Cyprus: A poor diagnosis, a bitter pill

After days of anger and worry about the safety of their savings, hundreds of Cypriot protesters gathered outside the parliament in Nicosia on Tuesday. They waved Russian flags and shouted “out with the troika” – a reference to the European Commission, International Monetary Fund and European Central Bank, the reviled threesome responsible for negotiating eurozone bailouts.

The EU leaders who had spent all night in talks to produce Cyprus’s ill-fated bailout plan – a plan that would have been paid for in part by a levy on ordinary citizens’ bank deposits – had seen much worse. In Athens, there had been riots and tear gas.

Yet despite three years of battling one crisis after another, the officials had still managed to misread the situation. They were wrong about Cyprus and its brand of politics.

They thought the island had elected another Antonis Samaras, the centre-right prime minister of Greece who became a champion of his country’s tough austerity-laden bailout when he was elected last June. But this was no Greece.

Instead, they were dealing with Nicos Anastasiades, a lawyer and career politician who had assumed the country’s presidency just two weeks earlier. Like many in Cyprus, he has ties to Russian interests – his family law practice has two Russian billionaires on its books. And other members of the Cypriot governing class felt pressure to protect the country’s banking sector, which counts Russians among its most important customers.

Failing to grasp the depth of such ties would prove a fatal blind spot. “The discussion in Cyprus was not about small savers,” says a senior German official. “It was about people who fly in Lear jets.”

By the end of the week there would be 13 private jets belonging to Russian owners of Cypriot companies parked at Larnaca international airport, ready to decamp with millions held in the two main banks. Cyprus has long been a popular tax haven for Russian businessmen, legitimate and not.

During the bailout talks that had begun the previous Friday night, Mr Anastasiades had threatened to storm out of the meeting with the IMF, EU and other officials at least twice. At one point he declared: “My country is not going to commit suicide,” recalls a person in the room.

And yet officials thought they could still make clear to the Cypriots what was at stake if he did not strike a deal. Jörg Asmussen, an ECB executive board member, matter-of-factly explained that if Mr Anastasiades decided to leave without a deal, the ECB would be forced to cut off the emergency low-cost loans that were keeping alive Laiki Bank, Cyprus’s second largest and its most troubled. If Laiki failed, Mr Asmussen said, Bank of Cyprus, the country’s largest financial institution, would likely go down with it. All savings in the island’s banks would be wiped out.

It was with that “pistol to the head” that Mr Anastasiades and his team would return to an uncertain fate in Nicosia. Just before the parliamentary vote on Tuesday, after eurozone officials urged the Cypriot government to modify the bank levy so it would fall exclusively on deposits above €100,000, EU officials had convinced themselves that Mr Anastasiades would not put his country at risk to protect wealthy holders of big bank accounts.

“I was thinking until an hour before it actually happened: it’s all a bluff,” a senior eurozone official who had been part of the negotiations says of the posturing by Mr Anastasiades. “He’ll turn around and instruct his party to vote for it after all. He wouldn’t be going to vote if he hadn’t made sure the desired outcome was there.”

More importantly, officials assumed Mr Anastasiades, having just three days earlier signed up to the deal – which controversially included seizing the €5.8bn from Cypriot bank accounts – would use his recent victory at the polls as political capital to ram the package through.

“Right up to the morning or midday, we thought: ‘It’s a presidential system’,” says another senior eurozone official who had negotiated directly with Mr Anastasiades. “He only puts a bill [before parliament] if it’s going to pass. We thought he’d take some time to negotiate with other parties. The moment we knew he was going to a vote, we knew it was over.”

This error of judgment could have vital consequences for the eurozone. Cyprus’s rejection of the deal has resurrected fears that the three-year-old eurozone crisis, dormant for more than seven months, is on the verge of spinning back out of control.

Although Cyprus only burst into world consciousness this week, its financial crisis has festered since the island was first cut off from international financial markets two years ago. Confidants of Angela Merkel said late last year that when she was asked about her biggest concerns in the eurozone, the German chancellor – despite upheaval in Italy and Spain – had given a one-word answer: Cyprus.

“Conceptually and policy-wise, this is more challenging than the Greek package,” says one senior EU official. “The size of the country does not correspond with the size of the problem.”

. . .

Senior US officials have quietly urged the IMF to backtrack from its hardline stance over “bailing-in” – or forcing losses on – Cypriot account holders. Eurozone officials acknowledge they have been planning for a possible Cypriot exit from the single currency. Leaders openly admit they have no idea where the solution lies.

“There are a lot of people in Europe who are just scared [and] would happily throw some money at the problem to make it go away for a few weeks,” says one official directly involved in the talks. “But the other possibility is they leave [the euro].”

In many ways, Cyprus presented the worst parts of other eurozone bailouts combined. Its banking collapse was on the scale of Ireland’s, and it entered the crisis with debt levels as high as Portugal’s. Like Greece, its economy was dysfunctional, reliant almost exclusively on its outsized financial sector for economic activity.

As if that toxic mixture were not enough, leaders had to deal with another very large wild card: the Kremlin. As far back as November 2011, Olli Rehn, the EU’s top economic official, had first privately suggested the option of a bailout to the finance minister of the previous Cypriot leader, Demetris Christofias. The president late that year won a €2.5bn loan from Moscow to put off the day of reckoning with Brussels.

