Cyprus: The Essence of FUBAR

If you’ve been waiting your entire life to witness the pure, un-adulturated, distilled essence of FUBAR, your dreams have been answered: for behold Cyprus!

For in one fell swoop, the with their monster mash of a bailout-bail-in of Cyprus, the Eurotards have succeeded in: gutting the rule of law and due process; riding roughshod over democratic institutions; increasing the risk of a catastrophic bank run in the event any Eurozone country (e.g., Spain) is believed to need to seek assistance; and sparking a huge diplomatic row with Russia.  Well played! Well played, indeed!

For those dwelling under a rock: as part of a 10 billion euro bailout for Cyprus, the Euros (meaning primarily Germany) required the imposition of a tax on deposits in Cypriot banks: a 6.75 percent tax on deposits below 100,000 euros, and 9.99 percent on deposits above 100K euros.

The bail-in essentially guts deposit insurance, which allegedly protects deposits below 100K.  A run on Cypriot banks is almost inevitable, because who is to say that this haircut is the last?  What’s worse, depositors in other peripheral banks have to take seriously the prospect that they will be similarly expropriated, in the event that their banks and/or sovereigns (to the extent this distinction has any meaning) require a Eurozone bailout.  This makes them much more likely to run at the first hint of trouble.  And of course, these things can be self-fulfilling.  If, say, Spanish depositors become more worried about the financial condition of the country’s banks, fearing having some of their deposits confiscated they might start to pull their funds from the banks; in the event, unable to fund themselves, the banks-and the Spanish government-may be forced to throw themselves to the tender mercies of the Germans, et al, leading to the imposition of the dreaded deposit tax.

The dynamics in these situations are always complicated, and highly dependent on beliefs, but it cannot be gainsaid that the actions in Cyprus increase appreciably the odds of a destabilizing run somewhere in the Eurozone, especially on the periphery.  Therefore, it is worthwhile to keep an eye on deposits at peripheral banks for any evidence of the beginnings of a run.  Relatedly, keep an eye on Target2 balances; an uptick in German Target2 assets could indicate attempts by peripheral depositors to move their funds to core banks.

The best-only?-hope of avoiding such an outcome is that Spaniards, Greeks, Italians, etc., believe that Cyprus is truly an exceptional, one-off case as the Eurocrats claim.  Which leads to the question: what differentiates Cyprus to such an extent that events in Cyprus do not cause depositors in Spain, etc., to update their beliefs regarding the probability they will be similarly expropriated in the event of a bailout of their countries’ banks?

There is one obvious answer: Russia.  Or, more properly, Russian money.

Cyprus has been the most popular destination for Russian funds leaving the country, and most notably dirty money: much of the money stolen in the Hermitage/Magnitsky fraud, for instance, went to Cyprus initially. Germany’s intelligence service, the BND, said in a leaked report that a Euro bailout of Cypriot banks would largely benefit Russian depositors whose money has dubious origins.

This became a huge political issue in Germany.  The Social Democrats made a bailout of Cypriot banks political poison for Merkel: No bailout of Russian thieves!  She is ramping up for an election campaign, and in no way could be seen as bailing out dirty Russian money.

Supposedly she (and the IMF) wanted to force uninsured depositors (including many of the Russian depositors) to bear the entire burden of the bail-in, but Cyprus’s government refused.  Hence sharing the pain with smaller depositors.  But that has unleashed a furious reaction in Cyprus, and it is likely that the deal will be redone so as to put more of the burden on the uninsured (read-Russian) deposits and less on the insured deposits.

Which will only infuriate the Russians more.  And they are already plenty furious.  Putin just about lost his sh*t today, calling the original deal “unjust, unprofessional, and dangerous.”  And that’s before any adjustment of the deal to the further detriment of Russian depositors.

Any initial schadenfreud should be stifled: yes, the Russians are the masters of unjust expropriation, but two wrongs don’t make a right.  If some Russian money in Cyprus is dirty, being laundered, etc., the right way to handle it is to investigate and provide protections of due process to ensure that the guilty are identified and punished, and the innocent are spared: the Eurotard approach is Red Queen justice: “Sentence first! Trial later!”  The innocent are swept up with the guilty.  This is why the Euro approach guts the rule of law, with all of the pernicious effects that inevitably accompany such actions.

In some respects, Putin’s reaction is a surprise.  Given his declamations against tax evasion and the off-shoring of Russian money, there are some benefits to closing down an offshore bolt-hole for Russian money that Putin would prefer to remain in Russia.  But the unilateral Euro action no doubt rankles deeply, and no doubt strikes very close to home for Putin and some of his cronies.

It is very interesting to note that Russian stocks and the ruble took a far bigger hit from the Cyprus news than did Eurozone stocks.  The loss (about 2 percent on the major Russian indices, MICEX and RTS, and a .7 percent decline in the ruble, as compared to less than 1 pct declines in European stocks) cannot be explained by the direct effect of the expropriation.  Estimates are that there are about 30 billion euros in Russian deposits in Cyprus: 10 percent of that is only 3 billion euros, far less than the decline in Russian market capitalization.  Meaning that there is some indirect channel by which the expropriation is hitting Russian corporations: I am still trying to think through what that channel might be, but haven’t arrived at any opinions yet.

Whatever the reason, the market reaction demonstrates just how important the Cyprus issue is to Russian interests.  It will further stoke Russian paranoia-an amazing accomplishment.  It could cause a major diplomatic fallout between Germany and Russia, which would have substantial geopolitical implications.

All in all, it is hard to imagine how the Eurocrats could have played this any worse.  They didn’t really solve Cyprus’s debt problem.  They made it all the harder to deal with debt and banking problems outside of Cyprus.  They committed a major foreign policy blunder.  A truly amazing trifecta.

One final thought.  This points out the absurdity of the Euro project.  If tiny Cyprus is too big to fail, if the effects of its default would be so horrible that the Euro mandarins feel it necessary to take such a desperate and dangerous measure to prevent it, how can the Euro be anything but an absurdity?

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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