OREANDA-NEWS. April 08, 2013. The unprecedented steps by the Cypriot government with regard to the deposits placed in its country’s banks have come as a painful shock for their clients worldwide – primarily in Russia and Great Britain. The ‘financial paradise’, whose reputation may already be regarded as killed stone-dead, has become a victim not only of the circumstances or its own short-sightedness, but also of the policy of the European Union authorities that decided to take it out of the small Mediterranean island at the utmost.

Flaunty Lashing of ‘the Scapegoat’

In our opinion, the desperate tearing of the Cypriots around, which started with the announced introduction of a fixed non-recurring tax on deposits, and was completed by the currently unclear fate of deposits exceeding EUR 100 000, are caused by two factors which have, generally speaking, the same roots.

Firstly, the intention of the European Union to take it out on small Cyprus, demonstrating to the taxpayers of northern countries the EU’s will in solving financial problems of the periphery, and simultaneously punishing the private sector as a result. Secondly, the position of the Chancellor of Germany, Angela Merkel, who also wants to show, on the eve of this year’s elections, that countries in the core of the euro-zone do not want to pay for the deeds of ‘the southerners’ any more.

The subsequent shock in the financial world was quite predictable – such measures as the introduction of a tax on deposits or their confiscation, which can actually signify the last option for ‘regulating a financial crisis’, could be regarded as the norm for Zimbabwe or Uganda, but definitely not for a member-state of the euro-zone and the EU.

There is a feeling that international creditors represented by the ECB, the European Commission and the IMF, just decided to let off steam following certain events in other countries in the euro-zone periphery, flushing a small Mediterranean island off the financial map. And Cyprus is not even on the periphery of the euro-zone – with its GDP of 0.25% of euro-zone GDP and 7% of the Greece GDP, it is, figuratively speaking, on the periphery of the periphery.

At the same time, this ‘isle of ill luck’ has been a significant cog in the machine of the Russian financial system for a long time, and that is why there is such increased interest of Russian authorities in the Cyprus problem – that is what allowed the Cyprus government to refuse the unprecedented measures of the partial nationalization of deposits. Being stuck between the interests of Europe and Russia, small Cyprus is desperately trying to avoid the collapse of its banking system. Still, it is obvious to everyone that as soon as foreign depositors get access to their accounts, the majority will try to withdraw their money (certainly if such remains on the accounts) from the island 'to play it safe'.

It seemed that during the two years of the crisis, the system of assisting peripheral countries in the euro-zone has been adjusted and runs like clockwork. If you live beyond your means then cut the budget, sell state property, increase taxes. With Cyprus, Europe has decided to go even further, creating an extremely dangerous precedent which cannot be logically explained. Cyprus faces an ultimatum – either introduce strict measures with regard to your deposits, or be left with no financial assistance.

Non-distinctive Feature of the Island Crisis

Last year Cypriot banks suffered from the restructuring of Greek debt (EUR 4-4.5 billion), as well as from their own operations in Greece. Therefore, the assistance to Cyprus is largely related to the recapitalisation of the banks of about EUR 10 billion. According to ECB data, as of the end of January, the assets of Cypriot banks had grown to EUR 126.4 billion (seven times the country’s GDP), whereas in 2007 they constituted only EUR 78 billion.

This situation resembles an endless circle of sovereign debt growth caused by the recapitalisation of the banking sector. Two PIIGS countries have already passed such process – Ireland and Spain. Let us note that, with all the problems in the banking sector, the public debt of Cyprus is at a quite acceptable level according to the current standards – 85% of GDP.

In accordance with European Commission forecasts, in 2013 the GDP of Cyprus will reduce by 3.5%. This being the case, pressure on the national economy is exerted not only by the banking sector, but also by debt-burdened households and non-financial companies. Debts of the island’s non-financial sector are the third largest in the euro-zone after Luxembourg and Ireland, at approximately 280% of the GDP.