This time, EU and IMF leaders wanted to be sure things were different. On the sidelines of the Group of 20 finance ministers’ meeting last month in Moscow, a high-ranking group met secretly with Anton Siluanov, the Russian finance minister, to sound him out on Cyprus. They wanted the Kremlin to help Nicosia by restructuring their €2.5bn loan – extending its repayments and lowering its interest rate – but they also wanted to know whether the Russians wanted to take over either Laiki or Bank of Cyprus.

An additional loan was of no help, the delegation told Mr Siluanov, since it would simply add to Cyprus’s debt level, and getting Nicosia’s sovereign debt down to 100 per cent of gross domestic product by 2020 had become a core reason for keeping the size of the bailout to €10bn. But a Russian takeover of Laiki, which had long been rumoured, was a different matter, since it would give Russian investors an ownership stake without adding to Cyprus’s debt levels.

However, according to one person in the room, Mr Siluanov was clear: he was willing to renegotiate the €2.5bn loan, but there was no interest in giving Nicosia more aid or in urging Russian banks to take over Laiki.

Just to be doubly sure, days before Jeroen Dijsselbloem, the Dutchman who chairs the committee of all 17 eurozone finance ministers, convened his counterparts in Brussels to bang out a deal on Friday night, he asked Mr Rehn to call Mr Siluanov once more. “Our Russian colleagues were very explicit: ‘We don’t want one of those banks’,” says one official.

The back channels to the Kremlin would prove useful when, after the bailout package was rejected on Tuesday, Michael Sarris, the Cypriot finance minister, flew to Moscow in an attempt to secure an alternative to the EU-IMF programme. One eurozone official says even as Mr Sarris was locked in back-to-back meetings and prime minister Dmitry Medvedev was publicly railing against EU leaders, accusing them of acting like “an elephant in a china shop”, he had received word from Russian officials that no help would be in the offing.

In fact, the biggest dispute was within the troika itself. The IMF, convinced it would not repeat the mistakes of the Greek bailout, was determined to have a programme that kept Cyprus’s debt manageable and cut its bloated banking system down to size.

Backed by Berlin, it proposed what came to be known as the “bail-in” or “Icelandic Solution” – to merge Laiki and Bank of Cyprus; create a new bank with all insured deposits under €100,000 and capitalised with Cypriot government and bailout funding; and put everything else in a “bad bank”. That meant large depositors, including many Russians, would have their holdings put into the bad bank and cut by anywhere from 20 to 40 per cent. But it also meant cutting the bailout’s €17bn price tag in half.

The European Commission, backed by Mr Asmussen of the ECB and Thomas Wieser, the Austrian who heads a committee of eurozone finance ministry deputies that sets the course of all bailout debates, was worried that the hit on large depositors would cause more problems than it solved, panicking investors, sparking a bank run and devastating the Cypriot economy.

The fighting between the IMF and the commission became nasty in the run-up to Friday’s meeting. The Commission, says one participant in the stand-off, was viewed by Berlin as “always spending other people’s money”. The IMF, on the other hand, was using “a small island economy as a test ground”, says a member of the rival camp. “The positions became locked at some point,” says another official involved.

In an effort to derail the IMF and German plan, the commission side devised the idea of the levy, which it felt would be less onerous than the “full bail-in”, particularly if Berlin could be persuaded to accept other forms of revenue, such as new taxes and pension fund contributions, as ways to reduce the €17bn price tag.

But the stand-off between the IMF and the commission continued. Mr Dijsselbloem decided that he had to call the eurogroup into session to finalise a deal.

“They had been farting around for months,” says one person sympathetic to Mr Dijsselbloem. “They would never, ever come together. We had to light a stick of dynamite and say: it’s burning.” As the all-night talks wore on, the bail-in and levy camps dug in. Wolfgang Schäuble, the blunt German finance minister, infuriated the Cypriots by his dogged pursuit of upfront savings; nearly everyone was put off by Mr Anastasiades’ emotional reactions and the strain in his relationship with the respected Mr Sarris.

Early in the evening, Mr Schäuble gave in on the levy. It was Mr Anastasiades, with some urging from Mr Rehn to keep the top rate below 10 per cent to prevent massive capital outflow, who set the rates.

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Despite the subsequent outrage, and Mr Anastasiades’ disavowal of the deal, the doors are rapidly closing on Nicosia. First, the ECB said it would cut its lifeline of emergency loans on Monday if a deal were not reached by then.

Then the Kremlin announced what officials already knew privately: it was not coming to the rescue. Finally, the troika said on Friday that the Cypriot counter-offer – an amalgam of previous ideas with others that had been already rejected – was insufficient. Mr Anastasiades seemed to be back where he began the week: accept the deal struck last weekend or face the decimation of his banks and, in all likelihood, a euro exit.

“In contingency planning, every option is always there,” one eurozone official who has been in regular contact with Nicosia says when asked if Cyprus could leave the euro. “I do not believe it will happen, but if they do not have a programme by Monday morning agreed with us …”

His voice trailed off, unwilling to express the consequences of failure.