Cyprus: Dismal lesson and obscure future

Cyprus is the latest casualty in the Euro crisis but the story of how this small island state became mired in a financial and banking crisis and the draconian nature of the bailout imposed on it by the Troika (International Monetary Fund, European Central Bank and European Union) has not been adequately and accurately reported by the international media. Roberto Savio explains what really happened.

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THE narrative of the Cyprus crisis story is an excellent example of how inadequate media coverage has now become. Very few will have understood what has really happened, and what its implications are.

Following events without any background or without placing them in their contexts is one of the main reasons for the decline of media as windows on the world.

To explain what has happened and what is likely to happen now requires three angles of analysis: how the Cyprus crisis came about, how it stands in the context of the banking sector worldwide, and what its implications for Europe are.

Let us start from Cyprus and, more precisely, with the Republic of Cyprus. In fact, when speaking about the Cyprus of the banking crisis, we are referring to three-fifths of the island of Cyprus, the Greek part. The other two-fifths are a separate political entity, the Turkish Cyprus that only Turkey recognises.

When Greek Cypriot nationalists and elements of the Greek military junta declared the union of the island with Greece in 1974, the Turkish army invaded the northern part of the island to protect the Turkish population, a substantial minority. The result was a serious blow to the island's economic development. Greek Cypriot losses of land and personal property in the occupied areas were substantial, and they also lost Famagusta, the only deep-water port, and the Nicosia International Airport.

The GDP of the Greek sector dropped by one-third between 1973 and 1975. Today, the Republic of Cyprus is a small territory of just over 5,000 square km, and a population of 860,000 people.

With only tourism as its main economic activity, the Republic of Cyprus chose to become a financial centre by making it attractive for companies that decided to set up on the island. It offered generous rates of 6-7% per year on deposits, and a very light 10% tax on foreign companies (even less than the 12% of Ireland).

There were not many other choices and when, on 1 May 2004, Cyprus joined the European Union (EU) together with nine other countries, everybody in Brussels knew that finance represented 45% of the GDP of the small Greek part of the island.

By becoming part of the EU, Cyprus became very attractive for investors from outside Europe, especially for Russians who wanted to take away money from the uncertain Russian banking system, and now about 60,000 Russians live on the island.

The banking sector grew so much that its total deposits reached nine times its GDP. In 2008 alone, $40.7 billion was funnelled into Cyprus through loans and bank deposits, amounting to 161% of the Cypriot GDP that year.

But the Cypriot banks, like all banks after the final elimination of the separation between deposit banks and investment banks (the fateful decision by US President Bill Clinton in 1999, under pressure from the financial lobby), used the money from their deposits to gamble on investments that could give a higher yield. So, they invested more than $4.7 billion in Greek bonds, which were giving a high return. But those bonds were based on fake data provided by Greek authorities about their financial health. And everybody in Brussels, Bonn, Paris, The Hague and elsewhere knew that!

Meanwhile, all banks became involved in two successive global crises: the derivative-mortgage crisis that originated in the United States in 2008, and then Europe's sovereign bond crisis (the bonds issued by states were not backed by healthy national budgets). The financial markets went into panic, and banks worldwide were stuck with bad investments.

To make a very long and complex story short, let us remember that worldwide over $4 trillion went into stabilisation of banks and stimulus initiatives.

And then, in May 2010, Greece asked for help from the EU, followed by Ireland in November 2010, then Portugal in 2011 and Spain in June 2012. The bailout for Greece was 172.6 billion euros, Portugal 78 billion, Ireland 67 billion, and Spain 41.3 billion. The bailout for Cyprus was established at 10 billion euros. This amounts to 0.06% of Europe's annual economic output. And the entire problematic Cypriot banking system, with 126.4 billion euros in combined assets, is smaller than the 11th largest German bank and the 44th largest bank in Europe.

So why did Cyprus become so important, and why did it shake Europe's foundations? And why did all this happen after the famous declaration of the President of the European Central Bank (ECB), Mario Draghi, that the ECB would never let the euro sink, thus stopping all market speculation against the bonds of European countries?

Here, we need to look into the timeline of the Cyprus affair.

On 25 June 2012, the then President of Cyprus, the Communist Dimitris Christofias, makes the first request to the eurozone for financial assistance.

