BACKGROUNDER

Russia and the Geopolitics of Cyprus Bailout

Rajorshi Roy is Research Analyst at the Manohar Parrikar Institute for Defence Studies and Analyses, New Delhi. Click here for detailed profile [+].
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  • June 14, 2013

    Introduction

    Cyprus is the latest episode in the European economic crisis which has seen bailouts of a country’s struggling economy become more of a norm rather than an exception. Although a deal has now been agreed upon, the crisis marks a watershed moment in the decision to force Cyprus to meet a part of the bailout by imposing a tax on bank savings of normal depositors. This fundamentally goes against an unwritten writ that such savings will always be safe. The fear of this same model being replicated across Eurozone has the potential to scare away investors, force people to hoard up their savings and in turn affect the availability of cash in the euro-zone. But more importantly, the crisis has ensued a renewed focus on the issue of Russian investments in Cyprus banks, Russia’s influence and interests in this tiny Mediterranean island which is part of the European Union (EU), Russia’s refusal to bailout a perceived ally and prevailing tensions between Russia and the EU. Discovery of huge hydrocarbon reserves in the region has added a new twist to the crisis. The ramifications may be felt for years to come.

    Economic Model of Cyprus

    Cyprus has for a long time been looked upon as an attractive investment destination and an offshore financial center. A favourable tax regime backed up by European laws, rules and regulations1 have made individuals and companies from across the globe keep deposits in Cyprus banks and register companies there. In fact, foreigners do not have to pay any tax on dividend income and capital gains in Cyprus. 2 Cypriot banks have relied more on deposits rather than issue debts as the model of their functioning. 3 This has manifested in the banking sector being close to eight times the country’s GDP. 4 With the banking sector being the overwhelming mainstay of the country’s economy, any change in status quo to this sector was bound to have a direct impact on the economy as a whole.

    The current crisis can be attributed to the Eurozone debt problem. The failure of Greek bonds, in which two of the biggest banks of Cyprus, Bank of Cyprus and Laiki Bank, had invested in heavily, contributed to their downfall. 5 As a result, total liabilities of banks across Cyprus were as much as five times the country’s GDP. 6 With the economy unable to make up for the shortfall, Cyprus was forced to seek a bailout to the tune of 17.5 billion Euros.

    Russia’s Interests in Cyprus

    From the outside, Cyprus with a population of less than a million7 and a GDP of US$ 25 billion8 looks highly unlikely to evince an interest from Russia. But its attractive economic model comprising of a favourable tax structure governed by sacrosanct European laws, discovery of new hydrocarbon reserves9 and potential in offering a port in the Mediterranean with easy access to the Middle East, had made it a very attractive destination for Russia.

    Russia’s dependence on Cyprus as an investment zone can be traced back to the uncertain period after the break up of the Soviet Union, when its economy was in doldrums and rules and regulations existed only in paper. The need for financial security forced many Russians to open offshore accounts. 10 This coupled with existence of a double taxation treaty and lower tax rates provided incentives for Russians to open accounts in Cyprus banks. 11 However and more importantly, Cyprus is a reflection of a few shortcomings within Russia’s economic system; namely a lack of investor trust and confidence in its banking system, absence of independent judiciary, widespread corruption, unfavourable business climate and inadequate investor protection agreements.

    Russian businesses and citizens have had a significant share in Cyprus’s banking system. Russia’s second largest bank VTB operates a branch (Russian Commercial Bank) in Nicosia and had deposits worth 2 billion euros. 12 The branch is also the third largest bank in Cyprus in terms of assets worth 14 billion Euros. 13

    But the massive influx of Russian money has brought with it criticism that Cyprus is a haven and used as a conduit for money laundering. 14 While there is no denying the fact that a portion of these deposits do comprise of money from dubious sources, a major part of it comes from genuine Russian investors who have sought protection under European laws in order to safeguard their investments.

    Their modus operandi: Russian investors deposit money in shell companies in Cyprus which is then either invested abroad in foreign companies or back into Russian companies in Russia. 15 There are close to fifty thousand Russian speakers of the erstwhile Soviet Union living in Cyprus. 16

    The importance of Cypriot economy for Russia also lies in the fact that Cyprus accounts for the highest foreign direct investment (FDI) into Russia. In 2012, Russia received foreign investments worth US$ 76.7 billion from Cyprus or roughly 21 per cent of its total FDI. 17

    Why Didn’t Russia Bail Out Cyprus

    The Troika of European Commission, European Central Bank and International Monetary Fund, responsible for the Cyprus bailout, were apprehensive of lending the full amount of 17.5 billion Euros to Cyprus. Past experience with Greece had shown that too much cash injection can prove to be disastrous in the long run. Therefore, the Troika wanted Cyprus to meet a part of the bailout by taxing the bank deposits of citizens and investors alike. This unpopular and harsh pre-condition made Cyprus turn to its only plausible ally in Moscow.

