Institutional Investor 2013-3-3 As he prepares to negotiate a bailout with top officials of the European Union and the International Monetary Fund, Nicos Anastasiades, Cyprus’s newly elected president, would seem to have a weak hand. The island-state’s small size — population 850,000 — gives it little clout, and its reputation as a shady tax haven for Russian oligarchs is anathema to German politicians, who will ultimately have to underwrite any deal.
Yet Anastasiades has some trump cards of his o n. EU officials are eager to avoid any fresh flare-up of the euro area’s debt crisis after Italy’s inconclusive parliamentary election triggered an abrupt bond market sell-off. And Cyprus is sitting on a massive natural gas field ripe for exploitation, which could bolster Europe’s energy security.
Those factors will be at play when Cyprus’s new finance minister, Michael Sarris, meet s with colleagues from other euro zone countries in Brussels on March 4 to resume negotiations on a bailout, estimated at about €17.5 billion ($22.8 billion). The money is needed to recapitalize the country’s banks, which suffered big losses on their holdings of Greek debt, and to help the government meet its debt obligations. Anastasiades says he wants to sign a deal before May, when the government is expected to run out of money.
“There must be no doubt about this: If Cyprus gets no external help, it will slide into default,” Jörg Asmussen, a board member of the European Central Bank, told the German newspaper Handelsblatt last month. Such a development “would have high financial and political costs,” he added.
The ECB, the European Commission and the International Monetary Fund make up the so-called troika that, since last June, has been negotiating the terms of an assistance package with Nicosia. Cyprus, which joined the EU in 2004 and the euro zone four years later, would be the fifth of the zone’s 17 countries to get a bailout, after Greece, Ireland, Portugal and Spain.
Nicosia has vowed to resist the kind of tax hikes and budget cutbacks that have sparked a backlash throughout much of southern Europe, most recently in Italy, where former prime minister Silvio Berlusconi and the Five Star Movement of comedian Beppe Grillo scored strongly by campaigning against austerity. Still, the country’s euro zone partners are likely to demand greater budget tightening in return for their support, as well as requiring holders of Cyprus’s sovereign debt to take write-downs, just as Greek bondholders did.
The most controversial part of the talks revolves around Cyprus’s outsized financial sector. EU and IMF officials are reportedly considering proposals to impose losses on uninsured depositors in Cyprus banks, something that they did not do in Ireland’s bailout.
“The biggest uncertainty” ahead of the upcoming talks, wrote Mujtaba Rahman, an analyst at political-risk consultancy Eurasia Group, “is the fate of uninsured depositors, given lingering IMF concerns about debt sustainability.”
Last month Anastasiades told the Financial Times that a haircut for large depositors would be “catastrophic” for Cyprus and could unleash the very contagion on the euro zone that the troika says it wants to avoid.
Cyprus’s banks grew at a feverish pace between 1995 and 2011. The banking sector’s assets currently total nearly eight times the country’s €18 billion gross domestic product, much bigger in relation to the economy than Irish banks, whose problems caused that country’s debt to soar.
The banks had an estimated €5 billion in Greek debt on their books, and they were obliged to write off roughly half of that exposure as part of Greece’s debt restructuring. In addition, the banks have some €22 billion in loan exposure to Greek companies and individuals. The state’s efforts to recapitalize the banks have driven up Cyprus’s public debt to 140 percent of GDP and prompted Standard & Poor’s and Moody’s Investors Service to lower Nicosia’s debt rating to junk status. Today, the Cypriot economy is propped up by Russian investors, who maintain cash deposits in local banks estimated at anywhere between €8 billion and €35 billion, according to a German intelligence report quoted by Der Spiegel magazine. The island’s reputation as a tax haven has attracted money from Russian oligarchs for years.
