As a general rule, when both Russian President Vladimir Putin and New York Times columnist Paul Krugman say something's a bad idea, you should probably do it. This is the case with the eurozone governments' decision to bail out Cyprus, which will include steep taxes on large deposits in the struggling Mediterranean nation's banks. Putin officially told his economic aides: "Such a decision, if it is adopted, will be unfair, unprofessional and dangerous." Krugman, though he acknowledged that he "wasn't watching Cyprus," felt no compunction about weighing in, writing, "It's as if the Europeans are holding up a neon sign, written in Greek and Italian, saying ‘time to stage a run on your banks!'"
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Given how many of the accounts being taxed in Cyprus's banks belong to Russian depositors, Putin's opposition isn't surprising. The main Russian stock index, RTS, fell by 2.8 percent on Monday, and most of all the prices of Russian state bank stocks fell. But Krugman and the other Western observers decrying the EU's shortsightedness and cruelty should probably take a closer look at how this situation developed.
Like Bermuda or the Cayman Islands, Cyprus essentially has two industries: beaches and banks. It is clean, safe, and well-run, with a British system of law. Like Iceland and Ireland, however, it has an oversized banking system, with banking assets eight times its GDP. During the final years of the Soviet Union, Cyprus concluded a uniquely favorable double-taxation agreement with Moscow that is still in force with the main successor states, Russia and Ukraine. Cyprus has been a member of the European Union since 2004 and adopted the euro in 2008. It has the lowest taxes within the EU, with a 10 percent corporate profit tax. The combination of all these advantages has made Cyprus a dominant financial intermediary for Russia. All kinds of payments heading to and from Russia pass through the island, and though there have been frequent accusations of money laundering, Cyprus has never been blacklisted. Cyprus is technically one of the largest foreign investors in Russia, thanks entirely to Russian-owned companies operating in the country.
Traditionally, Cyprus has been fiscally conservative. It typically had small budget deficits and its public debt was only 49 percent of GDP in 2008. But since then, its financial situation has deteriorated quickly. In 2009 the International Monetary Fund recommended stimulus spending to Cyprus: "With a slow recovery ahead, authorities and staff agreed that a supportive fiscal stance should continue into 2010...The staff cautioned against a premature withdrawal of stimulus," the IMF's report read. The government followed the recommendations and, as so easily happens, overdid them, turning the budget surpluses of 2007 and 2008 into budget deficits averaging 6 percent of GDP from 2009-2011. Because of its vital financial interest in Cyprus, the Russian government gave the island nation a large loan of €2.5 billion in December 2011. The bilateral loan was to be repaid over the next 4.5 years at 4.5 percent interest.
The real crisis hit Cyprus with the writing down of public debt in nearby Greece in March 2012. The two largest Cypriot banks, Bank of Cyprus and Popular Bank, held an inordinate amount of Greek state bonds. When I visited the Central Bank of Cyprus last May, officials there estimated the losses at €4.4 billion, but said they had been hoping for a private bailout or a big Russian loan. The main reason for the failure to reach any agreement with the EU earlier was that President Demetris Christofias -- educated in Moscow and the EU's only Communist leader -- simply refused to do so, not wanting to accept any austerity measures. Meanwhile, the crisis grew worse.
On Feb. 24, veteran center-right politician Nicos Anastasiades won the presidential election resoundingly with 57.5 percent of the votes. He knew that a debt settlement was his first task to quickly get his country's economy on the right keel. The IMF and the EU assessed the required financing at €16 billion -- almost equal to Cyprus's entire GDP -- most of it for bank recapitalization. If the country had received such a large loan, it would have ended up with a public debt of 145 percent of GDP, which would not have been sustainable. To tax the population of only 800,000 because of the failure of the banks would have been both unjust and impractical, since the taxes might not be very easy to collect.
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