EU straddles fault line with Cyprus on brink
Cyprus petrol station manager Gregory Dorotheu has a stern message for his customers: cash only, please. He is far from the only retailer to turn down credit cards on this troubled island. With the banks closed on command of the government until at least Tuesday and under real threat of imminent collapse, suddenly those little card-swiping machines feel flimsy and untrustworthy. Do those little electronic beeps really mean anything? Is money genuinely moving around? Will it still be there in a week? Does it exist at all?
Besides, Dorotheu needs the readies in hand, he told the BBC. His supplier has given its own stern demand: €40,000, in cash, for the next fuel delivery.
A bank run is an economist's worse nightmare - a vicious cycle that can only end in disaster, as distrust feeds on itself and the leveraged illusions of modern banking are brutally ripped away to reveal the empty vaults at its heart.
Cyprus isn't there yet. Not quite. Despite the lengthening queues at ATMs on Thursday, fear had not turned to panic. Most machines were still being supplied with euros. Many in the queues were withdrawing money simply because it was a long time until Tuesday, though a fair few wanted to bung it under their mattress.
But the clock is ticking. Earlier that day, the European Central Bank sent an ultimatum to Cyprus that boiled down to this: find an extra €6 billion by Monday, or we cut off the emergency cash drip that is keeping your two biggest banks (Laiki and Bank of Cyprus, both teetering on the edge of insolvency) alive.
"The Cyprus economy is on the brink," said the Bank of Cyprus in a statement. "The next move may prove its salvation or its destruction."
Things have changed quickly in tiny Cyprus (barely 9000 square kilometres, about the size of greater western Sydney and with fewer people), where, according to legend, the goddess of love, Aphrodite, was born from the shining foam of the Mediterranean.
Five years ago Cyprus was a jewel of the European Union, which it joined in 2004 as its easternmost member. Long-term unemployment was lower than anywhere in Europe other than Sweden. Tertiary education was more widespread than in Germany, inequality was lower than in Ireland.
But in June last year Cyprus became the fifth country to apply for financial aid from the "troika" - the ECB, the European Commission and the International Monetary Fund. The country's two main banks had taken a massive hit when Greece restructured its debt after its own financial crisis. Moody's estimated that recapitalising the country's banks would cost more than €8 billion and the country needed twice that to stay solvent.
The economy had collapsed like a punctured balloon. Unemployment went up by 50 per cent in a year. Government debt soared towards 100 per cent of GDP.
How could such a small country get in so much trouble, so quickly? The answer, says economist Paul Krugman, was runaway banking. Bank assets were about eight times GDP, stuffed with offshore money attracted by "high rates and opportunities for tax avoidance/evasion". At least 40 per cent of the €68 billion on deposit in Cyprus belonged to foreigners, and much of the rest of it belonged to people only nominally resident in the country.
A lot of rich Russians put their money in Cyprus, and many of them were believed to be laundering ill-gotten gains. When rumours of bank troubles started spreading early this week, the runway of Larnaca airport was suddenly crowded with private jets from Moscow, as worried "investors" came to harangue their accountants and lawyers (at least, the ones who had not taken their money out a year ago when things started looking shaky).
"Doom was inevitable," says Krugman. When the bubble burst, the island's tiny economy was unable to prop up its outsize financial sector.
But the peculiar nature of the country's banking system made the EU reluctant to follow its usual bailout model: loan money to the government and banks, guarantee deposits, demand harsh austerity measures and cross fingers for a recovery. Despite the small sum (at least relative to other rescue packages) it felt like the EU would be spending billions to guarantee the savings of Russians, crooks and tax dodgers. In Germany, particularly, it was a political hot potato for a public weary of propping up the continent.
So Cyprus reached a deal with the Eurogroup - the finance ministers of the Eurozone - and unveiled it last weekend. The EU and IMF would provide a €10 billion loan to keep the country from going bankrupt. Cyprus would, in return, commit to structural reforms (an austerity program and privatisation). It would also set up an independent audit of the Cypriot banks' anti-money-laundering framework and promise to plug any loopholes.
