Calm Down Over Cyprus

by: George Liu

It's not every day that the small island-nation of Cyprus dominates international news. After all, the economy of Cyprus is smaller than that of Wichita, Kansas. Yet for the past few days, hysteria over the bailout of Cyprus by the Eurogroup and the IMF has rattled the financial world.

The decision to bail out Cyprus itself wasn't the controversial part: Ireland, Portugal, and Greece have all been bailed out by the troika. Instead, it was the conditions attached to the bailout that brought condemnation: to partially pay for the 10 billion euro bailout, Cyprus is required to impose a one-off tax of 6.75% on Cyprus bank deposits of less than 100,000 euros and 9.9% on deposits above that. This tax is expected to raise 5.8 billion euros of the bailout.

Critics of the requirement immediately lambasted the decision on Saturday, with good reason. Depositors' accounts have widely been considered sacred in the European Union, as they are in the U.S. (think of the FDIC's net for U.S. depositors). Now that the aura of EU deposit safety has been permanently broken, critics fear that the Cyprus bailout will set a precedent in the taxation of bank deposits for future eurozone bailouts. Others fear that the added uncertainty will cause a flood of deposit withdrawals across the EU. They fear the instability caused by the controversial bailout will lead to a contagion that not only causes bank runs in Cyprus, but will drag the eurozone deeper into its economic crisis. Other critics declare that it unfairly "punishes ordinary people." Financial markets plummeted as the general consensus among investors was that the Cyprus bailout, for lack of a better word, sucked.

Yet, the Cyprus bailout isn't all bad. To understand it, we have to put the tax into context. Cyprus has long been a safe haven for Russians doing business overseas due to its stronger legal protections and lower corporate taxes. This safe haven status has also led Cyprus to become a huge attraction for money-laundering operations, especially those originating in Russia. In January, an investigation by Finance Minister Wolfgang Schaeuble was launched into Cyprus' role as a destination for Russian money laundering. The scale of the money-laundering and Cyprus' tax-haven status is evident: Some 30% of Cyprus bank deposits originated overseas from non-euro area countries (Russia) and according to Morgan Stanley, the Cypriot banking system is 8x larger than the overall Cypriot economy. Cyprus is also the largest source of foreign direct investment into Russia, sending $13.6 billion into the country in 2011 alone.

The taxation on deposits attached to the bailout of Cyprus will significantly take money from the wealth of those who manipulate Cyprus' tax-haven status and do not actively contribute to the Cypriot economy. The fact that deposits of over 100,000 euros will be taxed at 9.9% shows that the deposit tax will be mainly targeting the wealthy. Hopefully, the deposit tax will also encourage spending and boost aggregate demand as people withdraw bank deposits.

Also, contrary to popular belief, the deposit tax will not drastically punish "ordinary people," unless rich foreign oligarchs are counted as "ordinary people." The 6.75% tax on deposits below 100,000 euros is expected to be lowered and the overall deposit tax will most likely become more progressive, lessening the burden on the poor. It is already expected that the deposit tax will be scrapped for those with less than 20,000 euros in their bank deposits. Moreover, the Eurogroup, taking heed of the social unrest caused by austerity measures across Europe, has already indicated it favors a more progressive option and declared that changes would be acceptable as long as the return of around 6 billion euros was maintained.

Chances are, the deposit tax will be significantly modified to limit its detrimental effects on lower-income Cypriots. This in turn will make it more politically feasible and ease the tax through the Cypriot parliament, which is of utmost importance. Right now, the Cypriot government has barely enough votes to pass the tax: Opposition parties have already said they would vote "no" and even one dissenter from the fragile coalition of DIKO and DISY parties will lead to a stalemate on the tax. Politically targeting the wealthy foreigners will give the coalition some political weight and also alleviate the growing outrage among lower- and middle-class Cypriots.

It is also very unlikely that the deposit tax in Cyprus will be replicated in other troubled eurozone countries such as Italy and Spain. For one, the situation is unique in Cyprus due to its small size, relatively humongous banking assets, and status as a haven for money-laundering and tax-evasion. This combined to create a perfect source of revenue, in the troika's eyes, to pay for a part of the bailout.

Critics of the deposit tax may ask, "why not tax the incomes of Cypriots instead?" Simple: because due to the nature of Cyprus' tax-haven system, wealthy foreigners with vast holdings inside Cyprus banks will be able to worm through the income tax while the income tax will shrink the paychecks of the middle- and lower-income Cypriots, many of whom live paycheck-to-paycheck.

Cyprus is in much more dire economic straits than its eurozone counterparts. The country is practically bankrupt and doesn't have the capacity to repay the bailout, leading to the addition of the deposit tax. Taxing depositors was the only common-sense approach left instead of bankruptcy: Cyprus has a small tax base, limiting its ability to raise funds through conventional taxation, and its banks' corporate bonds are limited in size. Spain and Italy don't have these problems. As noted by Christine Schmid, a Credit Suisse analyst, "There was no other way as there was no debt outstanding at Cyprus's banks that they could impair."

In a perfect world, the troika would come to understand that its aid-for-austerity approach is shooting itself in the foot. In fact, crippling austerity is partially why Cyprus is in such a position in the first place; austerity measures (not factoring in the deposit taxes) are projected to result in a 3.5% shrinkage of the economy in 2013. Yet despite this, the fears of contagion are overblown; given Cyprus' unique situation, it is somewhat understandable that the troika took such a route and unlikely that deposit taxes will be levied in the future on other troubled eurozone countries. Moreover, the deposit tax will most likely be structured in a way as to not significantly burden the average Cypriot, which is a welcome divergence from the pressures austerity has piled on the middle- and lower-income populations in Greece, Spain, and Italy (among others).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.