20 March 2013

Paul N Goldschmidt: Cyprus - The EU plays "Liar's Poker" and "Russian Roulette"!

Though the Eurogroup’s proposals to rescue Cyprus appeared initially to reflect a healthy equilibrium between eurozone and IMF support on the one hand and a contribution by Cypriot taxpayers on the other, the rejection of the conditions by the Cypriot Parliament has created a very dangerous situation, capable of reigniting the smouldering embers of the financial crisis.

Let us recall that the agreement was totally in keeping with the constraints and demands of the parties: The Eurogroup and the IMF were subjecting their interventions to strict conditionality, including a contribution of €5.8 billion by Cyprus to the combined effort; this amount took into account the sustainability of the country’s sovereign indebtedness. Cyprus, as it should, was fully exercising its sovereignty by determining the tax base and rates applicable to its contribution; it was, therefore, its own choice to impose two rates which tended to penalise severely smaller depositors and shielded somewhat wealthier ones (though, apparently, its partners were recommending to hit harder large depositors and exempt smaller ones).

The fundamental error was one of communication. The main responsibility lies with the authorities which, by not being sufficiently precise, opened the field to a large array of commentators (politicians, economists, journalists, etc.) to spread here, there and everywhere, wrong interpretations concerning the nature of the proposed measures. Particularly harmful were criticisms by several finance Ministers who, hours earlier, had been party to the agreement. Public opinion, not only in Cyprus but also in the remainder of the EU, was totally destabilised.

The controversy focused on a superficial amalgamation between the proposed levy (tax) on deposits and the 2008 agreement among EU Member States to guarantee bank deposits up to €100,000. Victims of such uncertainty, aided and abetted by so many “opinion-makers”, it is hardly surprising that Cypriot citizens felt betrayed and manifested energetically (though without violence) their absolute refusal of the levy. It followed that any margin for compromise by modulating the tax rates to protect the more vulnerable evaporated and lead to an overwhelming outright rejection.

The Prime Minister had, nevertheless warned that unless the required financing was found, the banking system would collapse leading to the exit of Cyprus from EMU. This alternative would have far more dire consequences for all Cypriots as well as for both resident and non-resident depositors. The anger of the population gave comfort to the Parliament that – largely based on the Greek precedent – eurozone Members would, in the end, do “everything that was necessary” to avoid an exit of the euro by Cyprus. Thus started a mad game of “Liar’s Poker” in which no one knew who would be the first to lose their nerve though which was bound, regardless of the outcome, to leave deep wounds and have many consequences.

The first, unavoidable, is to manage under pressure the procedure of reopening local banks. In addition to the promised liquidity support from the ECB (within the constraints of its operating regulations), a massive withdrawal of deposits is to be expected; it will need to be contained by a series of specific unpopular measures (this might be compared with the 1944 “Gutt” operation that froze all Belgian bank deposits in order to cleanse the market in the aftermath of the German occupation).

With regard to existing deposit guarantee schemes, irreparable harm has been wrought: whatever clarifications may be forthcoming, trust in the intangibility of these guarantees has been permanently damaged. This is bound to impact negotiations surrounding the Banking Union, jeopardising the chances of agreement of a deposit guarantee scheme that would include a measure of risk mutualisation.

By crucifying any suggestion of “taxing” deposits, the fragmentation of the internal EMU bank market will also intensify, insofar as depositors will avoid holding excess liquidity in any country which might have recourse to such a form of taxation.

Finally, in addition to the purely financial and economic consequences, the protagonists of last Friday’s discussions have managed, once again, to designate “Europe” and the Troika as responsible, in the minds of ordinary citizens, for a failure that rests squarely on the shoulders of EMU national Governments. They also seem to have overlooked the basic “principle of precaution”: indeed, when one engages is a game of Russian roulette, one should not forget that if the single bullet misses its target, the weapon becomes useless, leaving others to take the advantage.

In this case, the spectre of a bailout of Cyprus by Russia raises a number of awkward geopolitical questions. The geographical situation of the island and its hydrocarbon reserves constitute major strategic assets within the context of the Middle East powder keg, where a broadening of the current conflict should not be excluded. The ability for a party to exert blackmail could prove very destabilising for the EU and provide additional grist to the mill of nationalist-populist movements, experts in exploiting such tensions. 

It is obvious that, in the face of the loss of trust resulting from the calamitous handling of the Cypriot crisis, a new financial crisis would destroy both the banking system and the sovereign debt markets. The relatively benign reaction of markets so far can change at very short notice. It is urgent that the political authorities reassert their control over the situation. Never has the quote of Paul Henri Spaak seemed more appropriate: “It is not too late, but it is high time”!

Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute

Tel: +32 (02) 6475310 / +33 (04) 94732015 / Mob: +32 (0497) 549259

E-mail: paul.goldschmidt@skynet.be / Web: www.paulngoldschmidt.eu

© Paul Goldschmidt