Cyprus' two options: Misery or suffering

I used to play a game with my children called 'what would you prefer'. It was a lot of fun and was usually a bit off colour, such as choosing between drinking a glass of vomit or eating a piece of raw, maggot infested, rotting meat.

What would you prefer?

As we laughed and squirmed at the thought of the options, we had to come up with an answer as unpleasant as it was.

The government of Cyprus is playing a similar, 'what would you prefer' game, this time dealing with questions about the country’s solvency as it works to avoid defaulting on its debt. For Cyprus, it is no fun at all with the austerity measures provoking social unrest and a severe downturn in the economy but that is being seen as the price that must be paid for the country to remain solvent.

In an extraordinary decision to address the effective bankruptcy of the banks and public sector, the government of Cyprus has been asked to impose a one-off tax slug of either 6.75 per cent or 9.9 per cent on all bank deposits or else it will not qualify for additional bailout money from the International Monetary Fund and European Union. The parliament in Cyprus, in an emergency meeting this morning Australian time, has not yet passed the necessary legislation to impose the levy and is seeking more time to debate the issue.

The difficulty for the government is that when, and only when, the bank deposit tax is in place will the additional €10 billion of financial assistance come from the IMF and EU.

The proposal is simple. For bank accounts in Cyprus with balances over €100,000, the levy will be a flat 9.9 per cent while for balances under €100,000, the levy is 6.75 per cent. The levy is forecast to raise €5.8 billion or close to a stunning 30 per cent of GDP, with about half of the revenue coming from foreign based depositors with the other half coming from the 1.1 million local population.

The EU is calling the levy on deposits an “upfront one-off stability levy".

With a vast array of what might be termed conventional austerity measures already implemented in attempt to stabilise the debt debacle, there were few alternatives so grand in scale open to the government of President Nicos Anastasiades. He said that he had to agree to the financial rescue terms from the IMF and EU as the only alternative was the banking sector and the country going bankrupt.

Mr Anastasiades said, "We would either choose the catastrophic scenario of disorderly bankruptcy or the scenario of a painful but controlled management of the crisis". The banking sector in Cyprus has €30 billion in liabilities.

The decision to tax savings has lead to a range of criticisms, particularly as savings are the antithesis of the whole problem and sovereign debt holders have not had to endure a similar hair cut. This is the main problem with the deposit levy as those active players in the whole crisis such as the hedge funds, banks and other bond holders are getting away scot-free it seems.

There is a lot of outrage, much of it legitimate, about the radical decision to impose a one-off levy on depositors. But aside from those advocating default, it is not clear what could have been done to fix the problem.

Radical and unprecedented problems require the consideration and implementation of radical and unprecedented solutions. This is why the deposit levy may not be all bad.

What else could be done?

Of course there could be yet higher taxes on profits, income or spending. These are, more or less, much the same difference as the deposit levy and much slower to collect, with market distorting effects.

The Cypriot government could have implemented a range of even greater cuts to social welfare, public services and entitlements. Again, this would have hit the community in much the same way as the deposit tax and would have been slower to accrue.

It was a case of name your poison. What would you prefer? Someone had to pay and had to pay quickly.

The benefit of the deposit levy is that it yields a large amount of revenue, and a significant proportion of it is paid by non-residents who for years have been parking what might be termed dodgy money in Cyprus. It is also quick.

Clearly, the levy will have a sharp negative impact on the economy in the short term and there will be a flight of capital as non-locals take their money away for fear of another levy being imposed at some stage down the track.

It must be highlighted that the government is, in addition to the deposit tax, implementing a range of other fiscal austerity measures. It is not just the deposit levy that the people of Cyprus will have to endure. There are pay cuts for anyone earning more than €1000 a month, while welfare allowances are frozen until the end of 2015. Over 5000 public service positions will be abolished and property taxes will be increased. Beer and cigarette taxes have been increased along with a range of many smaller ticket items.

These are, curiously, not as controversial at the bank deposit levy.

There will be some clear problems with the deposits tax. Savers in other fiscally challenged countries – Greece, Spain, Italy and Portugal for example – are likely to withdraw their cash for fear of a similar policy being implemented at home. Get set for a bank run or two. Just how severe these will be will be a critical issue for global markets in the days and weeks ahead.

The deposit levy looks like some maggot infested raw meet, but at least it is less bad than drinking a glass of vomit.