By Elizabeth Pond
Russia abstained, Cyprus buckled. Italy is still on hold. Angela Merkel won after a chaotic European summit—and France will be the hardest test of Europe's future. In the wake of Cyprus's acute financial crisis of the past two weeks, this is the mainstream view of policymakers in Germany, the reluctant euro zone paymaster and, by default, the equally reluctant political leader of Europe.
So far the three-year test of nerves favors the Germans. However much they are pelted by the wrath of Cypriot, Greek, and Italian protesters bearing banners painting Hitler's moustache on Chancellor Merkel's upper lip (and however warped the equation of Nazis with today's checkbook rescuers), Germans shrug off the invective. And they continue to set the price of each new bailout as root-and-branch reform of domestic financial sectors in the direction of fiscal rectitude, subject to supranational monitoring.
Cyprus is the latest in the line of euro zone petitioners to get bailed out at this price—and is something of a caricature of the genus.
For a start, the Republic of Cyprus is miniscule. It has a population of only 840,000 and a GDP that is less than 1 percent of the European Union's $15.7 trillion. Yet it boasts bank accounts eight times its own GDP and offers—or rather, offered—long-term yields of 7 percent in what is elsewhere in Europe a season of austerity.
The reason for this largesse is essentially the patronage of Russian oligarchs who like Cyprus beaches and, according to leaked German intelligence reports, the no-questions-asked financial culture that facilitates capital flight from Russia ($6 billion total in February) and money laundering. Their bountiful deposits in Cypriot banks and convoluted shell companies largely account for a swift one-generation rise in GDP per capita on this east Mediterranean tax haven to $26,900, close to Italy's $30,100 and not far below the European Union's average $34,500.
Until recently, the system duly rewarded all players, from Cypriot lawyers and hoteliers to the Russian billionaires who have formed a cozy expat colony in Limassol and, many of them, taken citizenship in their adopted country.
But then the global financial crisis erupted in 2009 and ignited the three-year existential crisis in Europe's common currency. Banks throughout Europe that made ever riskier investments during the bubble years of easy money turned out to be too big to fail when their investments crashed, and they had to be recapitalized by national governments—at the cost of raising sovereign debts to dangerous heights.
To finance this operation and thus stave off collapse of the euro zone, the world's fourth-largest economy of Germany and other rich north European countries had to improvise ways to bail out, successively, Greece, Ireland, and Portugal. At the beginning, Merkel categorically rejected bailouts as illegal. In response to turbulent markets, though, she came to endorse and pay for bailouts quietly as long as they were called something else—and as long as European Central Bank chief Mario Draghi would serve as the front man in pacifying volatile markets by vowing last summer that the ECB would do "whatever it takes" to save the euro.
In each rescue, the price extracted from aid recipients by the north European benefactors and the troika of the European Commission, the decade-old European Central Bank (ECB), and the International Monetary Fund (IMF) was a binding pledge to reform domestic institutions and abide by budget austerity, under European Union oversight. As one systemic flaw after another surfaced in the never-ending euro crisis, supranational goals widened to include building a firewall between private bank debt and sovereign debt and instituting a Europe-wide banking union, with common regulation and supervision by the European Commission and the ECB. Always the German quid pro quo for bail-out remained the same.
By this week it was the turn of the Cypriot banks and government to choose between going bankrupt and acquiescing in unpleasant terms to get fresh money. In mid-March the donor community negotiated a package of aid that—in order to avoid the moral hazard of EU assumption of losses from extravagant risk-taking or laundering by the huge Russian funds—required Cyprus to provide €5.8 billion of its own to qualify for €10 billion in international aid. The Cyprus government set the terms for its own contribution, and, to avoid alienating rich Russian (and Cypriot) account holders, proposed only a relatively light emergency 9.9 percent levy on deposits above €100,000. To collect the additional downpayment required of it, Nicosia ignored the EU-wide guarantee of bank deposits below €100,000 and prepared to take a 6.75 percent levy from these as well.
