I am shocked, shocked there are Russians in Cyprus

I am writing this post so that I can stop having to repeat myself in email. (1) The Germans claim to be confused at why there is Russian money and Russian transit flow through Cyprus

(2) That is impressive that Cyprus could have gone through its EU accession in 2004 (a vastly tedious checking of everything in the country) and its Eurozone accession in 2008 (a through audit of its financial system) and somehow the Germans missed the fact that 45% of the economy was in banking and the associated professional services.    Cyprus also goes through the Council of Europe Anti-Money-Laundering assessment and regularly scores higher than Germany and Austria and a good chunk of the rest of the EU, but we will ignore that too.

(3) Cyprus is being pilloried as if it was a large player in offshore banking.   Let's go to the numbers, from the February 16th edition of the Economist.

Largest sites of offshore wealth

Switzerland: $2.2T

Britain, Channel Islands and Ireland: $1.9T

Caribbean and Panama: $1T

HK and Singapore: $1T

United States: $600B

Luxembourg: $500B

Cyprus has about $20-$40B in offshore deposits.   That would be less than 0.5% of the offshore banking wealth.

One might have an opinion about whether or not people should be allowed to keep money offshore and there will be many points of view on this topic.   But certainly if your point of view is that offshore banking should not exist, it hardly seems like Cyprus is your place to start...

(4) What Cyprus is for Russia is a transit destination.    In other words, Russian money that is outside of Russia or earned outside of Russia and Foreign Direct Investment is routed through Cyprus into Russia.

Why?   Partially because of tax reasons (the tax treaty rates are favorable, though taxes are fairly low in Russia too), but mostly because Cyprus provides a predictable legal framework that is derived from English law (it was a British colony until 1960), has tax treaties with practically every other country of note and is a fairly neutral jurisdiction for firms from different locations.   Cyprus has also built over the three decades an extremely educated legal and accounting profession to support these transactions.

Basically, until three weeks ago, you would be practically negligent not to route a transaction into Russia without using Cyprus.

(5) If there is a theoretical "victim" to Russian tax structuring through Cyprus, it is the Russian Treasury.  It certainly is not the Germans.    Russia, however, renewed the Cyprus-Russia tax treaty just a few months ago.

Is that because the mighty Cypriot army forced Russia to renew an agreement against its will?  Or is it because Russia sees more value in having this channel for investment than its theoretically lost tax revenue?

In any case, why in God's name does Germany care?   The Russian government finds the arrangement to be useful & from an EU perspective, Cyprus ought to be commended in taking its greatest asset (a well educated workforce) and finding a niche that brings tax revenue into the EU.

The closest parallel I can think of would be if somehow China shut down the Caymans (used by US hedge funds for their offshore clients) and the Bahamas (used by the US for reinsurance) and confiscated US money there and said "yes, I am protecting the US from itself"

It does not make the slightest bit of sense but the newspapers swallowed the narrative hook, line and sinker.

(6) It is beyond the scope of this post, but anyone who reads the newspaper can recall the dozens of money laundering scandals of the major Western banks involved in Iran sanction-busting, Latin American drug money laundering and so on.    Somehow that is brushed aside (HSBC laundered billions for both Iran and drug lords, covering all the bases, and yet the not a single person was found criminally or civilly liable), yet apparently any Russian who engages in any international commerce is an 'oligarch', 'mafioso' or 'money launderer'

You Cannot Engage In Commerce Without Liquidity

As I predicted here, accepting the transfer of the 9B of Laiki ELA to Bank of Cyprus would be disastrous. The disaster has now appeared.   The latest Central Bank plan has the following to say about the large (>100K euro) depositors of the Bank of Cyprus:

(1) Loans outstanding to the bank netted against deposits.  Congratulations, you have now paid off your loans!   If you still have more than 100K of deposits, go to step 2

(2) 37.5% of amount >100K is converted to Bank of Cyprus equity senior to the existing equity.   In other words, we can consider this to be a 0.

(3) 22.5% of the amount >100K will be frozen for 90 days until a valuation of Bank of Cyprus assets is made, after which a decision will be made as to if it should be haircut or not.   In other words, you can consider this to be preferred stock, series A.    Note that I am not sure how one assesses bank assets when you simultaneously withdraw all liquidity from the system.   About 20% of Bank of Cyprus loans were non-performing two weeks ago.   It is hard to imagine that 100% of them won't be non-performing in 30 days from now.   If you are one of the very fortunate people to have some liquidity right now in Cyprus, would your first thought be to use it to make your loan payments???

(4) 40% will be frozen for an indefinite period (claimed to be short, but let's get serious) and will be returned to you when bank results merit it.    There is a word for financial instruments with this payoff schedule and it is called preferred stock, series B.   It is certainly not a checking account!

So, in the best-case scenario, this is a 37.5% haircut.   In the worst case scenario, this is a 100% haircut.

My more immediate concern however is liquidity.   In ALL scenarios it is a 100% liquidity haircut.   You will not be able to access a single euro above 100K on Tuesday morning.    Laiki and Bank of Cyprus are the two money center banks in Cyprus and the core of the local payment infrastructure, used very heavily by local businesses for their operating, payroll and working capital accounts.