    Foreign Minister Michalis Sarris’s emergency visit to Kremlin involved seeking favourable loans and an extension of upto five years the loan of 2.5 billion Euros taken in 2011. 18 In return, Russia could have a possible stake in Cyprus’s significant offshore hydrocarbon deposits and an all weather port in the Mediterranean. The importance of the port lies in its access to the Middle East, especially at a time when uncertainty prevails over Russia’s naval base in Tartus. On the other hand, a European bailout would have sounded the death knell of Cyprus as a hub of Russian investment since it would have involved the seizure of big investors money as part of bringing changes to the capital structure of banks. With big Russian businesses comprising of majority depositors in Cyprus banks, it was Russia which would have faced the biggest brunt of a European bailout.

    Russia had the advantage of a balanced budget and big financial reserves to help out the Cyprus regime. Surely, considering the cost-benefit analysis, the 17.5 billion Cyprus bailout was much more affordable than the staggering amount being spent on the Sochi Olympics19 scheduled for 2014 or the APEC summit held in Vladivostok in 2012. 20

    Therefore, it came as a great surprise that despite showing an initial willingness, Russia did not support the Cypriot government. This forced Cyprus to seek a European bailout.

    Russia’s ambivalent position raises questions on why did it forego such an opportunity, which from the outside looks like a win-win situation for both entities. However, a deeper analysis shows an interplay of several factors:

    First, the estimate of hydrocarbon reserves in the region is still a work in progress. This along with the geographical dispute between Turkey and Greek Cyprus, Israel’s own hydrocarbon claims and Russia’s strong economic ties with Turkey imply that any Russian hydrocarbon acquisition would have been a complicated proposition.

    Second, the reputation of Cyprus as a global financial center had been decimated and it would be impossible to restore investor confidence in the foreseeable future. Cyprus is facing the prospect of a prolonged recession with both inward and outward investments expected to dry up. Therefore, long term benefits of bailing out the banks appeared to be limited.

    Third, Russia’s current position appears to enforce prudence in its own financial spending. President Putin’s re-election manifesto, 21 with a focus on social spending, has put a great strain on the economy. Russia’s economy continues to be hugely dependent on the hydrocarbon sector and the recent fall in global oil prices has not helped matters much. Capital flight continues to be worryingly high. In 2012 alone, Russia faced a net capital outflow of US$ 65 billion. 22 With the country poised to host the 2014 Winter Olympics in Sochi and the Soccer World Cup in 2018, a Russian bailout of Cyprus would have involved some difficult budget adjustments.

    Fourth, at a time when Russia has been besieged by domestic protests demanding an end to corruption in the country, it would have been a political challenge for President Putin to convince voters on bailing out the Cyprus banking system. The West has time and again highlighted Cyprus as a safe haven for illicit Russian money.

    Fifth, Russia’s ambivalence could also have been driven by Putin’s desire to focus more on creating a common economic pace in the form of a Eurasian Economic Union, rather than bailing out an EU country.

    Russia-EU Relations

    EU’s decision to impose a levy on bank deposits in Cyprus, which would have a direct bearing on genuine businesses of Russia, has highlighted the prevailing tensions between Russia and the European Union. The fact that Russian businesses and citizens, despite having assets worth 31 billion Euros in Cyprus, 23 were not even consulted on any rescue measure ruffled many feathers in Kremlin. The crisis thus reflects a lack of trust in Russian businesses. The Third Energy Package24 , aimed at curbing Gazprom’s monopolistic practices, shows how deep the fault lines are.

    This is in sharp contrast to the rapprochement between the two entities after the Georgian military crisis; with President Medvedev’s modernisation alliances with the West, Russia’s accession to World Trade Organisation (WTO) and normalisation of ties with Poland, Norway and Latvia topping the agenda. 25 Close to 40 per cent of Russian government’s gold and currency reserves are in Euros and some of these invested in government securities of European states. 26

    The crisis also indicates a stress in Russia-Germany ties. While Germany remains Russia’s second biggest trading partner after China27 and its only major ally in Europe, recent events do indicate a cooling off in their bilateral ties. There has been an emergence of widespread criticism in Germany about human rights violations in Russia28 and the government’s reluctance to raise this issue with Moscow. Chancellor Merkel’s tough stand on tackling Russian oligarch’s money in Cyprus probably stems from this discontentment and the impending domestic elections scheduled for September. It would have been extremely difficult to convince German voters of the need for a tax-payers funded bailout in Cyprus which would have ended up helping Russian oligarchs.

