Cyprus

How Europe Let Cyprus Get Into This Mess


A man withdraws money from an ATM in the Cypriot capital of Nicosia, on March 16

Photograph by Barbara Laborde/AFP via Getty Images

A man withdraws money from an ATM in the Cypriot capital of Nicosia, on March 16

Is taxing depositors in the banks of Cyprus to finance a bailout a dangerous precedent? Yes. But the real scandal is how Europe let the Cypriot banks get into such deep trouble that there were no good ways out and the tax on depositors came to be seen (by some, anyway) as the least bad option.

Even though Cyprus is a militarily and ethnically divided country with a history of banking secrecy, it was allowed to become a member of the European Union in 2004 and a member of the inner sanctum—the euro currency zone—in 2008. Under the nose of the European Union, Cyprus developed a banking system that’s too big for the national government to support, with assets of seven or eight times the nation’s annual gross domestic product.

Cypriot banks took in billions of euros in deposits, including from Russian oligarchs who’ve set up business on the Mediterranean island nation. Naturally, they had to put all that money to work somewhere. Reaching for attractive returns, they invested depositors’ money heavily in Greek loans and bonds—and took a beating when Greece’s economy skidded. The Cypriot banks also invested heavily in the sovereign debt of Cyprus itself, a fatal embrace in which any losses forced on the holders of government debt would wipe out the banks.

All this happened under the supervision—clearly too lax, in retrospect—of the European Union, the European Central Bank, and the International Monetary Fund. Cyprus did bring itself into compliance with bank secrecy laws, but according to the German newspaper Spiegel, German officials, in particular, have argued that what’s true on paper may not be true in practice.

The ugly Cypriot bailout reinforces a lesson from Greece: Peripheral nations’ membership in Europe’s financial inner sanctum creates moral hazard and a dangerous tendency toward instability. International investors gain confidence that their investments will be protected. So money floods in. Prosperity increases. Buildings are erected. For a while, everything looks good. But discipline remains loose, corruption continues, and investments go bad. When the house of cards collapses, alarmed investors look to governments to save them. Everyone loses—taxpayers in Europe’s wealthy nations as well as ordinary citizens in the poor debtor countries.

The depositor tax imposed by the troika of the EU, ECB, and IMF is designed to redistribute the pain a bit from past bailouts. The Germans, suspicious that much of the Russian money in Cypriot banks is illegitimate, insisted that depositors take a hit. Germany has led calls for Cyprus to step up anti-money laundering efforts as a condition of receiving aid.

The upside of the tax is that it could bring some market discipline to banking—depriving rickety banks of easy access to foreign funds. The downside is that depositors in other countries with financial difficulties, particularly Spain, Portugal, and Italy, could fear they’re next and start a run that would destroy their banking systems. Troika officials insist Cyprus is unique.

If the troika hadn’t allowed Cyprus to get itself into such a mess, it wouldn’t have such an unenviable set of options.

Coy_190
Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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