On 29 November 2012, the first memorandum of understanding on financial assistance for Cyprus is drafted, barely noticed in international circles.

The EU waits to act. Why? Because Cypriot elections are coming, and hopefully a Conservative government will take over. Christofias is considered too close to the Russian investors, and he obtained a loan of $2.5 billion from Russia, bypassing Brussels.

On 11 January 2013, European Conservative heads of government, including German Chancellor Angela Merkel, arrive in Limassol to support opposition leader Nicos Anastasiades ahead of general elections. Anastasiades is a successful investment lawyer who has several Russian billionaires in his portfolio.

On 24 February, Anastasiades wins the presidency in a run-off.

On 1 March, the new government is sworn in, and Michalis Sarris, a former finance minister and World Bank official, becomes finance minister. He was also a member of the board of the second largest bank in Cyprus, the Cyprus Popular Bank (Laiki Bank in Greek).

Then on 15 March, Cyprus reaches a deal with the Troika [the International Monetary Fund (IMF), the ECB and the EU] for a 10 billion euro bailout. But, to reach its requested target of 17 billion euros, Cyprus must source the remaining 7 billion euros internally. From where? From its banking sector, of course.

The Cypriot president wants to defend the big Russian investors at any cost, so he presents a plan to impose a one-off levy of 6,755 euros on deposits up to 100,000 euros and 9.9% on deposits over 100,000 euros. The Troika and finance ministers accept this proposal. This was a major mistake, as the EU solemnly decided to protect all deposits up to 100,000 euros by insuring them with ECB backing, and leaving deposits over this amount uninsured.

A large campaign, triggered by a leaked German secret service report, and relaunched by German and British media, presents Cyprus as a haven of laundered Russian and drug money, and denounces any Cypriot resistance to the Troika requests as protection of dirty money and investments.

In actual fact, Cyprus has obtained high marks from MOKAS, the official Council of Europe body that evaluates anti-money-laundering measures, as one of the few countries in full compliance. And it scores 406.5 on the Financial Secrecy Index, against 1879.2 for Switzerland, 669.8 for Germany and 616.5 for the UK.

Anastasiades goes back to Cyprus, and, as we all know, the Cypriot parliament rejects this plan, with not one vote in favour. Anastasiades goes back to negotiations and on 25 March, a new plan is agreed, winding down the Cyprus Popular Bank, the second largest lender, and transferring its assets to the Bank of Cyprus, the largest. Insured deposits (up to 100,000 euros) will be left untouched, but uninsured deposits will be taxed, up to the level of coverage required for the bailout.

Close to $4 billion had already left the island at the time of negotiations, before banks were closed, and some estimate that uninsured deposits will have to be taxed up to 80% and all shareholders (136,000 people) and bondholders will lose everything, around 5,000 people will be fired and international companies will leave Cyprus. Strict control on capital is introduced, with many restrictions, strangling the island's economy.

Now, let us draw the main conclusions.

It is widely known that Germany was the main enforcer of this new approach to strict severity, where for the first time not only bank shareholders and bondholders but also depositors were called on to contribute to the bailout. But then, the new chairman of the Eurogroup that brings together Europe's ministers of finance, Dutch finance minister Jeroen Dijsselbloem, explained in a lengthy interview that this is a 'new template' which will be used for future bailouts. Bank investors will be required to participate, and no longer will European countries alone pay for the mistakes of banks.

Of course, this created a wave of concern in the weaker countries, like Spain and Italy, met by a soothing reassurance from the European authorities that 'the Cyprus case is exceptional'.

But then Klaas Knot, another Dutch member of the ECB, said that eurozone banks needed to clean up their balance sheets by winding down loss-making operations. 'Firstly, there has to be transparency about losses in the banking sector. Secondly, banks have to wind down their loss-making operations,' Knot said.

And then, ECB sources started to admit that this was going to be the basis for future bailouts. German finance minister Wolfgang Schauble declared: 'Cyprus is living with a banking sector with low taxes and favourable laws that is completely overdrawn and that makes Cyprus bankrupt. This business model is not sustainable.'

The same position was taken by the ECB board member Jorg Asmussen (former German finance minister), who represented the ECB in the negotiations. So, it was clear that there was an agenda being pushed by Germany and the Netherlands, which, together with Finland, represent the fiscal hawks of the Eurogroup. Largely absent in the negotiations were the ministers of other countries.

