Monetary union cracked at edges

Cyprus has fallen victim to the demands of the German ballot box, says Jeremy Warner.

Europe's monetary union was meant to be about solidarity among the many and prosperity for all. In practice, it's turning out to be a doomsday machine for the fringe economies that once so enthusiastically lined up to join.

If even Wolfgang Schaeuble, the German finance minister, is prepared to admit Monday's bailout is a bitter pill for Cypriots to swallow, then it must indeed have been merciless. Nicholas Papadopolous, chairman of the Cypriot parliament's finance committee, had a blunter way of putting it: "We are heading for a deep recession, high unemployment. They wanted to send a message that the Cypriot economy ought to be destroyed, and they've succeeded. They've destroyed our banking sector."

The terms of this latest bailout are scarcely any better than the ones so comprehensively rejected by MPs only last week. The offshore banking model on which so much of the island's recent prosperity has been built is being broken beyond repair. Small wonder the latest package is structured in a way that doesn't require another parliamentary vote. Democracy is once again being suspended for the supposed sake of the single currency.

Few international investors are going to risk their money in a Cypriot bank after this. Uninsured depositors stand to lose up to 40 per cent of their money and, if capital controls are imposed as expected, will struggle to remove even what's left.

No national banking system can survive such a restructuring. Thousands will lose their jobs, not just in the banks but in legal, accountancy and business services industries that the banks have supported. An immediate collapse of 10 per cent to 20 per cent in national income is in prospect, with unemployment soaring to more than a quarter of the population.

Apparently abundant reserves of natural gas might one day come to Cyprus's rescue as a substitute for finance but it's a long way off, even if the finds can be extracted and transported at economic cost. In the meantime, agriculture and tourism are all that's left.

If this destruction were just the random aftershock of the wider banking implosion sweeping Western economies, then what's just happened would certainly be brutal and unlucky but it would also have been just about understandable. It might even be argued that haircutting uninsured depositors is an entirely healthy development, and indeed just the sort of market discipline that should have been imposed on banks all along.

Now that it is understood that bank deposits are not automatically underwritten by taxpayers, depositors might be a bit more careful where they put their money. There would not have been a banking crisis in the first place had this principle been properly understood from the off. But it was not, and now, in the midst of a severe crisis, is precisely the wrong time to be imposing it.

In any case, the situation Cyprus finds itself in is not just an act of God, nor is it even a calamity which Cyprus has brought on itself. True enough, Cyprus did actively market the island as an offshore tax haven for Russian and other faintly suspect sources of money.

I recall visiting Cyprus sometime in the early 1990s and being amazed to hear Russian spoken at the table next to me in the local taverna. Though the Soviet regime had already fallen, it was still a novelty to see Russians out and about in this way. When I politely inquired what their business on the island was, one of their number replied in perfect English: "Finance and escape from the Russian winter, what else?"

Russian interest in Cyprus long pre-dated the euro but it was the single currency which turbo-charged their exposure. Cyprus offered a backdoor, no-questions-asked way into apparently "safe", tax-efficient euro deposits. As part of monetary union, it should in theory have been as risk-free as putting your money in a German deposit account. And it would have been had monetary union been underpinned by the banking union, which is a prerequisite of any lasting form of exchange. If anyone is responsible for the bloated size of the Cypriot banking system, it is not the Cypriots, who were only pursuing a market opportunity, but the architects of the single currency.

A fundamental principle of monetary union - that the currency is worth the same, wherever it is held - has been shattered. Some euros, it would seem, are more equal than others.

The possibility of capital controls to prevent deposit flight when the banks reopen only further clouds the picture. Free movement of capital is another basic principle of monetary union which the eurozone seems casually prepared to disregard. This is not a proper currency.

Lawyers who have had sight of the draft capital controls describe them as "draconian" - just as bad as Argentina's famous "corralito" in 2001. The corralito spawned a sizeable avoidance industry, as well as numerous legal challenges. Cypriot controls will do the same. European treaties do allow their imposition in very limited "emergency" circumstances but they have to be "proportionate, non-discriminatory and otherwise compliant with European law". What's more, Cyprus has some 20 "bilateral investment treaties" which guarantee rights of deposit withdrawal, including with Russia. A lawyers' paradise is promised.

Cyprus should plainly have accepted the bailout terms as offered eight months ago. They were infinitely preferable to the punishment now being meted out. By refusing, Cyprus has allowed itself to fall victim to the demands of the German ballot box. With national elections looming in September, Germany's two main political parties have become increasingly intransigent in their demands. For domestic political reasons, Berlin wanted to see large depositors in Cypriot banks punished, even though the eventual knock-on costs for the eurozone as a whole of bailing them in are likely to be far larger than bailing them out. In any case, there could be no question of hard-earned German savings being used to pay off Russian oligarchs.

As it happens, the really big ones have already got their money out. In any case, it was not excessive Russian deposits which finished off the Cypriot banking system but last year's eurozone-imposed haircut of Greek sovereign debt. As big holders of Greek bonds, Cypriot banks have suffered losses approaching €5 billion ($6.2 billion). Thus does each successive botched crisis lead directly to the next one. Narrow political self-interest has been put above that of the common good.

No monetary union can expect long to survive this sort of self-inflicted political battering. If Europe can make such a mess out of tiny Cyprus, just think what might happen when the crisis once again laps at the doors of larger economies such as Italy, Spain and Portugal.