Cyprus – oh the irony!?

Seemingly innocuous events can portend more serious outcomes, though we recognise them only in hindsight. This is the dramatic irony of history. When a single shot in Sarajevo took out a largely unknown European aristocrat, who would have known then that the world would plunge into the First World War.

The Cypriot savers must have thought the authorities were being highly ironic, of the Socratic kind, when they were told they were receiving a bail-out, except it was a “bail-in”. I don’t know the Greek/Turkish for ‘you are having a laugh’, but I bet that’s what they are saying. So what is a bail-in?

A bail-in takes place before a bankruptcy, and involves losses being imposed on bondholders, something that has rarely taken place throughout the GFC and euro crisis. In fact taxpayers (the government) have consistently bailed-out the private sector in full. The Cypriot bank rescue is no exception, except this time there is a bail-in and ironically again not of bondholders but of the depositors first. This is a direct contravention to the usual legal claims on the capital structure.

So there you have it – on Friday 14^th March Cyprus became the 5^th country to receive an EU bail-out (in), except this one was a bail-in but one with a significant and severe twist of fate. The Cypriot government in Nicosia is scheduled to vote on a EU bail-out plan which calls to extract a “tax” on bank depositors (savers) some €5.8 billion: 6.75 per cent for anyone with less than €100,000 in a Cypriot bank account, 9.9 per cent for anyone with more than that.

This is an unprecedented assault on individual property rights and every individual in the developed world should take notice, and far from stabilising the eurozone, the bail-out likely heightens contagion risk across the EU.

Why bother holding a bank account when your government can expropriate your savings? Far from containing a bank run in Cyprus, it will exacerbate it, absent capital controls, and likely begin significant depositor flights across the European periphery.

These events I believe signify one of the most alarming developments in the Eurozone crisis and the global economy since the financial crisis began.

Cypriot Disputes and Levies

For a sovereign entity so small, Cyprus has had more than its fair share of international controversy and disputes. Cyprus has a long and convoluted history with the British, Turks and Greeks, whose tensions have wreaked havoc across Europe over two World Wars. This weekend marked yet another period of disquiet in the history of this troubled island.

Cyprus is reeling from an oversized and ailing banking system.  Technically bankrupt, domestic banks stand at €126.4 billion in size, or over 7 times the size of the economy.  Without a bail-in, depositors would be wiped out and Cyprus would undergo economic collapse, bringing along with it all the attendant social misery and deprivation of a depression.

Ironically Cyprus is no stranger to levies.  The British extracted taxes in the 19^th century to cover the compensation they owed to the Ottoman Sultanate, who had conceded the island to the British.

In 1878, under the Cyprus Convention, the Cyprus became a protectorate of the British in a secret agreement between the United Kingdom and Ottoman Empire. The Greek Cypriots believed the British would eventually help Cyprus unite with mother Greece, just as with the other Ionian Islands. The indigenous Cypriots believed it their natural right to reunite the island with Greece; after all, the very first census showed the population was comprised of 74% Greeks and 24% Turks.

Fast forward half a century and most of us over the age of 40 refer to the Cyprus dispute as that of the conflict between the Republic of Cyprus and Turkey over Turkish-occupied North Cyprus. My knowledge of the origins of the Cyprus dispute is a little sketchy, but as I understand it the dispute originally was born out of the Cypriots’ desire for self-determination away from the British Crown, which had unlawfully declared itself the constitutional ruler after Greece failed to fulfil its WWI obligations to invade Bulgaria; in return, the Republic of Turkey recognized British rule of the island.

Eventually this colonial dispute became an ethnic one between Greek and Turkish islanders and their respective mother countries. In 1974 Turkey invaded Northern Cyprus and declared unilateral independence, as well as itself a sovereign entity – the Turkish Republic of Northern Cyprus – but has never received UN and international recognition. There has been a UN no-go zone buffering North and South ever since.

Another irony of the day was that in return for the British protectorate the Ottoman Empire received military support against Russia in Asia. As I will cover later, Russia has been integral to the demise and now the future well-being of Cyprus. Another legacy dispute that has compounded the Cypriot collapse was their adherence to Enosis. This refers to ‘the union’ – incorporation of the island of Cyprus into Greece. Observance of this tradition led the Cypriot banks to misguidedly purchase vast amounts of Greek sovereign debt before and during the euro crisis. Cyprus became a casualty of the Greek’s very own bailout restructuring. Oh the irony again.

Creditor Structure

Bank depositors by now will have realised that bank deposit guarantees are not worth the paper they are written on and the legal precedent to label this confiscation of assets as a ‘stability levy’ or tax has no doubt been framed as such so as to circumvent EU deposit guarantee law, which this levy clearly violates. This is stealing – period.