Now, it is certainly upsetting that so many supposedly brilliant personages did not realise the message they were sending to Europe. They were basically saying:

(1) Deposits are no longer safe. If in the first negotiation, the Troika accepted to tax ALSO deposits below 100,000 euros, this meant that no deposits in European banks are safe in the event of a crisis. Bondholders and shareholders make investments in a bank, and they enter a financial game in which they can lose. But depositors enter a bank to protect their money, not to speculate. To wipe out those deposits is an ethical issue, especially if - without the depositors' knowledge - the bank gambles with their money on the market and thus becomes responsible for its demise. Depositors are, in other words, victims twice over. As Nobel economics laureate Paul Krugman says, this is like putting up a big neon sign saying 'Bring your money to the safest bank in the safest countries, like Germany or Switzerland'. But this will increase the internal imbalance between the countries of Southern Europe and Northern Europe. Is this in the interests of the whole of Europe?

(2) To avoid capital flight, restrictions on capital are now in place in Cyprus that will last a long time. But freedom of movement of capital was a very central European idea. This idea has now been undermined. And so has the idea of a European currency. There are now two euros, not one. The Cypriot euro, for example, can be spent freely only in Cyprus.

(3) The destruction of Cyprus as a financial haven is an understandable idea. But what about the people? There will now be a drop in GDP of at least 20% in the immediate future. The EU will have to do another bailout, as was the case with Greece. Again, a large part of the population will go into suffering and misery. Will the hawks take the same moral attitude of intransigence?

(4) The credibility of the Troika has taken a serious hit. After the collapse of the first proposed agreement (the one which also taxed insured deposits), a sad show of leaders all trying to pass the blame for this mistake to the others has undermined the legitimacy and trust of the present leadership. And it has provided further ammunition to those who complain about the opacity and unaccountability of the EU.

(5) This handling of the Cypriot crisis has made it very clear that Germany is the undisputed decision-maker on European questions and acts according to its views, with little ability to listen to others. Commerzbank's chief economist Jorg Kramer has already suggested 'a one-time property tax levy and a tax rate of 15% on financial assets' to save Italy from probable bankruptcy. Of course, this looks like a not-too-subtle invitation to shift Italian deposits to German banks.

(6) Russia was never involved or consulted, in spite of its massive presence in Cyprus. In Moscow, this was seen as further proof of German Chancellor Merkel's efforts at containing Russian leader Vladimir Putin's access to Europe.

To complete this part on Cyprus, let us make clear that if that financial model is not acceptable, next in line are two other European countries: Slovenia and Malta.

The IMF says that Slovenia will need to issue three billion euros in bonds this year. Since yields have shot up from 4.5% to as high as 6.4% as a result of the Cyprus rescue, that could be a costly order. And notice that these are dollar bond yields; the country is taking a currency risk to obtain these funding rates. The country may be forced to seek painful assistance from the Troika. It is also one of the smallest members of the EU, with fewer than two million inhabitants.

As with Cyprus, Slovenia's problem is its banking sector. But it is a tame 200% of GDP, not the Cypriot banks' 900% of GDP. One of Slovenia's biggest banks was one of only four in Europe to fail the stress tests (two of them were the banks in Cyprus now inflicting haircuts on big depositors). Non-performing loans at the three biggest banks, according to the IMF, rose from just under 16% in 2011 to over 20% last year. That means that they are insolvent. The debt is mainly corporate debt, the result of lax lending by state-owned banks to cronies. Therefore, in the case of Slovenia, there is even less ground for pity than there was for Cyprus.

The next case is Malta. Covering just over 300 square km of land, it has few natural resources, restricted freshwater supplies and no domestic energy sources. Until the late 1980s, the Maltese economy was heavily dependent on tourism, a limited manufacturing sector and its favourable position as a freight transshipping stopover, but that has changed radically over the past 25 years. The government decided to develop the financial sector, and to make it a viable alternative to Dublin and Luxembourg as a base for investment funds and operators alike.

Although the country is sometimes still referred to as an offshore tax haven or a low-tax jurisdiction, neither term correctly describes Malta's tax system. In response to a request from the European Commission that Malta abolish tax provisions that might distort competition within the EU, a number of changes were introduced in 2007 creating a tax regime that is fully EU-sanctioned.

