Punishment in Nicosia

The bailout in Cyprus has created quite a commotion across the euro zone, even though the island only accounts for 0.2 percent of the GDP of the entire monetary union. The reason for this anxiety is not so much down to the amount of the bailout ¡ª although it is more than just a footnote when it comes to Europe¡¯s ongoing financial problems. Cyprus needs around 17 billion euros, of which 10 billion euros must go to the island¡¯s banking sector ¡ª the backbone of the Cypriot economy. Bank assets account for eight times more than the country¡¯s GDP. This unique fact goes someway to explaining the peculiar characteristics of the Cypriot bailout, which are different from those already seen with Greece, Ireland and Portugal ¡ª and, of course, are nothing like the interventions in the Spanish and Italian debt markets.

The unease stemming from this rescue plan is related to the way that it is designed, whereby holders of savings accounts at financial institutions in the country will have to pay. This is in contrast to what has occurred in other interventions, where banks have a primary responsibility to their clients before paying back the public funds they have had to tap. In the case of Cyprus, holders of accounts with more than 100,000 euros deposited will be taxed 9.9 percent, while those with less than that amount will pay 6.7 percent. To avoid capital flight before the measure is approved, Brussels has put a temporary freeze in place on bank accounts ¡ª a move that has damaged Europe¡¯s image of a free-flowing capital continent.

It is a tricky situation, because this unusual step was considered essential by the euro authorities in order to block the clear-cut flight of money to other banks outside the country. Some estimates indicate that more than 19 billion euros of Russian funds are deposited in banks across Cyprus, and outstanding debts from loans are worth much more ¡ª some 40 billion euros. Greek banks are also trapped in this Cypriot hole. The results of the intervention will be seen over the coming weeks, but they are likely to be severe.

Alarming factors

And, of course, anxiety over the Cypriot bailout will no doubt spread in the coming weeks. It must be remembered that many European nations, Spain included, have bank deposit insurance. But in the Nicosia government¡¯s case that protection is not guaranteed. It can be argued that the Cypriot case is exceptional, but investors and savings account holders don¡¯t tend to pay too much attention to these factors when it comes to such an important decision. Nevertheless, the most alarming factor of this bailout has been the freeze on Cypriot bank accounts, because it foments a situation whereby money deposited by non-residents can be quickly taken out of a country that is running the risk of seeking a bailout, even though the first steps usually taken in such cases are interventions in the debt markets.

This monumental measure should not hide the fact that the Cypriot banking system urgently needs restructuring and reductions, and an exhaustive investigation into money laundering, which is common through bank accounts. It is not acceptable that the corporation tax is lower than that of Ireland, and Nicosia will have to increase it to at least 12.5 percent and adjust its budget to an equivalent of 4.5 percent of GDP. Cyprus will also have to face up to its excesses.