But there was an extra clause, unprecedented in previous bailouts. Cyprus would stump up €5.8 billion to reduce the size of the loan, and ensure its ability to repay it. And it would get this money by taking it from the banks' customers.
This so-called "one-off stability levy" would take 6.75 per cent of the savings of depositors with less than €100,000 in their accounts, and 9.9 per cent of the savings of those with more. It would hit every bank customer (including Alexander Downer, now the UN special adviser on Cyprus).
The levy stunned observers, who were almost unanimous in their disdain. Trust in European banks is already precarious - the last thing you want to do is set a precedent for ripping money off depositors without warning.
"What has been asked of Cyprus hasn't been asked of any other country which has received a bailout," Downer told the ABC. "The risk here is ... it sets a precedent for a country like Spain or Italy and if that's the case, then that could lead to a run on banks."
The BBC's economics editor Stephanie Flanders said on Tuesday "nearly everyone involved in the deal ... now agrees it was a mistake."
When bank deposits are under threat, the "herd mentality" is to move those deposits somewhere safer. Cyprus declared a bank holiday to stop this happening, but the fear was that it was too late.
On Wednesday, the furious Cypriot parliament vetoed the levy. Even the governing Democratic Rally party, which had proposed the levy, did not vote for it, despite a frantic change exempting people with less than €20,000 in savings. Lawmakers called the levy a shameless attempt to "blackmail" the island.
But the fact remained: Cyprus needed to raise the money somehow.
Several schemes were proposed, many involving Russia (which, after all, would be protecting its citizens whose money was in the country). One was for a Russian bank to buy up Cyprus' bank debts.
Cyprus Finance Minister Michalis Sarris went to Moscow to seek a deal, but reported back that he had "no offers, nothing concrete".
Many observers speculated on a plan to hand over the island's untapped offshore gas reserves in exchange for aid, but the trade never materialised (to the relief of those already worried by Europe's energy reliance on Russia).
Then on Thursday came the ECB's ultimatum. The government had until Monday to reach a deal that satisfied the EU and IMF, or it would turn off the cash tap that was keeping at least two of the country's banks afloat.
Cyprus moved to set up an "Investment Solidarity Fund" - essentially a begging bowl for a quick whip-around - but it seemed unlikely it would fill with €5.8 billion by Monday.
"Confusion reigns supreme," commented Danish investment banker Lars Seier Christensen.
"We have seen again that the eurozone is unable to deal rationally with its problems. This has got to be the most incompetent handling of a euro crisis so far.
"The slow realisation that confiscating our money will be the next move in the debt crisis has been made very acute."
Raoul Ruparel, of independent think tank Open Europe, wrote that, unless Cyprus or Europe changed their minds on the levy, the only alternative would be for Cyprus to exit the eurozone and print its own money to save the banks.
"The new Cypriot currency would have little international trust," he wrote. "This scenario has all the hallmarks of an inflation spiral and collapsing GDP."
On the other hand, if the ECB stays in the game, it could find itself stumping up more and more money to compensate for the now near-inevitable run on the Cyprus banks - hitting its credibility hard.
On Thursday night, the Eurogroup reportedly offered Cyprus another option: save €3 billion by restructuring one of its ailing banks (believed to be Laiki). However, it would be a bitter pill for the country to swallow: "restructure" being code for "cut thousands of jobs".
"They are changing their demands every time," complained Cypriot MP Marios Mavrides.
Oxford University lecturer in economics Dr John Thanassoulis says Cyprus is "on the brink" - and the ECB stands to lose whether it carries out its threat, or reveals it to be a bluff.
"The EU have manufactured a situation in which it's quite possibly Cyprus might be forced out of the euro," he told the BBC. "That makes it very hard to see how [they] could really follow through on their threat. It's an incredibly dangerous precedent."
From nowhere, the EU has set up a game of Russian roulette, he said. And pointed the gun at its own forehead.