A full imputation tax system has existed in Malta since 1948. The rate for corporate taxation in Malta stands at 35%; however, upon distribution of dividends, shareholders may qualify for a refund generally equivalent to 6/7 of the tax paid, resulting in a paid tax rate of 5%. The financial publication The International Banker reported, 'Malta Represents A Safe Haven For Currency Flight From Cyprus Misery'.

With the situation in Cyprus critical, Malta - just a two-hour flight away from Cyprus - may play an important role for business and domestic capital flight from Cyprus and even more so for the Russians who have invested in Cyprus and are seeking an alternative international financial services centre.

These facts, combined with the strength of the financial services sector in Malta, make it the ideal international financial services centre for 'currency flight from the misery in Cyprus'. Malta's banking sector is already three times its GDP. But it is unclear how much money went into bad investments, and the rumours are not positive.

Then, finally, comes Luxembourg, the richest country in the world on a per capita basis. It is also a small country, with an area of 2,586 square km and a population of fewer than half a million. It will probably not need any bailout because it is doing extremely well, thanks to a very cautious investment policy. But Luxembourg is the paradigm of the model that Germany's Schauble and the Troika are fighting. Its financial sector is 21.7 times its GDP. It has three billion euros of offshore capitals, of the 20 existing worldwide. And it has a Financial Secrecy Index score of 1621.2, against 406.5 for Cyprus.

It has created the SPF ('Societe de gestion de patrimoine familial') regime, which does not pay taxes on capital, on revenues or on VAT, and is only subject to an annual subscription tax of 0.25% levied quarterly on its share capital. Already, Luxembourg authorities are raising voices against the argument that financial havens are not sustainable and legitimate.

But it is clear that new bailouts are looming on the horizon and this brings us to the second point of this Cyprus crisis post-mortem. It is incomprehensible why our political system agrees to place so much suffering on its citizens without facing a very simple fact: the banking system as we know it is intrinsically fragile, and will continue to create one crisis after another.

This is because there are two problems that we do not address: one is the bad investments made by banks worldwide. Nobody knows exactly how much is hidden in bank budgets. Some estimates talk of $2 trillion, others of $3 trillion. The IMF estimates that there are $800 billion of toxic titles still in existence, after all the efforts to clean up bank budgets.

The second problem is clearer. Until 1999, we did not experience this state of permanent financial crisis. That was due to the fact that until then the deposit banks were not allowed to use their funds for speculation. The deposits were held in a stable system, and the banks did what they were supposed to do: take deposits, and make loans to households or enterprises on the basis of a cautious evaluation of the quality and feasibility of the loan, taking into account the collateral.

But ever since Bill Clinton eliminated the distinction between deposit and investment banks, all banks have gone into the market, creating financial instruments like derivatives and many other high-risk investments in order to obtain higher returns.

That has brought about a division between finance and production. Finance has taken on a life of its own: make revenues, even at a high risk, to be able to give absurd bonuses to bank executives.

Today, for every dollar which comes from production of goods and services, there are $40 moving in financial transactions. And of course, this enables more money to be made from investing/speculating in financial markets than from making loans to households and enterprises.

The banks have become entities that are frequently subjected to criminal investigations, something that has never happened before. They have become a systemic risk for the international community. It would take pages and pages to report the cases in which they have been found guilty of criminal activities.

Just to report what has been going on recently: In Spain, 92 financial executives are in court for fraud, linked to the 37,700 million euros of taxpayers' money they have received - more than what was cut in health and education spending.

In the United States, the SAC hedge fund paid an amount of $602 million in a settlement with the Securities and Exchange Commission (SEC).

In Europe, Deutsche Bank has set aside 600 million euros for legal costs, for its role in fixing the Libor interest rate. This fraud will cost the banking sector more than $2 trillion.

Incidentally, we now know that Deutsche Bank received at least $11.8 billion in US taxpayer-funded bailout money. What did it do with the funds provided by the American taxpayers? It invested this in opening the giant Cosmopolitan Hotel and Casino in Las Vegas for a total of $4.9 billion: a poor investment, because the world capital of gambling is suffering from the consequences of the US economic crisis.

And the bleeding continues. On 1 March, the US government gave AIG, the giant insurance company, another $30 billion of taxpayers' money; this, after the $150 billion given since September last year.