Every saver in Italy, Spain, Portugal – but not limited to these countries, as it potentially applies to any saver in northern Europe and the UK – is at risk of a confiscation of their hard-earned money.  We will likely see depositor flight from the periphery to the supposedly more robust surplus countries, principally Germany. This is despite the very large outstanding Target2 balances owed Germany by the periphery, but don’t expect the man in the street to be aware of this fact.  This is unfortunate as some progress was being made in the reduction of Target2 imbalances as deposits in the periphery showed renewed signs of growth.

The Troika has run roughshod over the rule of law. By calling for a universal bail-in of depositors (the most secure rung of the bank capital ladder) before extracting money from shareholders, junior and subordinated bondholders, the EU bureaucrats and IMF have unilaterally ripped up the legal framework for property rights. This is a truly worrying and frightening progression – actually regression – in economic freedom.

At Hinde Capital, we have no issue with uninsured depositors contributing to the bail-out of a banking system, even as unpalatable and clearly undesirable as this would seem.

Unfortunately bank depositors (savers) have long been under the misguided impression that they are potentially immune from a bank collapse, with the State providing a safety net in the form of deposit guarantees up to a declared sum.  I would argue that individuals, partly due to government propaganda in the good times, have long since forgotten – or indeed have never understood – that once you deposit your money into a bank, you give up your right to ownership, i.e. it’s a LOAN! An asset which is lent out multiple times according to the agreed practice under fractional reserve banking clearly has a risk of no return, albeit a seemingly a low risk when confidence and trust in the economic system is high.

In truth, the correct order of claims on the creditor structure in this ‘bankruptcy’ proceeding has been largely ignored as the Cypriot banks have such a small sliver of equity and debt, and have an unusually large depositor base.  It is the involvement of the depositor base that turns this whole debacle into a plot of immense political intrigue and, indeed, even conspiracy.

Cyprus-sia ‘Tax’ Haven

It has been long known that Cyprus has held a vast sum of deposits from Russian lenders, and because of that Russia has been its biggest direct foreign investor. Low corporate tax rates, sub 10%, were the attraction, with Russians transferring their money into companies based in Cyprus. Some of this was then reinvested back in Russia.  According to Der Spiegel:

An internal study by the German foreign intelligence agency, the Bundesnachrichtendienst (BND), says banks in Cyprus hold $26 billion (€20.33 billion) in deposits by Russian investors. According to the BND, most of this money has been illegally moved abroad to evade Russian tax authorities. By Cypriot standards it’s a tremendous sum given that the island’s entire annual GDP amounts to €17 billion.

The Cypriot government on Monday denied the money-laundering accusation. A government spokesman said SPIEGEL was trying to besmirch the reputation Cyprus has as an international investment location. The country had effective money-laundering rules and adhered to EU law, the spokesman said.

Indeed, Russians aren’t the only ones who sought the refuge of this once tax safe-haven, and consequently other European countries were not keen to be seen to be using their own tax payers’ money to afford a bail-out for ‘tax dodgers’ and money laundered in Cypriot banks by Russian KGB, mafia and their own citizens. So you could call the tax on uninsured depositors actually a levy on money laundering – call it a 10% haircut for washing your dirty linen. I bet any good money launderer worth his salt would take that cut.

Conspiracy Talk

The question is why have the small savers been penalised? This is the point in the plan which makes the EU bureaucrats look so dysfunctional or at best dishonest – I meant to phrase it that way round. By penalising small depositors, mostly local Cypriots, they, as I have stated, undermined the universally agreed EU depositor guarantee that currently stands at €100,000. The talk is that the Cypriot government took a line of credit of some €2.5 billion from Russia in 2011, and having utilised it fully, wanted to appease the ‘motherland’.  So they have agreed not to levy the full tax on deposits above €100,000. By doing this they hope for further assistance from Russia. I suspect they will offer support as Russian banks have loaned in excess of $40 billion to Cypriot companies of Russian origin (according to financial reports).

The Private Sector Initiative (PSI) on depositors is a victory for the ‘northern league’ of Europe, for now at least.  With a German election year in full swing, Merkel needed to satiate German taxpayers by no longer exposing their euros to the profligacy of the periphery. Yes, a victory in round one for Merkel and the CDU, but ‘ding ding’, here comes round two: I bet the Cypriots pull a few punches by pushing back on the levy on small depositors. ‘Ding, ding’ – round 3 – I say Merkel gets knocked off her feet as depositors flee the periphery and then (eventually) Mario has to step in and decide whether to cite ‘irreversibility’ status as a clause to stem a banking sector collapse in Europe, and provide unlimited monetary support, but without the conditionality clause of austerity. I say ‘eventually’ as Mario had repeatedly slapped the EU finance ministers, and Schauble particularly, for advocating a haircut on bank deposits. So he could really make Germany sweat by holding back on a re-load of its big bazookas’ – long-term LTROs and OMTs.

