Published in Business Spectator (Melbourne), 24 January 2013
When Greece got into trouble more than three years ago, many observers were puzzled. How could a country accounting for about 3 per cent of eurozone GDP be ‘too big to fail’?
Why would a minuscule economy on the periphery of Europe threaten to destabilise a currency area consisting of 16 other countries and 300 million people?
As it turns out, even countries smaller than Greece can still turn into major headaches for Europe’s policymakers. The country in question is the island nation of Cyprus.
Cyprus contributes 0.2 per cent of eurozone GDP, is home to about one million people and some of the most troubled banks in Europe.
Cypriot banks have always been closely linked to Greece and so Greece’s crisis had ripple-on effects across the Mediterranean. Unfortunately, solving Cyprus’ banking problems is hard for a number of reasons. Emergency loans to the Cypriot government could eventually lead to a state default; it could set a dangerous precedent for other eurozone countries; and it could be politically poisonous since Western European taxpayers fear that they are mainly bailing out Russian oligarchs, money-launderers and tax-evaders. It’s complicated.
All of these problems are difficult but there is one even bigger worry. Although the sums in question may not be big in absolute terms, at least compared to previous bailouts, whatever happens in Cyprus could still be interpreted as a precedent for the eurozone as a whole.
If the Europeans allow Cyprus to default and leave the eurozone, markets may once again start wondering about the prospects of Greece and other problematic economies. If on the other hand Cyprus receives a bailout despite being hardly “systemic” to the eurozone as a whole then it sends a strong signal to other governments that they will always be bailed out no matter what.
Given these two rather unpleasant options, the Europeans are looking for alternatives. Asking the Russian government to contribute to a bailout may be one. Forcing Russian depositors to take a haircut on their investment in Cypriot banks may be another one. Neither of them is too likely, and just a public discussion of the second option could trigger a bank run by foreign depositors, perhaps not just in Cyprus.
Cyprus’ economy is small. Its annual economic output is roundabout €18 billion. However, in relative terms its problems are enormous. According to estimates, about the same amount of money is needed to recapitalise the country’s ailing financial sector. A bailout worth 100 percent of GDP makes Greece’s previous packages look small in comparison.
The sums in question are so large because for many years the Cypriot banking sector grew strongly. Only a decade ago, the total assets of Cypriot banks were four times GDP. Today they are more than eight times economic output.
As a World Bank paper published two years ago explained quite drily, the growth of Cyprus’ banking system was the “result of an accommodating global environment and policy measures by national authorities to promote them as international financial centres”.
It is a diplomatic way of putting it. Cyprus attracted foreign capital by offering among the lowest taxes anywhere in the European Union. At the same time, not much attention was paid to the sources of these capital transfers into Cyprus.
In November last year, newsmagazine Der Spiegel revealed the existence of a dossier prepared by Germany’s secret service Bundesnachrichtendienst alleging 80 Russian oligarchs had deposited up to €26 billion of illegal money in Cypriot banks. A bailout would thus mainly benefit them, the intelligence agency warned.
The Cypriot government, of course, denies any such claims. All relevant anti-money-laundering agreements had been turned into domestic law, so they have told their European partners. Although this may indeed be true, it is less clear whether these laws are routinely and effectively applied. Other eurozone member governments more or less openly doubt the assurances given by Cyprus.
The political dynamite of a bailout for Cyprus is obvious. Whereas previous eurozone rescue measures could always be sold to the electorate as exercises in pan-European solidarity, providing taxpayer assistance to save illicit Russian money in a tax haven is a much harder sell. Undoubtedly, that’s the last accusation German chancellor Angela Merkel wants to face during her election campaign this year.
Even if the Europeans managed to solve the black money issue, there remain several other problems with Cyprus. A bailout equivalent to about 100 percent of GDP would push Cyprus’ public debt into dangerous territory. Currently its debt-to-GDP ratio stands at 71 per cent at which it is still serviceable. Pushing it up to 170 percent, however, would surely be a level at which Cyprus would struggle to ever get its public finances back under control.
It is also unlikely that the International Monetary Fund would be prepared to be part of such an exercise. Under its own guidelines, the IMF cannot engage in bailouts which look doomed to fail from the start. However, the healthier euro countries insist on the IMF being involved in Cyprus – not least because it provides them with an ally when it comes to enforcing austerity policies and privatisation of state assets. The real question is why the IMF would consider joining the Europeans once again when critics believe the IMF has already become too involved in Europe.
In the end, there is no solution to the Cyprus problem in sight that is both economically sensible and politically possible. So it will probably come as it always does: the Europeans will try to delay the inevitable as long as possible, ideally until such a time after the German elections. And if nothing else helps, then Cyprus will of course get its bailout. Having already mobilised hundreds of billions of euros to ‘save’ the euro, why jeopardise the ‘success’ of these previous efforts now over just a few billion for Cyprus?
The Greek problem has been with us for more than three years now. The Cypriot crisis is more difficult and may last even longer. At least we have learned another lesson: You can be too big to fail – and also not too tiny not to be bailed out.