The Cyprus market could probably operate (with a lot of random, unfair pain) with the Laiki acccounts being lost.    It seems inconceivable to me that the market can operate with both Laiki and Bank of Cyprus being frozen.   They must be the bankers for 70% of Cyprus firms.  Hundreds of firms will miss payroll, not be able to pay suppliers, etc in this scenario.   I am really at a loss as to what is going on.   It is like taking a century of knowledge about how banking supervision is supposed to work and throwing it out of the window.

I hope this is the Central Bank of Cyprus off in outer space as it has been several times last week  (e.g. they wanted to open the banks without capital controls) and some adult supervision will enter the picture, otherwise this is going to be a very, um, interesting few weeks.    If these restrictions last for, say, a month, there is a large likelihood Cyprus is back on the CYP, whether they want to or not.

Pop Quiz: How Big Is the Bailout Of Cyprus?

Most publications talk about the 10B or 17B Cyprus bailout.   Let's take a pop quiz on the right answer (a) 17 B Euros (89% of GDP)

(b) 10B Euros (52% of GDP)

(c) 2.5B Euros (13% of GDP)

(d) -3.0B Euros (-15% of GDP)

(e) -7.5B Euros (-39% of GDP)

Now let's work through the answers, in steps:

(a)  The 17B figure was calculated assuming the bailout would provide 7B for the banks.    The final number provided not a single Euro for the banks who were asked, against the approach taken in the last 147 banking crises worldwide tracked by the IMF, to find the whole 7B out of their depositor base.   So, part (a) is wrong

(b) The remaining 10B is described as a bailout of the government.  Of this 10B however, 7.5B is being used to refinance maturing debt.

This debt, I would guess, is mostly at this point beneficially held by ECB.   This is just an assumption, but we know that 75% of it was held domestically, largely by the banks.   This was probably the first collateral pledged by the banks via the ELA, so ultimately if the Central Bank and the government default it will ultimately fall on the ECB's balance sheet.   The 25% is probably traded internationally and, again outside of Cyprus hands.

So, the 7.5B is being lent to Cyprus in order to be paid right back to Europe.   That is not charity, that is 'hiding their embarrassing losses until later when someone else is in office'.    If moral hazard requires clueless Cypriot retail depositors to pay for their banks' decision to lend to the insolvent Greek government, then presumably it also applies to the financial wizards at ECB that lent to the insolvent Laiki, despite having full access to their financial information.

That leaves 2.5B of fresh financing for the government which I will concede is new money, though until we see the Memorandum and the terms under which we receive this money, I am not too excited about it.    Cyprus could raise this amount domestically so long as it did not have to do it overnight (which it does not - it is to fund deficits over the next few years).

(c) Does that mean that 2.5B is the right answer?  Not really, see below.

(d) At least 5.5B of the ELA taken by the banks (I suspect it is more) was for losses in the Greek branches of the Cyprus banks.    These branches have 15B of deposits that presumably could have also been haircut, along with the Cyprus-based deposits, to make up for the losses.   Yet, under tremendous time pressure, they were sold to a Greek bank (very suspicious), while the liabilities (the ELA) stayed in Cyprus and are now, beyond all logic, is being transferred to the Bank of Cyprus.

We can call this: "Cyprus Contribution To Recapitalization of Greece, Part II".    And since Greece is insolvent and illiquid without EU assistance, it is really assistance to the EU.

Given that, it is perfectly fair to subtract it from the EU's assistance back to Cyprus.   That takes us to -3B

(e) The Greek PSI (write off of Greek government debt, implemented by the EU) impacted Cyprus, as Greece's neighbor, in a wildly disproportionate manner.   Cyprus banks took 4.5B in losses there.

One could have imagined a solution at the time that partially compensated Cyprus for these losses.  In any case, it was a contribution by Cyprus in reducing Greek public debt and given Greece is backstopped by the EU, it reduces the EU debt load, so that is how we get to -7.5B.

Cyprus has certainly contributed to Greece's bailout on a per-capita basis at a level vastly exceeding any of the nations that are putatively suffering from "bailout fatigue".   Cyprus, voluntarily or not, has contributed around 5% to Greek public and private debt reduction, despite being 0.2% of the European economy, so a rate of 25x the European average, plus or minus.

The apparent "thank you" from the EU, is to try to talk down the main basis of the Cyprus economy (financial services) and aim to destroy the rest of the otherwise fairly healthy Cyprus economy by sucking all liquidity out of the system, literally overnight.

I would grade (d) or (e) as correct answers.    But I don't see any version of the numbers where Cyprus is not a net creditor to the EU bailout regime, as opposed to a net beneficiary.

Stop The ELA

Dear Lawyers of Cyprus, Instead of getting pointless injunctions to preserve the existing Bank of Cyprus shares (that are worthless in all future scenarios), spend the time to figure out how to block the ELA transfer from Laiki to Bank of Cyprus which will preserve a few Billion euros worth of deposits.

It is hard to imagine how it is constitutional to force the liabilities of one private company onto another private company (while simultaneously stripping both company's Greek assets), just because the CCB/ECB does not want to recognize the reality that it has a loss on its hands due to its extension of ELA to the obviously wildly insolvent Laiki (which it extended in direct contradiction of its own regulations and policies).    Just in that one sentence, I can see three possible areas to attack this move.

Note: I understand that the Government of Cyprus backstops the Cyprus Central Bank and would become liable for these obligations.    Obviously the government will have to extend the maturities of these obligations and/or otherwise negotiate an approach.    But at least that is a negotiation between two parties that have some ability to negotiate, not an asset grab from powerless retail depositors.