In the interim the national central bank (NCB), in this case Cyprus is no doubt utilising the ELA (Emergency Liquidity Assistance) to supply the Cypriot banks with sufficient funds to remain liquid in the event of insolvency and failure.  This is at the risk of the NCB concerned and outside the ECB’s refinancing operational framework.  It is completely opaque and in truth it will appear as a Target 2 ledger or on the ECB asset side as ‘Other assets’.

For now the Cypriot banks are on holiday, forcibly closed for business until at least Thursday at time of writing, so depositors cannot withdraw their money. Likewise, ATMs have been deactivated and electronic wire transfers suspended. They will be opened once the Cypriot parliament has ratified (or not) the deposit levy and other terms of the bail-in. It could well be that the terms change to protect small savers as they should have been all along. Either way, the psychological damage has been exacted across European populations.

Contagion Risk

Those who think there is little risk of a levy being imposed on other periphery members are missing the point. The seeds of doubt have been planted. As a saver facing zero yields on deposits and a potential haircut, why keep your savings in a bank? Sure it is convenient for electronic transactions, but individuals can adapt easily. As one of my more amusing colleagues put it, “mattresses now hold a 10 per cent premium”.

Talk of ‘exceptional’ circumstances and a ‘one-off’ are true but only because Germany and the Troika would never succeed in enforcing such illegal measures on Italy and Spain without risking social unrest and a collapse of the euro. The Cypriots have more leverage than they realise. The Russians don’t need a failure as it could mean Russian bank risk. Moreover, Target 2 imbalances likely ensure that the ECB would not cut off the ELA and risk a euro currency break-up.

Conclusion

What this should reaffirm to you all is how the handling of the crisis has only succeeded in heightening the risks associated with this current monetary order.  The excessive amounts of debt have continued to grow and are clearly not sustainable. Policymakers have resorted to draconian methods of expropriating private sector assets (households, pension funds and corporates) either by excessive explicit ‘taxation’ and/or stealth taxation administered by a policy of negative real rates to help reduce the fixed real burden of debts.

It also reinforces our long-held views that when push comes to shove policymakers (the State) will escalate oppressive tactics against their electorate in a bid to maintain their status quo and that of their fiat currency system.

Of most importance is the adherence to retrospective changes of law and different rules for different people and countries. Insolvencies are generally well-defined in law. The first is to equity, then subordinated debt, then deposits and senior bonds together.  The creditor structure has been up-ended and more than merely tweaked over the last few years.  I suspect with levels of ignorance high amongst populations they haven’t quite woken up to the reality that the state is not in fact here for your protection as it once was and that we all need to take on self-reliance and a heightened sense of responsibility for ourselves. Some notable rule changes of late are subtle but growing in number:

1. The ECB, holders of Athens-law and foreign law Greek debt all received different treatment
2. The Dutch didn’t restructure SNS Reaal paper, they confiscated it
3. The Irish banned lawsuits against the ultimate wind-down of Anglo Irish
4. Portuguese private pensions were confiscated

The list is long but you get the idea.  Rule-changes are getting ‘regressively’ more creative and sinister. As a friend pointed out to me, this as if the “football referee has gone from being a quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties.”

The bail-out should have been a legal bail-in whereby equity is wiped out, and all bank debt is written down. Then unsecured (uninsured) depositors i.e. above €100,000 should have taken a double digit hit. By doing this EU finance ministers and lawmakers would have been respecting the creditor hierarchy and honouring the rule of law. The retrospective change of law is what should alarm us all. The insidious and subtle nature of this encroachment on our civil rights sets an ominous precedent and those who glibly mock libertarians for their ‘rants’ are no doubt those same people who thought PIIGS really do fly.

The bail-in announcement for the Cypriot banks late Friday night was one of those events when we all look back and think that was the beginning of the end of the real global financial crisis. Every investor in Europe should be left with no illusion. The political elite will enact whatever it deems fit to protect the euro and their own positions of power.

It is clear that markets and investors underestimate the reality that debt restructurings are necessary but won’t necessarily be enacted, which leaves only more private sector wealth transfers (confiscation) and likely circumvention of the underlying problem of sovereign insolvency by central bank deficit financing.

So much for EMU solidarity…comrades.