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Can Cyprus Turn Back from the Abyss? Three Options to Escape the Financial Crisis

The small island of Cyprus continues its race against bankruptcy. Following the European decision to tax all depositors, [fr] the Mediterranean republic faces a critical situation. Three options are emerging for the island: to carry out an agreement with Europe, to turn to Russia, or to declare bankruptcy and leave the Eurozone.

Origins of the crisis

This crisis arose after a significant loss in assets of the Popular Bank of Cyprus and the Bank of Cyprus, due to the debt restructuring plan in Greece, in March 2012. The two Cypriot banks then found themselves obligated to seek recapitalization in the capital city, Nicosia [fr].

Private-sector solution?

For their part, Greek banks are also closely tied to Cyprus. The Bank for International Settlements, [fr] or BIS, estimates the Greek banks’ investments in Cyprus at 12.6 billion euros, an amount not less than 28% of all Cypriot banks’ investments. This therefore rules out the possibility of a private-sector intervention plan on the island.

Les bureaux de Bank of Cyprus à Aglandjia via wikipédia CC-BY-2;0

The offices of the Bank of Cyprus at Aglandjia, via Wikipedia CC-BY-2;0

So, if Cyprus could contribute from its banks the sum of 7 billion euros, refused to them by Europe, out of the 17 billion euros which it owes, Europe would be obligated to give aid to Greece again [fr], further weakening the recovering stability of the country. A renegotiation, particularly in the plan of the troika, would be risky. This is also partly why the Greek economy is affected by the tax on deposits.

Furthermore, organizing a private-sector intervention in Cyprus might be frowned upon by investors. It should not be forgotten that “the Greek case” is expected to remain unique. Otherwise, it would be tempting for other countries now experiencing a complex economic situation, such as Spain, Italy or Portugal, to seek private-sector assistance as well.

The consequences of this would be irrevocable. For the market to finance vulnerable states would become complex, even impossible, and restructuring of public debt for other countries, and of the European Central Bank, would loom dangerously on the horizon. In fact, regarding the deposits, this is another “unique case” which Europe hopes to create.

The Social Democratic Party of Germany [fr], or SDP, wants to make an example of Cyprus, in order to stop the vote in favor of European aid in the Bundestag [fr], which is essential to Chancellor Angela Merkel. So, aid for Cyprus is not likely to occur without the support of the Bundestag. The SDP sees a reserve of money in Cyprus which is noted to be of Russian origin, and suspected to belong to the “mafia”. The private sector intervention did not really hit the wallet of Russia, so the European solution should focus on deposits. Since Cyprus refused to accept a drain of deposits more than 10%, so as not to ruin the reputation of its economic system, it was necessary to broaden its tax base, and to spread the impact across all depositors, including residents. But this could still be enough to push Cyprus into the abyss. This is why it rejected the European plan.

At this point, Cyprus finds itself faced with several possibilities. Given the intense reactions in Europe, and especially in Cyprus, during recent days, some of the European decision-makers seem to want to backtrack, regretting their original choices. We see attempts to reduce the participation of Cyprus in its own bailout. However, Europe may not accept an attempted renegotiation. The debate about the complete participation of the ESM (European Stability Mechanism) [fr], which oversees 5.8 billion euros in aid, still remains.

Alliance with Russia

The second solution would be for Cyprus to ally itself with Russia. Indeed, Putin wants to defend Russian assets on the island, asking, in exchange, for large concessions on gas and Russian military facilities, not to mention the recent discovery of an oil deposit off the island. Russia could repurchase Cypriot banks [fr], notably the Laïka Bank, the second-largest banking establishment on the island, in order to save 2.5 billion euros in recapitalization. Russian aid would probably be complementary to European aid, and undoubtedly there would not be any actual rupture between Cyprus and the Eurozone. For its part, Russia would gain significant influence in strategically important Cyprus. The island would safeguard the interests of Moscow in Europe, but would risk creating some problems in the future.

But Russia is apparently in no hurry to make a decision. Andrei Kostin, director of VTB Bank [formerly the Vneshtorgbank], announced on March 21 that his institution was not at all interested [fr] in buying bank assets on the island:

Sur place, il y a deux banques dans une situation critique qui ont besoin d'être assainies. Il serait absurde de prétendre que nous aurions un intérêt là-dedans. Notre seul intérêt, c'est de retrouver au plus vite la faculté d'effectuer les paiements et de gérer les comptes de nos clients.

First, there are two banks in critical condition that would need to be cleaned up. It would be absurd to suggest that we would have an interest in those. Our only interest is to regain the ability to make payments as quickly as possible, and to manage the accounts of our clients.

And he added that his bank would need to:

arrêter son activité et quitter purement et simplement le marché chypriote” en cas de “décisions violant le droit, dictées par la politique.

 ”cease its activity entirely, and simply leave the Cypriot market” in the event of “decisions which violate the law, dictated by politics.”

Last resort – Bankruptcy

Finally, Cyprus can opt for the extreme but inevitable solution, if Russia and Europe deliver no proper support – bankruptcy. Then, recapitalization in Cyprus would be accomplished by banks issuing money.

That would mean leaving the Eurozone [fr], instituting strict controls over the flow of money, and blocking current accounts during the period of conversion to the new Cypriot currency. The island would be ruined, and its financial credit would be permanently damaged. This would be followed by a period of economic reconstruction under complex circumstances. And for the Eurozone, it would be a failure, and a disturbing precedent.

The final agreement reached in Brussels, with the intention to dismantle the largest bank of the country, and to tax bank deposits greater than 100,000 euros, is an ineffective hybrid solution, according to American economist Tyler Cowen:

 What will the price of a Cypriot euro be, relative to a German euro?  50%?  I call this Cyprus leaving the euro, but keeping the word “euro”, to save face.

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