Cyprus has found its way into the epicenter of the European debt crisis by forcing their government to publicly choose whether they’re on the side of their citizens or whether they’ll side with billions of Rubles. It’s been several months since we’ve discussed the European debt crisis, which has now been brought to the fore by tiny little Cyprus. This little island in the Mediterranean is home to about 1.2 million people and sits on about 3,500 square miles. This makes its population smaller than Dallas and San Diego and slightly larger than San Jose or, Jacksonville while physically it fits between Rhode Island and Delaware.
Cyprus joined the European Union in 2004 amidst reports that Cyprus is primarily a money laundering country used mostly by Russians. Der Spiegel, a German newspaper, published a lengthy article in January based on an investigation by Germany’s Federal Intelligence Service regarding the degree of money laundering in Cyprus. The report found that more than $26 billion of the $80 billion that flowed out of Russia in 2011 ended up in Cypriot banks. The $26 billion that found its way into Cyprus is greater than their entire annual GDP.
The issue that Cyprus faces is that their role as a financial services hub has been severely hampered by the economic collapse of 2008. This has been made worse by the low tax rates and favorable corporate regulations that were used as incentives to attract capital in the first place. Therefore, Cyprus is stuck with the compounded slowdown of a declining economic base due to increased regulation along with a declining domestic tax base. The final blow to the Cypriot banking system is due to the failure of their banks’ investments in Greece.
The Cyprus government is now left with the unenviable task of finding a balance between its residents and the appeasement of its Russian investors. Current proposals suggest sharing the load between the Cypriot citizens and the Russian oligarchs. The European troika, (European Safety Mechanism, European Central Bank and the International Monetary Fund) wants Cyprus to come up with matching funds to bail them out.
The original proposal would have taxed bank accounts under $100,000 6.75% and accounts over $100,000 9.9%. The second proposal has several splits including removing the protection on deposits over $100,000 and taking the money from over funded accounts most likely held by Russian businesses. The downside, according to JP Morgan is that this would cost investors about 15% of their funds above $100,000. The third option is to split the costs of the failing banks by charging 3% on accounts less than $100,000, 10% on accounts between $100,000 – $500,000 and 15% on accounts above $500,000.
These are all logical solutions to an illogical problem that must be addressed by our societies as a whole. We’ve been discussing the flight of capital and capital will always flow towards the greatest possible potential. Cypriot corporate tax rates are half of the Russian rates and their capital gains taxes are even friendlier. The policies that have been put in place to attract capital come at the expense of those with no capital to spare. These morals are not tied to foreign capital and money laundering; they’re based on the collusion and graft of the people making the rules. Unfortunately, those of us with no voice will be expected to pay their share when things turn south.
Cyprus has seen its banks closed for days. There could be a run on the banks but I don’t think there will be. The billions of Rubles that flow through Cyprus will provide enough grease to absorb the bad debts on Grecian investments. Russia has no desire to see the back door closed. There will be a battle between transparency to the general public and the Great Oz who will do everything they can to ensure business as usual, regardless of the income source or destination of profits.