The angry Cypriot parliament rejected the original EU rescue package, however, and furious demonstrators blamed Berlin instead of Nicosia for the planned charge on smaller bank accounts. The Cypriot finance minister promptly flew to Moscow to seek less onerous terms—and set off two days of Western worry that Russia would now step in, expand its already substantial influence in this eastern extremity of the EU, and possibly gain a Mediterranean naval base or lock in a hold on Cyprus's undeveloped offshore gas reserves.
For reasons that remain unclear, President Vladimir Putin rebuffed the Cypriot overture, even though Prime Minister Dmitri Medvedev afterward compared the final hit on Russian deposits in Cyprus with Nazi expropriation of Jewish wealth. Some Western analysts thought Putin played hardball, demanding too much even of a semi-client state, and lost. Others wondered aloud if the Russian money in Cyprus comes mainly from "Russians who are not Putin's Russians."
Whatever the explanation, Nicosia turned back to the EU and to avert imminent bankruptcy agreed in last weekend's all-night negotiations to drop the hated levy on small accounts. To raise its required contribution to the EU bailout, Cyprus will expropriate up to 40 or 50 percent of large accounts to reap an estimated €2-6 billion. And it will radically restructure its top hot-money banks, shutting down the second largest Laiki Bank and converting uninsured deposits in the Bank of Cyprus to bank equity. With one stroke Cyprus is no longer a shady tax haven—a radical reform that would have required a generation to effect, had there been no crisis.
Moreover, in what is a possible game changer, creditors and stakeholders rather than sovereign national banks and taxpayers will in future be held accountable for the bulk of losses of failing national banks, according to Jeroen Dijsselbloem, Dutch finance minister and very new president of the Eurogroup of monetary union members. (After stock markets dropped in response to his statement, he corrected himself to say that Cyprus was unique, but his expectation remains in the air.) And in another break with crisis practice so far, capital controls are now being imposed on Cypriot citizens and institutions—though even before Cypriot banks have reopened after their 10-day closure, the ECB reports leakage of millions or even billions out of the Cyprus Central Bank.
Market reaction to the Cyprus deal will show whether this week's unprecedented "bail-in" of bondholders and stakeholders will spook investors or whether the calm of the eight months since Draghi promised to do "whatever it takes" to preserve the euro will continue. Optimists argue that increasing use of bail-in could mean that the euro zone's various pledged funds will not have to pay out very much after all. Pessimists expect turmoil.
As for the next national euro crisis, the likely venue is Italy. The elections in February discredited outgoing technocratic Prime Minister Mario Monti and his acceptance of tough EU reforms. The new parliament is split three ways, has not yet been able to agree on a new government, and contains many members whose primary instinct is to reject the austerity Monti signed up to, without replacing it with any alternative policy.
After Italy—which at least has the experience of surviving years of chaotic governments or non-governments in Rome—comes France.
"The most dangerous country is France," says a senior German diplomat. "We took two-and-a-half years to put rules in place in the fiscal compact that was basically a reaffirmation of the [old French-German] stability pact."
If Socialist President Francois Hollande—who has been passive in recent euro issues and is now struggling with the worst popularity rating of any French president in 30 years—gives up on French adherence to these fiscal rules and returns to the economic dirigisme that Socialist President Francois Mitterrand abandoned 30 years ago, "then you get erosion of the whole strategy in the past two-and-a-half years. Which then may also raise the question in financial markets whether there is a viable strategy out of the crisis.”
He adds, “if a real gulf exists between Germany and France" on this fundamental policy, then “there is no Europe any more. Then you are splitting the core."
If so, the euro zone's manic wrestling with Cyprus over the past 10 days and the likely amorphous wrestling with Italy in summer will just be the warm-up to the European Union's ultimate showdown, between France and Germany.
Elizabeth Pond is Berlin-based journalist and the author of The Rebirth of Europe.
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