Worrying erosion of trust is biggest Cypriot euro risk

Raoul Ruparel
IN TAKING the radical and “unique” step of imposing a tax on Cypriot depositors to help fund a €17bn (£14.5bn) bailout of the island, Eurozone finance ministers look to have sparked off the euro crisis once again.

Much has been written about the motivation behind the move – from German aversion to bailing out Russian businesses to technical difficulties in restructuring Cypriot sovereign and/or bank debt. But one thing that should not be forgotten is that Cyprus requested a bailout over 8 months ago and everyone involved left it to the last minute, leaving few other options to raise the necessary cash. All that said, there are three key lessons from the move.

First, Germany has grown tired of funding bailouts. With elections looming it seems the German government has reached the limit of what it will force its taxpayers to accept to avoid potential Eurozone contagion. This marks a significant change in approach – it also raises questions about any future bailouts or activation of the European Central Bank’s (ECB) bond buying programme, which are both tied to German parliamentary approval.

Secondly, this has the potential to become politically toxic on a number of fronts. The Cypriot government was elected just a few weeks ago, partly on the promise that no depositor would suffer losses under a bailout programme. Reversing such a promise surely makes the government’s position close to untenable. Further, it has emerged that, although the general concept of the deposit tax was driven by Berlin, the ultimate decision to apply it to even the smallest depositors was taken by the Cypriots.

Who will become the focus of public anger is far from clear at this stage. It would, however, be surprising if this domestic consternation didn’t evolve into broader discontent with the Eurozone. The bailout will also likely come with stringent austerity conditions – a potent mix. The final political aspect is a geopolitical one. Cyprus has close links to Russia, which last summer made overtures about placing a naval base on Cypriot (and therefore EU) soil. Political discontent and instability in Cyprus could inadvertently push it into Russian arms, a worrying prospect for all involved.

Thirdly, the tax highlights that, in extreme moments of crisis, the rule of law remains bendable to political will. There are valid concerns that this move breaks numerous laws, including: protection of property rights under the Cypriot constitution and the European Convention of Human Rights, EU laws on deposit guarantee schemes and rules against capital controls in the EU treaties. In the end, these concerns have been quickly brushed aside under the veil of a “solidarity levy” – far from sufficient legal grounding in the eyes of many.

Ultimately, immediate contagion may be limited due to Cyprus’s size and the backstop of the ECB, so fears over deposit-led contagion shouldn’t be overstated. But as these three lessons show, the bigger risk is that a future bailout will be far more difficult to activate, as political trust between EU partners, as well as with populations, is eroded. It’s that loss of trust which is the real story here.

Raoul Ruparel is head of economic research at Open Europe.