Cyprus: A Small Country Raises Big Questions

The Cypriot bailout rekindled many fears about the eurozone’s ability to stay together.

Recent negotiations over Cyprus’ bailout plan tested the hard wrought stability of a union which seemed finally to have solved a few of its core problems.

Few imagined that the Mediterranean country’s financial problems, well known in advance, could rattle the European Union anew. Yet an economy approximately one tenth the size of Greece’s, where the estimated sum of a bailout package would reach a maximum of €18 billion, in relative terms a paltry sum, raised more existential problems for the euro.

Cyprus’ rescue could have been the culmination of two years of negotiations and institution building. It could have shown the world and indeed the European Union itself that it was finally able to handle these situations with little ado.

Yet old superstitions arose and instead of following on recent developments, the European Union and the International Monetary Fund decided to break assurances and introduce new contingencies, the consequences of which will only be fully known once a bigger euro country enters a period of instability.

Northern European countries believe that Cyprus’ economic policy structure has two undesirable elements to it.

First, it has an oversized financial sector. Cypriot bank assets are worth roughly seven times the island’s gross domestic product. Financial institutions choose to settle in Cyprus because it is part of the single-currency union but has a lower corporate tax rate than most member states.

Second, it is a hub for Russian investors who wish to deposit their funds in the eurozone. This has created the perception of European taxpayers having to bail out a tax haven of the Russian oligarchy.

Even in ordinary times, saving Cyprus from the possibility of sovereign default would therefore have been difficult. With German elections scheduled for later this year, the bailout was all the more politically toxic.

The Cypriot bailout was preceded by half a year of negotiations about how to decouple the problem of indebted states from banks that might need financial aid to survive. One of the pieces missing from the framework is a European deposit guarantee that should alleviate the fears of savers in especially the south of Europe. If a bank there collapses, states, coping with high debts of their own, might not be able to compensate savers. A deposit guarantee scheme spanning the whole of the euro area if not the whole European Union would remove such uncertainty.

Instead of building on this framework, however, Cyprus was presented with something else entirely.

The first proposal from the European Union would have required all depositors to contribute to the refinancing of the banking industry. This meant a 9.9 percent tax on big savers and a 6.75 percent levy on deposits under €100,000.

Uproar ensued and capital controls were imposed to stave off a bank run. Parliament rejected the rescue plan unanimously. Only later did it emerge that the scheme had been suggested by Cyprus’ president Nicos Anastasiades who feared that if regular depositors were not included, big depositors would take a hit that could destabilize his country’s economic model.

The revised rescue plan safeguarded deposits under €100,000 in accordance with a 2009 guarantee pledge. The damage, however, was already done.

Even if the deposit guarantee was honored, the situation left many wondering what would happen if a similar situation occurred in a systematically more important member of the eurozone. If Cyprus, small enough to be bailed out, could consider a deposit tax, are savings in Italy and Spain safe? Just how solid is Europe’s deposit insurance promise anyway?

European leaders insisted in July 2011 that private-sector involvement in the restructuring of Greece’s debt was “exceptional” and “unique.”

All other euro countries solemnly reaffirm their inflexible determination to honor fully their own individual sovereign signature and all their commitments to sustainable fiscal conditions and structural reforms.

The situation in Cyprus was different. Private investors were not directly involved in a sovereign debt restructuring. Yet given the context of the Cypriot bailout, the question for businesses and savers across Europe must be — how different?