Russia to the Rescue of Cyprus?

There is a certain rich irony attached to the sight of corrupt Russian oligarchs now posing as liberal champions of the rule of law as they find themselves sucked into the maelstrom of Cyprus’s ongoing financial crisis.

Why is that the case? Because a large chunk of those deposits in Cyprus bank accounts belong to Russians - some of it of course might well be related to dirty money laundering activities. But for the most part, as Yves Smith of Naked Capitalism has pointed out, the Russian dollars are overwhelmingly medium- and large-size corporations. They are there for tax avoidance reasons a la GE and other multinationals companies, seeking to lower their tax rates as much as possible via tax arbitrage and preferring to do their business in a jurisdiction that allows recourse to English law.

So it is very much in Russia’s interests to help sort out this problem, which is getting messier by the day. As for the Cypriots themselves, the answer of what they should do in part depends on whether the country was planning on remaining an international money-laundering centre (which has made them particularly ripe targets for the Troika and Germany in particular).

In an ideal world, here is what should have happened in Cyprus: No hit for depositors within the insurance limit – a tax is an implicit haircut, and it violates EU promises. It threatens to create a runoff of deposits in many banks of the periphery, especially Spain.

Yes, the bondholders are, at best, pari passu with the deposits in excess of the insurance limit (some nations give even deposits in excess of the insurance limit priority over unsecured debt), so it is a good thing to require the bondholders of insolvent banks to take a large loss (and sub-debt should be wiped out). It is probably not wrong in general for uninsured depositors to take losses, though I can see why the EU might rationally be worried about doing so now given the problems of the periphery (of course, in reality the opposite is true, the EU is gung ho to force losses on uninsured depositors).

Of course, we now know that none of that has occurred. In the end, the twice-postponed debate on the bills for the levy on bank deposits was finally held on Wednesday and the House of Representativesoverwhelmingly rejected it. Not even President Anastasiades’ party, DISY, supported it, as its 19 deputies abstained.

The defeat of the bills was expected as all the political parties, apart from DISY had taken a stand against the idea of the haircut on deposits. It was immaterial that the government had yesterday morning presented a revised bill that left deposits under €20,000 untouched.

No matter how the levy was raised, the political parties would have voted against it because they are opposed to it on principle as it would destroy the Cyprus economic model as a provider of financial services to foreign businesses. Any levy on bank deposits would drive away foreign businesses, spark an exodus of Russian capital from Cypriot banks, and drastically contract the economy.

At this point, opening the banks is going to be very tricky. They will need a corrallito like the Argentines had. Restrict withdrawals and only gradually release them. It’s a 100% temporary haircut. The situation is further complicated by the fact that the ECB has issued an ultimatum to Cyprus, in effect threatening to suspend support via the EU’s Emergency Liquidity Assistance (ELA) program, if Nicosia failed to agree to a bailout package by Monday.

So whom will the Cypriots get to stabilize their banking system?

Can they get the Russians to stabilize their banking system? It is legitimate to ask why a foreign state would do that without control on the future use of its funds – the same problem Europe has. On the other hand, it cannot be comfortable for Russia to move its illicit financial activities to a jurisdiction which comes under stronger American control.

So Russia might well come to the rescue, but the cost might well be, say, future natural gas rights off the coast of Cyprus for Gazprom (hardly a comfortable situation for the Turks). Failure to resolve this situation, though, could well mean a Cyprus exit from the euro zone. And that’s something the markets still have not discounted by any factor.

But more importantly, what is the future of deposit insurance, given this huge breach of trust represented by Nicosia’s attempted actions (backed with the full imprimatur of the EU’s Troika)? It’s said that hard cases make bad law. We can extend that point by saying that dysfunctional economies make bad policy. And does Cyprus have implications for the global banking industry?

I discussed a number of these issues today on “The Current”, a nationally broadcast show on the Canadian Broadcasting Corporation.

Share your perspective