IMF's radical proposals to reduce the size of Nicosia's funding needs could spark panic in other countries struggling to maintain public confidence in their banks
Eurozone finance ministers are expected to delay a bailout for the Mediterranean island state of Cyprus tomorrow as its prospective lenders continued to wrangle over terms that some fear could spark panic in other vulnerable member states.
Irate bondholders took to the streets of Nicosia last week after Cyprus's finance minister, Vassos Shiarly, warned that local people who had invested in bank debt face losses as part of the proposed deal. Shiarly said in The Hague on Thursday: "Provisions have been made [for a writedown] – unfortunately, for junior bondholders, a very unhappy situation."
This represented a victory for the International Monetary Fund – one of the "troika" of likely rescuers along with the European commission and the European Central Bank – which is known to fear that Cyprus could need so much funding that its debts would become unsustainable if bank investors were not forced to take losses.
The Greek-Cypriot controlled south of the divided island got into trouble because of its ties with Greece. Its banks lost more than €4bn (£3.4bn) when Cyprus's president, Demetris Christofias, agreed to a "haircut" of Greek sovereign bondholders without seeking exemption for his island.
Shiarly told the Observer the move added 25% to Cyprus's debts overnight. No other member state had taken on more than an extra 1%. "We're accepting these losses. We're not asking for a gift from our partners. We're asking for this understanding of our excessive solidarity in 2011."
The Cyprus government needs cash for its public finances. But the banks need more – up to €10.3bn, according to leaks from a provisional assessment by US investment firm Pimco, commissioned by the troika and Greek-Cypriot officials.
Fiona Mullen of Nicosia-based consultancy Sapienta Economics estimates that, by 2016, that would inflate Cyprus's debts to more than 140% of its annual GDP. The eurozone has ruled out further Greek-style writedowns for holders of eurozone government bonds on the grounds that they weaken the banks of other member states. In any case, they would drain capital from the very Cypriot banks that so desperately need recapitalising.
To reduce the size of the bailout, therefore, the IMF has argued behind the scenes for haircuts not just for holders of bank debt, but for savers too – a prospect that appals EU and ECB officials, who fear it could frighten account-holders in parts of the eurozone where confidence in the banking system is still low.
This is where first the Russians, then the Germans, enter an already crowded picture. According to Mullen, Russian deposits in the Greek-Cypriot banking system account for between €8bn and €15bn of the €70bn total.
The central bank reckons the figure is lower, but no one denies that Russians have a big stake, and not everyone would be sorry to see those funds raided, perhaps by enforcing the haircut only on deposits of more than €100,000, which are not covered by a deposit guarantee scheme.
A report by the German foreign intelligence service, leaked to the press last year, concluded that much of the Russian cash in Cyprus was put there by tax dodgers and money launderers. This was a gift for Germany's opposition parties, seeking a way to distance themselves from Chancellor Angela Merkel's eurozone policies. Social Democrat leader Sigmar Gabriel said last month he could not imagine German taxpayers bailing out Cypriot banks, whose business model depends on abetting tax fraud.
Cypriot officials admit they have used low taxes to attract business, but argue that Cyprus's array of more than 40 double taxation treaties (DTTs) means it is no tax haven. "A tax haven is, by definition, a country that refuses to sign DTTs," said one.
Mullen says: "If Russians invest, even in Russia, they will often structure it through Cyprus. But the assumption that everything that comes out of Russia is dirty I find almost racist."
Several ways of reducing the size of Cyprus's bailout are being explored. Merkel favours privatisations, which could raise €2bn. Greece was forced to put public assets, from airports to casinos, up for sale to help reduce the size of the rescue package it needed.
Christofias has flatly rejected the idea of privatisations, but he is not standing in the general election on 17 February. His likely successor is centre-right candidate Nicos Anastasiades, who backs asset sales.
Russia could help out in at least two ways. One is by joining the other lenders in the bailout. It would not be the first time a country outside the eurozone had taken part in a rescue: Britain chipped in around £7bn for the £77bn bailout of Ireland in 2010.
But on 18 January, Russia's first deputy prime minister, Igor Shuvalov, said niet: "We need to be very frugal at the moment, very conservative. I don't want to provide any money for Cyprus."
Russia is more likely to agree to spread the repayment of €2.5bn it lent to Cyprus two years ago. "We are hopeful," said Shiarly after talks with Moscow. "It sounded as if they were seriously considering it."
Making the bailout repayable over a long period would make sense: huge gas deposits found off Cyprus should bring in revenue equal to twice the annual output of the Greek-Cypriot economy. Shiarly said discussions with the troika had not taken into account the gas reserves, but that, given time, Cyprus could repay a bailout.
"And the smell of gas makes us feel even more confident," he said.
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