The Meaning of Cyprus

European officials reached an agreement to support Cyprus, which initially sought aid in June 2012. Cyprus will become the fifth euro zone country to receive assistance. This count includes Spain, even though it got funds for a bank recapitalization program, rather than a broader package that the others are receiving.

The general condition of Cyprus must be understood, It shapes the aid package. It also must be recognized that as the crisis in Europe has evolved, the German Bundestag has a greater role, and its approval, not just support of the Chancellor or Finance Minister.

Cyprus is a terribly small country.  At less than 0.25% of the euro zone's GDP, there was an argument advanced, especially by some German officials initially, that it was too small to pose a systemic challenge and, therefore, may not qualify for joint assistance.  

There are two important elements of Cypriot banks that need to be stated.  First, Cypriot banks, which relative to the small domestic economy, were as large as Ireland's.  It was their exposure to Greece and the restructuring of its private sector debt that was the tipping point.  

Second, Cypriot banks are widely thought to hold large sums of legally questionable funds--a true tax haven--especially by Russian nationals.   Estimates suggest more than half the deposits in Cyprus belong to non-residents. 

Almost a year ago, Cyprus projected its needs at 17 bln euros, which is nearly the value of the country's annual output (~18 bln euros).  However, the deal worked out is for only 10 bln euros and even that will be largely paid by domestic parties.  Therein lies the most controversial elements.  

There will be an immediate tax on depositors in Cyprus.  Large deposits, which are defined as in excess of 100k euros, will lose 9.9%.  The government will take 6.75% from small depositors.    This is expected to raise 5.8 bln euros.  

Electronic transfers have been frozen and reports suggest ATMs have run out of cash within hours of the announcement.  Cyprus is on holiday on Monday and when the banks re-open on Tuesday the tax will have been collected; the funds confiscated. 

This is the most controversial aspect of the concessions.  It is unprecedented in terms of euro area aid programs.  It is not though unprecedented in modern times in Europe.  Italy, it may be recalled, taxed (confiscated) 0.6% of savings to ensure it would be able to join the monetary union in the first place.  Moreover, what is generally not appreciated is that in the EU, unlike in America, depositors do not have preferred status over bond holders.  This makes them significantly more vulnerable.  

Russia, not a member of the EU, has a vested interested Cyprus.  It is thought that the tax on small savers was required so Russia did not think that its citizens were being singled out.  In exchange, Russia will ease the terms of the 2.5 bln euro loan it extended to Cyprus two years ago.  In the coming weeks, a lower rate and longer repayment schedule is expected to be announced.  

To soften the blow of the confiscation of savings, depositors will be given shares in the lenders--a type of forced debt-for-equity swap.  The precise terms are not clear, but it does have the makings of a prisoners' dilemma in terms of what one does with the shares when they are available.  

As part of the conditions for assistance, Cyprus is also being forced to raise its EU-low corporate tax schedule rate of 10% to 12.5%, which matches Ireland (and means that it remains very low).  Many of creditor nations in Europe complain about the low corporate tax rates in some countries.  Yet, as we know, tax schedule rates and the rate companies actually pay are two different things.  The Irish argue that when the effective tax rate, which in Ireland also includes various fees, is calculated, it is actually higher than in a country such as France, which often harangue against low Irish taxes.  

Cyprus is also required to privatize 1.4 bln of state assets.  Recall this was one of the stumbling blocks under the previous president.  Christofias, the former president and Communist, balked at the EU privatization demands.  In response, it was as if the EU waited for regime change (though the ballot box).  The new president, Anastasiades is considerably more pliant.  

It appears that EU officials have agreed to ring fence Greek depositors in Cypriot banks, two of which has notable presence in Greece.  To the extent that Cypriot banks have a presence elsewhere in Europe, those depositors may also be ring fenced, though it is not immediately clear.  There are a number of legal issues that it may turn on.  

When haircuts were forced upon investors in Greek bonds, European officials argued the uniqueness of the circumstance.  Head of the Eurogroup of euro area finance ministers Dijsselbloem talked about the "exceptional nature" of the challenges facing Cyprus.  However, he did not rule out bailing in depositors elsewhere, though quickly added that there were no plans to do so.  

Some have argued that quantitative easing is financial repression because interest rates are arguably lower than they otherwise would be.  Others have argued that the repression lies in the negative real interest rate.  We have been skeptical of the claims and remain so.  

  

The returns on the factors of production (land, labor and capital)  are not guaranteed.  A guarantee of a positive return is associated with rent-seeking behavior or monopolistic position, but not with modern capitalism.  When farmers cannot get enough money for their crop or herd to cover their costs, none cry "repression".  When wages do not keep pace with inflation, none cry "repression".  

Low interest rates to fixed income earners has been offset by the appreciation of assets, including stocks, bonds and real estate.  In addition, the lower rates helped foster stronger economic activity than may have otherwise been the case spurred growth in profits.  Capital is not repressed in the United States and investors from around the world continue bring their savings to America. 

If a central bank buying government bonds and forcing investors to change the portfolio allocation, is financial repression, then what is one to call the confiscation of savings?  Clearly, there is a profound difference between the two. Just ask a Cypriot depositor!

Although the details of aid package for Cyprus are unexpected, the spill over into the capital markets on Monday is likely to be minimum.  Cyprus asset markets are too small for large pools of capital such as mutual and hedge funds, as well as insurance companies.  We do not expect savers in other European countries to be fearful of a confiscation of their savings and spark a run on banks. 

One general principle that the EU continues to pursue is tightening the linkage between solvency and sovereignty.  This is vital and the basis upon which a more integrated Europe will be built.    To the extent one becomes less solvent, one must surrender greater sovereignty.  Cyprus was insolvent.  A large swath of its sovereignty has been ceded to the EU.