Among the most prominent and detailed allegations of money laundering in Cyprus were those leveled by the late Sergei Magnitsky, a Moscow-based lawyer for the London-based investment fund Hermitage Capital Management. He claimed that Russian officials laundered an estimated $30 million through Cypriot banks as part of a $230 million tax fraud. Not long after making his charges, Magnitsky was arrested and thrown in jail, where he died in 2009.
The Cypriot foreign minister, Erato Kozakou-Marcoullis, strenuously denies her country is a vortex for shadowy deals. Since Cyprus reached out to the troika, she says, its legislature has passed a raft of reform bills, including vigorous laws and enforcement mechanisms to deter money laundering. “Cyprus has one of the cleanest records as far as money laundering is concerned,” Marcoullis tells Institutional Investor, “not only relating to legislation but enforcement. We have done our homework.”
Yet a viable bailout agreement will most likely require Cyprus to commit to adopting additional anti-money-laundering regulations tough enough to appease hardliners in the Bundestag but not so severe as to offend Moscow, says Eurasia Group’s Rahman.
Germany, which has contributed amply to previous bailout agreements and thus wields considerable influence over their terms, is reluctant to stump up for another package, let alone one that might reward Russian tycoons. Moscow has already extended a €2.5 billion loan to Nicosia. Some EU members, including opposition lawmakers in Berlin, believe Moscow should assume a greater cost of a bailout by easing the terms on Cyprus’s debt.
Last month the Financial Times reported details of a closely held European Commission memo that called for a reduction by half of Cyprus’s bank assets over the next ten years. It recommended that large-scale, uninsured depositors in local banks as well as investors holding Cypriot sovereign bonds bear the brunt of the bailout, and called for an increase in the island’s corporate income tax to 12.5 percent from 10 percent. By forcing depositors and investors to absorb the shock of the rescue package, according to the plan, the EU could reduce its share of the bailout to a mere €5.5 billion. The Cypriot government opposes such measures. Higher taxes would undermine its appeal as a tax haven, it argues, while imposing losses on uninsured depositors might trigger a destabilizing flight of capital.
If a bailout package is agreed to and implemented faithfully, the IMF reckons Cyprus can reduce its debt to a sustainable 100 percent of GDP by 2020. Such an estimate does not, however, account for revenue Nicosia hopes to be generating from its gas field, known as Aphrodite, by 2019.
In a speech in The Hague, Jeroen Dijsselbloem, the Dutch minister who chairs the Eurogroup of euro zone finance ministers, suggested that the Cypriot government deposit the proceeds from future gas sales into an escrow account to be managed by the troika. That idea was quickly dismissed by Neoclis Sylikiotis, Cyprus’s commerce minister, who insisted that the very existence of the natural gas reserves made the country’s current debt burden sustainable and insisted that Nicosia would “take the lead role in managing its wealth.”
Just how much wealth Aphrodite might represent is, at this point at least, a matter of speculation. In December 2011, after drilling an exploratory well, Houston, Texas–based Noble Energy declared that Aphrodite could yield between 5 trillion and 8 trillion cubic feet of natural gas. A second borehole, which would firmly establish the size and quality of the gas, was to be drilled in December. When that deadline passed, Noble Energy announced it would drill in April. Last month the company said it would miss that target date as well, citing equipment problems. A new deadline has yet to be introduced and analysts are cautioning Nicosia against airy assurances that natural gas will deliver Cyprus from fiscal collapse with or without the troika’s help.
“We won’t know for sure how much gas is available until after the second hole has been drilled,” says Hugh Pope, director at the International Crisis Group. “Cyprus is in a dreadful economic state, a tailspin. The Cypriots need a new story and they’ve wrapped themselves in the gas story.”
Of course, a lot could happen before the end of the decade, when Nicosia presumes it will be a regional energy exporter. The American “shale gale” could fizzle and Cyprus, by leveraging its gas reserves with Israel’s, could quickly retire its debt obligations with energy income and emerge in the coming decade stronger than ever. As it is now, however, its geopolitical burden is one of many that obscures its outlook and weakens its hand as it digs in against the troika.