What is disheartening is the declaration by US Attorney General Eric Holder before the Senate that there is a reluctance to pursue legal actions against these firms for fear of destabilising the markets.

'It does become difficult for us to prosecute when we are hit with indications that if we do ... bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy,' he said. 'It has an inhibiting influence [and impacts on] our ability to bring resolutions that I think would be more appropriate.'

The subsidy and its effects remain entrenched and continue to distort the free market. And if justice acts, the banks fight back. In New York, 15 banks are fighting a ruling in the US mortgage case, where they have been summoned for selling billions of dollars in sub-prime mortgages that soured, causing banks and investors to incur huge losses. That was the start of the global financial crisis which has left millions suffering all over the world.

And now, who has been appointed as the new head of the SEC? Mary Jo White, who has spent the last decade in private law practice defending banks, including JP Morgan, which lost $1 billion on the London exchange through gambling beyond reason. And in the US House of Representatives recently, seven bills explicitly designed to expand taxpayer backing for derivatives were approved in a committee by 31 to 14 votes.

By now, it is clear that the financial mess is due to lack of political leadership. Nobody dares to put the genie back inside the bottle.

As an example of what we have lost in political leadership, let me quote part of a speech given by former German Federal Chancellor Helmut Schmidt on 4 December 2011 at the Social Democratic Party Conference in Berlin. At that time, he was 94 years old:

'At all events, the members of the euro currency union should work together to introduce radical regulations for the common financial market in the euro currency area. These regulations should cover the separation of normal commercial banks from investment and shadow banks; a ban on the short selling of securities at a future date; a ban on trading in derivatives, unless they have been approved by the official stock exchange supervisory body; and the effective limitation of transactions affecting the euro area carried out by the currently unsupervised rating agencies ... Naturally, the globalised banking lobby would again move heaven and earth to prevent this. After all, it has thwarted all the far-reaching regulations that have been introduced so far. It has deliberately engineered a situation in which its herd of dealers has put European governments in the predicament of having to constantly invent new "rescue mechanisms" and to extend them by means of "leverage". It is high time something is done about this. If the Europeans have the courage and the strength to introduce radical financial market regulation, we have the prospect of becoming an area of stability in the medium term. But if we fail in this respect, Europe's influence will continue to decline ...'

This brings us to how memory is short. Sweden did exactly this. When its banks went bankrupt, they were temporarily nationalised, their shareholders and bondholders were wiped out and boards and management fired. Then, the state restructured and recapitalised the banks before selling them on the market, with the proceeds going back to the taxpayers, offsetting the restructuring costs.

Iceland went well beyond. The three largest banks amounted to 10 times the country's total GDP. There was no way the government could face that amount of loss. The government decided to let the banks go bankrupt. A large part of the deposits and investments were from British and Dutch citizens. British deposits alone were 2.3 billion pounds. Of course, the UK and the Netherlands governments held Iceland's government accountable, and asked for repayment, with the UK using an anti-terrorism law to freeze the UK-based assets of Kaupthing Bank, Iceland's biggest bank.

Then the Icelandic government organised a referendum, and the 312,583 inhabitants voted 93% against and only 2% in favour of the British and Dutch requests. Even more, the prime minister and the finance minister were brought to court because of their inability to monitor the banks. So, the UK and the Netherlands went to the court of the European Free Trade Association (EFTA), which recently delivered a judgment in favour of Iceland. But did you hear anything about this?

And now, the last lesson from the Cyprus mess. It is clear that Europe is in a very serious crisis but there was no need to bring the IMF into European affairs.

The IMF is under Washington, which is the single largest shareholder and has a blocking vote in that institution, and its managing director Christine Lagarde has much less power than her predecessor, Dominique Strauss-Kahn. The IMF staff has been pressuring Europe with its traditional financial cure: bleed the patient for his recovery. Countries can afford welfare and social justice if they have the means. Otherwise, a good bloodletting will do.

The IMF interaction has given legitimacy to the sinister bow of the EU to the financial markets, with the misery that the macroeconomic quest for balanced budgets has brought to the weakest sectors of Europe's population.                                                       

Roberto Savio is founder and president emeritus of the Inter Press Service (IPS) news agency and publisher of Other News. The above is extracted from an article which first appeared on the Other News website (www.other-news.info).

*Third World Resurgence No. 271/272, Mar/Apr 2013, pp 5-9