like “a shot through the heart to the Cypriot economy. Coupled with the slow economic growth and the turmoil in the eurozone, things got out of hand.”
Prior to the 2008 financial crisis, the IMF described Cyprus' economic performance as a "long period of high growth, low unemployment, and sound public finances".
Unlike the first attempt at the start of the present drama, when the Cypriot parliament almost unanimously rejected the deal then on the table on the insistence of the very same IMF, the present deal is structured in such a way that parliament will not need to approve it.
The raid on large depositors is being achieved via a restructuring of Laiki Bank and Bank of Cyprus, and not via a levy or tax. Effectively, technocrats outside the country have succeeded in sidestepping the democratic institutions of Cyprus.
In the struggling countries of southern Europe, Portugal, Italy, Greece and Spain – which are battling to overcome the effects of their own ‘bailout’ deals – investors would have watched the Cypriot drama with apprehension. As things stand, Spain is presently experiencing a collapse of its property market.
It can be expected that history will describe the events around Cyprus as the start of the final phase in the decline of the financial system that has been in place since the Great Depression of the 1930s.