Satyajit Das: Cyprus - a faraway country, but more important than you realise

Midweek View: Politically expedient accusations of money laundering and tax evasion in Cyprus are hypocritical

In 1938, the British Prime Minister, Neville Chamberlain, decided to ignore "a quarrel in a faraway country between people of whom we know nothing". The world has now convinced itself that Cyprus is simply not systemically important. They may be wrong.

As with Greece, it is unlikely that the package, if approved, will work. The crippled financial system as well as the effect of capital controls and uncertainty on tourism will mean a prolonged recession which will make it impossible for Cyprus to meet its targets and repay its bailout debt, necessitating further bailouts and/or future debt restructuring.

The guarantee of small depositors (up to €100,000) is from the insolvent Cyprus government. Small depositors are also affected by "temporary" capital controls, which may need to be in place for a prolonged period. This means that small depositors' cash remains trapped and at risk in any future restructurings.

The EU's new position towards bailouts, shifting losses on to shareholders, bondholders and depositors, is self-serving. The German Chancellor Angela Merkel's statement that policy has always been that taxpayers can't save banks and that this remains the case for Cyprus represents a revisionist view of history.

To date, with minor exceptions, European, as well as the UK and US, governments have protected all creditors, including subordinated bondholders, of failed banks to avoid the risk of contagion and triggering a wider financial crisis. In Germany, the state bailed out depositors in IKB. Similarly, the government did the same for major Dutch banks until the recent case of SNS.

Alternatives such as Cyprus leaving the euro and restructuring its bank and sovereign debt were ignored to avoid losses to the ECB on its €9bn to €10bn exposure to Cypriot banks and to European banks on holdings of Cypriot government bonds.

As in previous European bailouts, the funding is mainly to be used to refinance existing debt owed mainly to European banks and investors. About €7.5bn of the proposed Cyprus package will be applied in this way

Whatever its merits, allocating losses to investors and bondholders may prove difficult in practice.

European banks own €692bn of Spanish government bonds and €832bn of Italian government bonds. They also still own €791bn of Greek, Irish and Portuguese bonds. The ECB has purchased more than €200bn of European sovereign debt, primarily that of Italy and Spain, as well as lending more than €1 trillion to European banks secured by sovereign bonds.

Any attempt to write down bank or sovereign debt of troubled nations would result in large losses to European banks, mainly in the northern European countries. The EU has conveniently forgotten that the bulk of Cypriot bank losses resulted from writedowns to loans to the Greek government, overseen by the EU.

Cyprus has merely highlighted Europe's "doom loop" linking European banks and sovereigns. This will make it difficult to pursue the policy that investors must be accountable for the risk they take, recently articulated and then quickly disavowed by Jeroen Dijsselbloem, president of the Eurogroup.

The German Finance Minister Wolfgang Schäuble's position that "savings accounts in Europe are safe" contrasts sharply with his earlier statement that deposit guarantees were "only as good as a state's solvency". The absence of a Europe-wide deposit insurance scheme and lack of funding for recapitalisation of banks (both opposed by Germany) means that all depositors are vulnerable.

Politically expedient accusations of money laundering and tax evasion are hypocritical. The majority of affected Cypriot bank deposits were from domestic residents, including around 60,000 British retirees and 40,000 Russians living in Cyprus.

Cyprus is not alone in its large banking system, involving substantial levels of offshore deposits. Cyprus is a low tax jurisdiction, not a tax haven. It is puzzling how Cyprus could have been admitted to the eurozone and been eligible for ECB funding until recently if it has such heinous and odious financial practices.

For the EU, Cyprus represents the familiar continuation of its serially clumsy efforts to deal with insolvent banks and countries. It also continues the strategy of ensuring that embarrassing losses are deferred past crucial election dates, or even more desirably until someone else is in power.

Satyajit Das is a former banker and the author of 'Extreme Money' and 'Traders, Guns & Money'

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