Big repercussions from Cyprus

After Greece, Ireland, Italy and Spain, fixing tiny Cyprus’ problems should have been quick work for European leaders and financial institutions. Instead, the deal to fix the island’s troubled economy has raised doubts about one of the most sacred of banking principles and undermined assumptions about best banking practices. It sets a worrying precedent.

With a population of a little over 1 million people, Cyprus is the eurozone’s third-smallest economy, with a gross domestic product of $23.5 billion in 2012. It actually handled the 2008 global financial crisis well; its recession was much milder than that of most euro economies and it has registered higher growth than its neighbors.

Unfortunately Cypriot competence was swamped by the Greek debacle. Not only is the Cypriot economy closely tied to that of its much larger neighbor, but the banks in Cyprus were holding large amounts of Greek debt. When Greece wrote down that debt — giving what is sometimes called a “haircut” to its creditors — Cypriot banks took a big hit.

Cyprus Popular Bank was holding €3.4 billion in Greek government debt and lost €2.5 billion, nearly three-quarters of the value of its holdings. Total Cypriot losses are reckoned at just under $6 billion.

In response, the government nationalized Popular Bank. That put a big hole in the national budget, and the country’s debt-to-GDP ratio, currently at 87 percent, is anticipated to swell to about 140 percent. That has pushed up borrowing rates for Cyprus’ bonds to 7 percent on long-term debt.

The government turned to “the troika” — the European Union, the European Central Bank and the International Monetary Fund — for aid. A €10 billion aid plan was cobbled together, but on the condition that Cyprus itself contribute half of that amount.

To do so, the government first announced that it would impose a one-time tax on bank depositors. Accounts under €100,000 would be charged 6.75 percent; those greater than €100,000 would be taxed at 9.9 percent. Altogether, these charges were expected to raise €5.8 billion, which would constitute Cyprus’ contribution to the bailout.

There are three problems with the proposal. The first is the most obvious. Forcing bank depositors to pay those taxes renders meaningless the concept of deposit insurance, a government guarantee that money put in banks is safe from mismanagement. No pledge is more essential to the banking system.

Without it, smaller banks or any bank with questions is likely to be subject to a run on deposits at the first sign of a problem, creating liquidity crises. The promise of government protection of deposits provides solidity and stability for banks and their customers.

Second, and related to the first issue, is that Cypriot banks have extensive deposits — at €68 billion, more than four times the country’s GDP. Banking growth has come from those deposits, not as with many other banks, as a result of massive bond sales.

After the events of 2008, many observers think this is a better model for banking, and can ensure that banks do not become over exposed. So, on one hand, giving bondholders a haircut — the usual way of dealing with such crises — would not work in the case of Cyprus because it would not raise enough money. On the other hand, taxing depositors undermines the idea of encouraging banks to use deposits to underwrite growth.

The third problem is the fact that most of the big depositors in Cypriot banks are Russians, many of whom are suspected of using the country’s lax regulations for laundering money. It is reckoned that they constitute €19 billion of the deposits in Cyprus. And it is generally believed that the tax on large deposits was set at 9.9 percent to avoid topping double digits, and thereby necessitated the tax on smaller account holders.

The imposition of a tax on all depositors raises moral questions given the provenance of many of those funds, especially when many of the smaller account holders are British pensioners. Yet even that ceiling has offended Russia, where officials have complained about insufficient protection for their nationals.

In sum, those problems were large enough to get the Cypriot Parliament to reject the proposal on Tuesday. Not one of the country’s 56 legislators backed the plan.

Now the government is looking for other options. One possibility is to play up the Russian connection and sell rights to the country’s gas reserves to Gazprom, the Russian gas giant. That could tide the country over until the gas is produced and the country can tax those flows. The country’s finance minister has already gone to Moscow to see what can be arranged.

Small as it is, Cyprus has the potential to do great harm to Europe. If the deposit tax is adopted, then depositors elsewhere in the region could pull their funds from banks fearing the more widespread adoption of the tax.

If Cyprus is allowed to turn down the troika’s terms for aid, then other governments could be tempted to do the same. And if Cyprus decides that it must eventually leave the euro, it sets a dangerous precedent. A tiny country has created a huge headache for Europe.