What Has Europe Wrought in Cyprus?

The eurozone will pay the price for its treatment of Cyprus.

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A student holds a Cyprus flag in front of the Ministry of Finance after a parade for Greek independence day celebrations in capital Nicosia, Cyprus, Monday, March 25, 2013. Cyprus secured what its politicians described as a painful solution to avert imminent bankruptcy.

Scheherazade S. Rehman is a professor of international finance/business and international affairs at The George Washington University. You can visit her homepage here and follow her on Twitter @Prof_Rehman

The Cyprus rescue bailout case is special and different on two fronts. The first is that the bailout literally went after (plundered) foreign investors' money, and the second is that for the first time local depositors are being held responsible for fixing their own banking crisis directly.

On the first issue of the predatory raiding of foreign depositors, I would like to ask the question very few have raised: "What if the large depositors in Cyprus had been French or German?" Would the troika—European Commission (EC), the International Monetary Fund (IMF), and the European Central Bank (ECB)—then have demanded that large foreign depositors take a 40 to 60 percent haircut directly?

It turned out, instead, that the large foreign depositors were mostly Russians parking their money in Cyprus's offshore banking system legally and in some cases for money laundering schemes. Cyprus is, in effect, a smaller, less developed, southern version of a Luxembourg or Lichtenstein money center.

This is what makes Cyprus special and different from Portugal, Greece or Spain. The Europeans, especially the Germans and French, have never wanted this small, offshore, less developed island to be in the big money tax haven business, especially with Russian money. Going after deposits of over euro 100,000 almost guarantees that all Russian investors would be hit and hit hard. Estimated losses are between 60 and 80 percent for these foreign (and local) investors who have uninsured deposits of over euro 100,000. Perhaps Russian paranoia was justified.

[See a collection of political cartoons on the European debt crisis.]

Well, nonetheless, the troika has done a good job of making sure that Cyprus can no longer compete with Luxembourg or any other small country offshore tax haven. It is, in fact, no longer a viable place for offshore banking. The unintended consequence of trying to clean out a sketchy offshore banking system is that foreign investors will be very reluctant to invest in Cyprus again for any reason.

This effectively cuts Cyprus off at the knees, as we know that a deep recession and all sorts of socio-economic ills are going to befall the island. The loss of confidence as a safe place for foreign investors is the proverbial death knell for this economy.

The second reason why the Cyprus bailout case is different is that, for the first time, local depositors (taxpayers) are being held responsible for fixing a banking crisis directly. When Dutch Finance Minister Jeroen Dijsselbloem (Chairman of the eurozone finance ministers group) indicated that this particular rescue now "represents a new template for dealing with financial crisis in the eurozone with uninsured deposits bearing some of the cost," he doomed all small southern country banks.

When Cypriots fully reopen their banks and remove their capital controls, all large local and foreign investors will want to flee to safer grounds. This is why Cyprus has become the first country in the eurozone to impose capital controls in order to halt the outflow of money.

There are a few subtleties to note here. Although losses will be experienced by hierarchy (shareholders, bondholders and then uninsured depositors) what has happened is that the principal of moral hazard has been firmly established. For starters, depositors will be forced to swap out their cash deposits for bank shares (equity) for over 60 percent of their deposits. Additionally, instituting capital controls essentially makes captured Cypriot euros different than the euros in the rest of the eurozone (they are worth less due to their inability to travel easily).

Capital controls, although always meant to be temporary, tend to last longer than expected. For example, Iceland instituted them during its crisis and four years later they are still in place. I cannot imagine the Cypriots loosening capital controls anytime soon.

[See a collection of political cartoons on the economy.]

Investors and large depositors do not forgive nor forget these things easily. All off this will make sure that the southern periphery countries of the eurozone will remain weak. Ultimately, this will come back and haunt northern Europeans. This has all but reinforced a two-speed eurozone (North versus South).

The Cypriot government should never have entered into such a deal (although they didn't have much choice) and the EC, ECB and IMF have opened Pandora's box in scaring investors and depositors from putting their money in any southern European bank in the near term. In the end, the northern Eurozone members will have to pay the price for this debacle of a rescue.

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