    Paradoxically, without this justification, it was next to impossible for the EU to impose taxes on bank deposits in Cyprus or for that matter any other European country. In a sign of apparent retaliation, immediately after the German led Cyprus bailout agreement was signed, there was a crackdown by tax officials on German non governmental organisations (NGOs) operating in Russia. 29 The NGOs which were raided included the Konrad Adenauer Foundation in St Petersburg and Friedrich Ebert Foundation in Moscow, leading to an outrage in Germany.

    EU’s unusually tough stand on Russian economic interests can possibly stem from the discovery of mammoth proven gas reserves in the Levant basin30 , where production has already started from March 2013. If conditions remain favourable, the discovery can help cut down EU’s overriding dependence on Russian hydrocarbons.

    However, the Cyprus bailout does raise questions as to whether the crisis was all about Russia. By levying taxes on bank deposits, would the EU be willing to risk its credibility and position as a pre-eminent global financial leader so that it can tackle Russian black money? There are not just Russian but European citizens and companies who have accounts in Cyprus banks. They all would have been affected by the bailout conditions.

    Perhaps, it is a message to the EU peripheral countries to observe financial prudence or else face the prospect of massive recession or even exit from the Eurozone. Cyprus can always be referred to as a one off case, especially due to its economy not being big enough to affect the rest of Europe. The ‘dirty money from Russia’ factor was the justification which EU needed to impose the levies.

    The EU move can also be seen as an attempt to restore the faith of the Union’s taxpayers in these bailouts by trying to remove the perception of them being bottomless pits with states now making an effort to fund a part of their own bailouts.

    The crisis also reflects the emergence of Germany as a leading player in EU issues and a possible strengthening of the European core. But for Russia, which has long looked upon the EU as an attractive model for itself, the crisis may strengthen the hand of those who have favoured the country’s drive towards Asia and the Eurasian Economic Project.

    Will Russia benefit from the current crisis?

    The Cyprus crisis may have a silver lining for Russia. The need for an effective banking and financial system, rule of law, independence of judiciary, tackling corruption, adherence to investment protection agreements and implementing efficient business practises has been glaringly highlighted. Russia stands at 112th position out of 185 countries in the World Bank’s ‘Doing Business Global Index’. 31 Capital flight continues to go on at an alarming rate. Therefore, tackling these issues has become a priority.

    Two Decrees have been issued which will force government officials to report their income and expenses and declare foreign assets. 32 President Putin has called for a ‘deoffshorization’ policy which should help in bringing back the capital based abroad. 33 Therefore, the crisis could just be the incentive which Russia needed to push through domestic reforms.

    Moreover, the crisis may in the long run facilitate Russia strengthening its ties with Cyprus. Cyprus will now have to follow a different model of economic growth and the discovery of hydrocarbons in the disputed territory holds great promise. But in order to tap into this potential, Cyprus will need advanced technology and political support and this is where Russia may come into the picture. 34 President Putin has already instructed his government to restructure the 2.5 billion euro loan issued to Cyprus in 2011.35

    Conclusion

    The Cyprus crisis has highlighted the existing geopolitical fissures between Russia and the European Union and raised the proverbial ‘east vs. west’ conundrum. For Russia, which has long considered itself more ‘European’ than ‘Asian’, despite a majority of its geographical territory being in continental Asia, this could prove to be a momentous event which sees it focus more towards the East. President’s Putin’s Eurasian Economic Union project and Russia’s growing engagement with countries of Asia indicate the turning of wheels.

    While there has been a significant amount of discussion about the sources of Russian money, often in derogatory terms, the present crisis is expected to jumpstart the much needed economic reforms in Russia.

    From a European perspective, the rise of Germany in taking the lead in economic matters assumes great significance. It remains the only economic powerhouse of the Eurozone and is one of the few countries to have experienced some growth in the last few years. The strong message sent out to the peripheral economies to follow austerity measures and undertake effective restructuring of their economies does indicate a tough posturing when it comes to bailouts. How these economies react to such diktats and the response from the ‘core’ will determine the future of the Euro-zone.

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