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Brave New Bailout

Photo Credit: REUTERS/Yorgos Karahalis

Photo Credit: REUTERS/Yorgos Karahalis

Writing in 1931, Aldous Huxley used Cyprus as the setting for a social experiment gone wrong in his dystopian novel “Brave New World.” The failed experiment sent a warning to future generations regarding the perils of excessive social tampering. Fast-forward nearly a century and Cyprus is yet again the setting, but this time for a struggling European and economic experiment led by the troika of the European Union (EU), European Central Bank (ECB), and the International Monetary Fund (IMF).

Asked to accept a “voluntary haircut” of 75 percent of Greek bonds held by Cypriot banks in 2011 as part of the initial experiment of the Greek bailout, Cyprus did so hesitantly in a show of European solidarity and faith in the ongoing integrationist project. The amount came to between €4.5-5 billion, roughly 22 percent of an economy that is estimated at €18 billion. When the impact on Cypriot banks, coupled with the disastrous policies of the communist party AKEL and their President, Dimitris Christofias, led to Cyprus becoming the most recent of five European Union countries to ask the EU for a bailout, it became clear this bailout would be quite different from the rest. All this despite Cyprus being a net contributor to the EU budget and never running a deficit until the economic crisis began.

Cyprus, with it’s small population of roughly 1.1 million and low contribution to the EU economy, at 0.2 percent, seemed like the ideal setting to experiment with a message to countries that would require a future bailout, while also measuring the reaction of markets to a possible exit of a EU country from the Eurozone. It would also not be called a bailout, but rather a “bail-in.”

Unlike his predecessor, the newly elected Cypriot government of Nicos Anastasiades, that came to power on February 17, 2013, ran on a successful platform of greater EU cooperation, assembled a Euro-friendly cabinet, employed a Noble Prize winning economist on its advisory board and was support by European leaders (including Angela Merkel).

By Saturday, March 16, this same government was forced to present its populace with an experimental and unprecedented, one-time, 9.9 percent levy – a.k.a. “bail-in” – on uninsured bank deposits over €100,000 and 6.75 percent on insured deposits under that. The EU hoped Cyprus would implement the levy to come up with €5.8 billion, similar to the “haircut” Cyprus sustained for Greek bonds, so the EU could loan its banks €10 billion to keep them afloat. The deal was rejected by the Cypriot parliament to the stunned amazement of international governments and press. But with no alternative methodology to offer, Plan B would look much the same.

The plan that was eventually agreed would lead to the breaking up of Laiki, the island’s second biggest bank, into “good” bank and “bad” bank. The Bank of Cyprus, the island’s biggest bank, would absorb the deposits of the “good bank” under €100,000 and its nearly €9 billion in Emergency Liquid Assistance (ELA); the “bad bank” would be dissolved. Capital controls, a limit on amounts that could be withdrawn from banks, were imposed at an initial €300 a day. The Cypriot corporate tax rate was also increased to 12.5 percent, up from a EU low 10 percent. Deposits over  €100,000 in Laiki and Bank of Cyprus are to receive an estimated 40 percent haircut.

Seeing this grim situation, Anastasiades personally took a pay cut of 25 percent, with his staff following at a 20 percent cut. Electricity companies have vowed not cut power if bills are late, or paid at all. The islands main telecommunications company is also allowing free calls within Cyprus. Memories of the 1974 invasion and subsequent ongoing occupation of the island has stirred a collective response and social cohesion that has been unique to Cyprus and stunned observers.

For its part, the “bail-in” was targeted at Cypriot banks, estimated at eight times GDP, with the aim of reducing their size to sustainable levels. Despite parliament rejecting the Plan A proposal, the mere fact it was a real possibility effectively destroyed the island’s status as a banking hub, which, combined with tourism contributes to 75 percent of Cypriot GDP. While the beaches aren’t going anywhere, the islands reputation as a reliable place to park money in a notoriously unreliable region is finished. This has also sent a worrying signal to other Euro members with large banks, like Malta (seven times GDP) and Luxembourg (22 times GDP).

What isn’t often mentioned is that these are loans, not gifts; interest is charged, at often-favorable rates, and they must be repaid. The high cost of bailouts on domestic politics seems to have taken their toll and with elections, specifically in Germany, on the horizon there seems to have been a push to assuage respective domestic EU voters that bailout money would not go to prop up banks bloated on Russian deposits in Cypriot banks.

Heavy Russian investment in Cypriot banks was the clear variable to the bailout experiment. Claims that Russian money was laundered through Cypriot banks had become a claim cited, with little proof, in popular media. It’s true that Cyprus has a favorable double-taxation treaty with Russia and had a EU-low 10 percent corporate tax rate. But Cyprus is also ranked 29th on the Transparency International 2012 ranking and is a member of MONEYVAL. If laundering was a concern, it would be listed in the report and legal recourse could and should have also been sought in concert with a shrinking of the banking sector over time, as opposed to the irreparable damage to Cypriot banks and the economy that has occurred instead. This has led many to questions if this was a consideration of the experiment at all.

Whatever the case may be, Cyprus stands poised to confront serious economic questions in its short, medium and long terms, just as the EU faces serious questions about its solidarity and future. The preliminary results of the experiment are in and its outcomes have left a lot to be desired.

Meanwhile, other countries are contemplating an experiment of their own.


Gus Constantinou is a commentator on U.N., EU and international affairs. You can follow him at @gus_c13