The Next Domino: Cyprus and the Euro Crisis

The Cypriot financial crisis again begs the question: how long can the Euro-structure survive these periodic tremors, especially since every single shock which comes is bigger and has a deeper structural impact than its predecessor.

If In Doubt, Blame the Germans?

German finance minister Wolfgang Schaeuble is technically correct to reject accusations that his country - which serves as Europe's bankroller - bears any responsibility for Cyprus' current predicament: 'nobody outside Cyprus is to blame for it', is how Mr Schaeuble rather tortuously put it a few days ago. However, the reality is that the Cyprus fiasco arose largely as a result of previous German political decisions and the burden of tackling the ensuing mess now rests squarely on Germany's shoulders.

Cyprus requires approximately €16 billion to stave off immediate bankruptcy, peanuts for a continent which is the world's biggest economic block. But Germany's politicians are fearful that, if they approve another unpopular bailout package they will be punished by the long-suffering German taxpayers at the general elections scheduled in September. So Germany insisted that Cyprus must be seen to be bleeding while it is being saved; apparently, that was the only way German voters could be persuaded to part with their money.

There was no reason to adopt this stance; the German government knows how to stand up to its own electorate on issues considered of national importance. Still, there was a belief in Berlin that letting the Cypriots fry was the least bad of all options. In fact, it was probably the worst. For hitting at Cyprus was both easy and popular, since the island is already perceived as just a place where Russian oligarchs pile up their bank accounts, while their peroxide-blonde girlfriends top-up their sun tans. But the result of this German pressure was a nonsensical bailout which tried to shore up banks in Cyprus but which, by proposing to rob depositors of up to a tenth of their money, also managed to destroy confidence in the island's entire banking system.

Now that the deal was rejected by Cypriot lawmakers, the options facing German leaders are stark. They can either insist that Cyprus should find money elsewhere, thereby risking a prolonged crisis which may affect all European banks. Or they can eat humble pie by reversing their policies and offering Cyprus more cash, at a risk of provoking an electoral backlash inside Germany.

Either way, Germany stands accused of acting as bully: 'Schaeuble go home' read one banner in front of the Cypriot parliament in the capital of Nicosia. And, annoyingly for the Germans, these accusations still do not absolve them from responsibility of paying Cyprus' bills. The first impact of the Cypriot crisis is, therefore, back in Germany where Schaeuble, the most loyal and competent lieutenant of Chancellor Angela Merkel, is now perceived to have flopped by misjudging the European mood. And, as a result, the question of the Euro remains one of the top controversies in the German general elections, precisely what nobody wanted.

Other EU Leaders Not Much Better

However other EU leaders do not come out of this any better. They knew for years that Cyprus was endangered by an artificially bloated banking sector; after all, Cyprus' problem is identical to that of Iceland, which also teetered on the verge of bankruptcy as a result of nursing a banking sector which was bigger than the country's economy and could not, therefore, be saved. Europe also knew about the suitcases stuffed with banknotes which made their way to Cypriot banks courtesy of Russian couriers, but yet again did nothing. And it was obvious that, once Greece was bailed out, it would only be a question of time before Cyprus - whose economy is intertwined with that of Greece - would also face bankruptcy.

Still, the crisis was only dealt with after it exploded, and then in a classic European way: by reaching a deal behind closed doors, and by announcing it surreptitiously in the dead of night.  It should have been clear to anyone who cared to think even for one moment that the package had no chance of being approved by any parliament in any democracy. And even a child with no knowledge of economics could have figured out that grave consequences await a government which reneges on the most basic of all sovereign guarantees: that of the safety of deposits in its banks.

Evidently someone thought about this: the deposits of Greek citizens in Cypriot banks were explicitly exempt from the levy imposed on other depositors, obviously in order to prevent another 'contagion' from Cyprus to Greece, by prompting a bank-run in Greece itself. But why was the deal with Cyprus still allowed to go through? Apparently because that's what the Cypriot president wanted. So, an entire continent went along with a disastruous plan which had no chance of working, tone-deaf to the very idea that their actions require some democratic legitimacy or even a tacit popular approval.

The biggest challenge for the EU Commission in the days to come is how to prevent the bankruptcy of Cyprus without exacerbating the serious divide which already exists between the continent's prosperous northern member-states which are growing tired of paying for their poorer southern neighbours.

Enter Super-Mario?

And that will depend very much on how the European Central Bank (ECB) decides to behave, for the ECB is also facing its moment of truth. Late last year, Mr Mario Draghi, the ECB's president, vowed that his bank will do 'whatever it takes' to prevent the collapse of the Euro currency. That promise never had to be redeemed: the mere fact that it was uttered by one of the world's most powerful bankers was sufficient to calm investors' frayed nerves.

Now, however, Mr Draghi may be forced to prove what his promise means. Would he rush to keep Cypriot banks afloat, regardless of whether a deal is reached and despite stiff opposition from Germany, which believes that it's not the ECB's job to lend? Or would Mr Draghi pull the plug on Cyprus on the principle that someone must be punished so that others are brought to order? One false step on this issue may endanger the entire Euro project; Seldom before had a small country such as Cyprus mattered so much.

Russia and Cyprus

Contrary to general perceptions, the Russians never viewed Cyprus as their 'strategic outpost'; the island was always regarded in Moscow as a useful R&R station for the oligarchs, a nice conduit to obtain a coveted European Union passport, a handy clearing-house for Caucasian prostitutes but not much more; better banking facilities are available in some Gulf states which are even further away from the prying eyes of either Russian or other European law enforcers. President Vladimir Putin is annoyed about the 'haircut' imposed on Russian deposit-holders, especially since some of the oligarchs caught in the crossfire are his friends. But, on the whole, the Russians are treating the island's current crisis as a good opportunity to humiliate Europe as a whole, rather than the moment when Russia can gain a foothold inside the EU.

That is why it is highly unlikely that Russia will offer further cash, on top of the €2.5 billion it already lent Cyprus; Moscow knows that this cash will be ignored by Europe, and that nothing would please the EU more than to see Cyprus default on its Russian loans. Talk that Gazprom or some other Russian energy monopolist is about to get exploration rights for oil and gas in Cypriot waters in return for advancing the government in Nicosia some money is also wishful thinking: the Russians know that such Cypriot exploration concessions are not recognised by Turkey, and are in any case uneconomical to exploit. So, all the Russians will do is play with Cyprus in order to stroke their own national ego about how powerful Russia has now become, but also in order to increase the discomfort of the Europeans.

An Uncertain Future

Still, the crisis has grim consequences for Europe. It serves as another reminder of just how disorganised its leaders remain, and how cavalier is their treatment of basic principles of legality and good governance. It is also a reminder of how detached the policies of the Euro are from the broader public opinion mood on the continent: not one of the Cypriot parliament's MPs voted in favour of the deal, the most stinging popular rebuke imaginable in any democracy. And, finally, it also highlights the split between periphery and core in Europe. The Euro currency was supposed to unite Europe; in fact, it is the sharpest instrument of its division.

But, when all is said and done, the toughest choices still face the Cypriots themselves. They will have to come to terms with the fact that, as one of Europe's smallest nations, their views on what should be done about their country no longer matter; whichever way they vote and whatever they think, they will have to swallow hard and accept EU demands, regardless of how illogical or unworkable these may be.

Cyprus' sun and good beaches will remain. But nothing else will be the same.


Jonathan Eyal

Associate Director, Strategic Research Partnerships

RUSI International

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