Makes you Wonder What’s Next?

Richard Croft
March 25, 2013
10 minutes read

The title reflects the elephant in the room that overhangs the silent majority; is anything safe from the long arm of distressed governments? It sheds light on the veiled risks associated with unchecked governments searching for new sources of revenue! This week we witnessed the “what next” which is the Cyprus Solution.

Cyprus was initially pursuing a €17 billion bailout from the European Union (EU) to prop up the country’s banking system. The EU was only willing to provide a €10 billion bailout with serious pre-conditions attached to it.

Early proposals had demanded that Cyprus raise its corporate tax rate to 12% putting it at the same tier as Ireland. The current 5% corporate tax rate in Cyprus is the lowest in the EU. That proposal was rejected by Cyprus.

The next wave of negotiations led to the controversial Cyprus Solution whereby Cyprus would levy a one-off 9.9% tax on deposits in excess of €100,000 and a 6.75% tax on accounts with less than €100,000. The levy was to happen on March 16th but at this point negotiations are ongoing. Cyprus banks re-opened on March 21st but limited the amount that depositors could withdraw from their accounts as the country works to prevent a run on the banking system.

The ensuing uproar has reverberated across the globe and caused serious debate as to the unintended consequences of opening a door that was previously considered impenetrable. Not to mention the spectre of runs on other seemingly more stable EU banks if account holders believe that other governments in distressed countries follow the same strategy that absconds with an individual’s life savings.


To understand what lead to this draconian measure and to give fair value to both sides of the debate we must put the Cyprus situation into context.

Cyprus banks were major holders of Greek debt and when Greece forced some of its private bond holders to take a “haircut” Cypriot banks were hit particularly hard. Many to the point of insolvency!

The Bank of Cyprus, the largest financial institution in Cyprus, requested assistance which in turn forced the government to approach the EU in June 2012 seeking a bailout.

You might ask why an insolvent bank would make the country insolvent. The problem is the size of the banking system which is five to seven times larger than the entire Cyprus GDP. According to the EU that disparity makes the Cyprus situation unique.

The reason for the disparity is that Cyprus is considered a tax haven. Supported in part by that previously mentioned low corporate tax rate and a double tax avoidance treaty with Russia! It doesn’t hurt that Cyprus also has a halfhearted regulatory regime that appeals to wealthy Russian citizens and corporations who want to move capital into and out of Russia seamlessly without having to provide evidence supporting the legitimacy of those deposits.

That Russian citizens and corporations have been major beneficiaries of the tax haven in Cyprus adds to the complexity of the situation. Russian companies and wealthy individuals have deposited more than €27 billion in Cypriot banks or about a third of all deposits in the country. Add to that total loans to companies registered in Cyprus and Russia’s total exposure is estimated to be in excess of €54 billion.

Not surprisingly Russian President Vladimir Putin has been highly critical of any penalty imposed on Cyprus bank deposits, saying it sets a dangerous precedent that could cost Russian citizens dearly. If taxed at the highest rate the total cost to Russian citizens and corporations could exceed €2.7 billion.

“Such a decision, if it is adopted, will be unfair, unprofessional and dangerous,” Putin told a government meeting Monday, according to CNN citing a statement posted on the Kremlin website.

The Debate!

There are two sides to this issue; The Cyprus government contends that without the bailout banks would be declared insolvent and depositor losses would be greater. Certainly accounts with greater than €100,000 would not be able to avail themselves of the depositor insurance presumably backstopped by the government.

According to CNN, Cyprus President Nicos Anastasiades said the bailout option was “very difficult” but one that would eventually lead to economic recovery in Cyprus. He went on to say that failure to agree to the package would “lead to disorderly bankruptcy as a result of the decision of the European Central Bank to immediately discontinue the provision of emergency assistance to preserve the liquidity of the two large banks.” This would have meant depositors would have lost access to their deposits, and a large number would have faced significant losses, he said.

The other side posits a more subjective argument that has far reaching implications. Notes CNN Money “the move is being closely watched because of the potential to destabilize financial markets in Europe; there are also concerns that other financially weak nations might be exposed to similar bailout pre-conditions in the future.

Quoting Steven Englander, global head of foreign exchange strategy at Citi, “The question is whether this becomes a full-blown crisis or a mini-crisis? Depositors and investors elsewhere could easily see this as another in a string of ‘one-offs’ and react badly.”

Writing in CNN Money Brookings Institution fellow Douglas J. Elliot notes that there is “grave risk that the bank levy would eventually lead to serious bank runs in other parts of the eurozone.”

This is a significant backward step. Never before have we witnessed such a tax being proposed in the EU although according to the International Monetary Fund, there was a bank debit tax imposed in Latin America in 2001. But in that case, notes CNN Money, “the tax was on financial transactions and not an outright grab as is being proposed in Cyprus.”

The Rule of Law EU Style

The Cyprus Solution will not have a marked impact on the financial markets unless of course we see runs on other banks in the Eurozone. Cyprus is the smallest member in the EU. So small in fact that the GDP of Cyprus is less than the GDP of Vermont, the smallest of the 50 States south of the 49th parallel.

That’s an important data point in that it tells us that the bailout would not be on the radar screen if it did not subjugate a fundamental tenet that underpins civilized society. That is to say; no one country or individual should be above the Rule of Law.

That governments are willing to sidestep such a fundamental tenet is what gives weight to the Cyprus Solution. Are we ready to accept a position that unique situations allow governments to skirt the rule of law? It is certainly a major backward step taken by the EU to demand such pre-conditions.

It is also difficult for the US government to challenge as their bailout of General Motors and AIG falls under the same moniker as does the Treasury’s insistence that too-big-to-fail financial institutions had to take part in the Troubled Asset Relief Program (TARP). In fact the too-big-to-fail label is itself a breach of the Rule of Law tenet.

What investors must weigh is the unintended consequences that come from letting governments deal in the realm of absolute power. Because that too leads to an inescapable consequence; absolute power corrupts absolutely!

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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