Russian Interests: Finances, Gas, Weapons

Cypriot banks used to pay 4.45% on average for deposits placed for less than two years . In comparison, in 2008 this rate was 4.25%. During the same period, the ECB reduced the refinancing rate from 4% to the record low level of 0.75%, and German banks lowered their rates from 4% to 1.5%, whereas Cyprus attracted the ‘hot money’, with a general tendency to lower rates of return in other countries of the euro-zone.

According to Cyprus Central Bank data, as of the end of January the total volume of deposits in Cypriot banks reached EUR 68.4 billion. Of this, EUR 42.8 billion belongs to residents of the country, EUR 4.8 billion to residents of other countries of the euro-zone, and EUR 20.8 billion to the rest of the world. It is obvious that the lion’s share in the last category is composed of deposits of Russian citizens. At present we hear different estimates of Russian deposits in Cyprus, but the more or less approximate figures are within the limits of EUR 14-16 billion.

According to Moody’s estimates, about EUR 60 billion of deposits of Russian private individuals and companies could be subjected to the non-recurring tax on deposits. Of this amount, about EUR 31 billion are direct deposits in Cypriot banks and their subsidiary companies. The remaining EUR 29 billion are Russian loans to Cypriot banks and companies (including their subsidiaries and lower-tier subsidiaries). The largest exposure, according to Moody’s data, is for the state bank VTB, which holds the subsidiary Russian Commercial Bank with assets of about EUR 13.8 billion.

In the near future, Russia can prolong the loan of EUR 2.5 billion granted to Cyprus in 2011 for the term of 4.5 years at 4.5% p.a. Cyprus has requested to defer the loan payments for five years and reduce the interest rate. Thereat, the contribution of Russia in saving Cypriot banks could be increased, in the event Cyprus does not reach an agreement with the European group. However, the recent events show that the contrary proved to be the case.

The interests of Russia, which has conducted as yet fruitless negotiations with Cyprus, can be explained not only by Russian deposits, but also by the natural gas field in the economic waters of Cyprus. Without any doubt, Gasprom, which has huge financial resources, wants to access this gas field for cheap. Apart from this, there is speculation about the intention of Russia to establish a military base in Cyprus in exchange for financial aid. Naturally, such talk has caused irritation on the part of the Europeans, and this has been publicly declared by the Chancellor of Germany, Ms Merkel.

Restructuring of Bonds as an Alternative to Confiscation

It is clear that both the initial decision about ‘confiscation’ of funds available on deposits and the subsequent decision, which generally challenges the fate of deposits exceeding EUR 100 000, have been taken in despair. For instance, the restructuring of sovereign bonds would cause even more damage to the balances of Cypriot banks which have already suffered from a similar operation in Greece.

The earlier announced high rates of punitive tax are also clear. According to Barclays Capital data, deposits exceeding EUR 100 000 form about 55% of all deposits in Cyprus. In order to relieve the insured deposits of below EUR 100 000 from the tax, the rate for deposits which exceed EUR 100 000 must be put at about 15.5%.

If the Parliament of Cyprus refused to touch the deposits according to the proposals of the European authorities, Cyprus, in fact, would have to refuse the entire anti-crisis programme worth EUR 10 billion. Then one of the options could be the restructuring of sovereign bonds of Cyprus. Let us remind that currently bonds in the amount of EUR 4.4 billion, which fall within the purview of Cypriot laws, and in the amount of EUR 3.8 billion, which fall within the purview of British laws, are traded on the market. However, restructuring of the bonds issued in accordance with Cypriot laws is almost excluded, as they predominantly lie on balances of the Cypriot banks which will have losses incurred in the course of restructuring.

EU Will Not Hurry up before Push Comes to Shove

For the EU, the situation in Cyprus was not a secret. Authorities on the island state applied to the European Union for help as far back as last June, and during this time the Europeans could have developed an adequate plan for providing support. However, as always happens with debt problems of the euro-zone, nobody takes any decision before push comes to shove.

A new turn in the European debt crisis leads to unhappy conclusions – at present no assets can be considered as risk free, especially in countries with weak state and banking institutions. Under the oppression of the crisis, governments can resort to the maddest and the most unfair measures which often contradict both their pre-election promises and common sense.