Cyprus: The Game has Changed

After the rejection of the rescue plan by the Parliament, the game has changed and Cyprus will have to choose its preferred development.

Until now, the situation can be perceived as fuzzy. Cyprus is under the shelter of the Euro Area and at the same time has an important role in recycling Russian capital flows. The question which is asked now is to know if these two options are compatible.

Reminder: The rejection of the rescue plan has its source in part that has to be financed by Cyprus itself. The amount of the plan is € 17bn. The EU and the IMF will finance 10bn, privatization and taxes on corporation will add 1.4bn. The remaining 5.8bn have to be found in Cyprus. This amount cannot be found in debt restructuring as a large part of the public debt is hold by banks which are at the heart of the Cyprus problem. The solution was found in deposit taxation. There were two tax rates depending on the deposit amount. The main question was on deposit below € 100 000. They were supposed to be taxed at 6.75 % but this was not compatible with deposit insurance scheme. This is this part of the project even after negotiation on the tax rate level that has been rejected by the Parliament.

New options have to be found.

Felix Salmon (http://reut.rs/16Jkj86 ) following a proposal from Buchleit and Gulati (http://bit.ly/YG6gZG ) made a very simple but interesting suggestion. Taxing deposit now without counterparties is unfair. So the solution could be the following: current taxation is considered as buying an asset with duration of 5 to 10 years and with real collateral. As gas industry is developing rapidly, the collateral could be based on gas development. For the deposit holder it’s an intertemporel trade off and it is not only taxation as mentioned in the initial rescue plan. This scheme may be specified for deposits above € 100 000. In that case the deposit insurance scheme for deposit under € 100 000 is still available.

This solution makes the hypothesis that deposit holders will accept to freeze their deposit for 5 or 10 years. This can be long and complicated for Cyprus. As a majority of large deposits is held by foreigners, the scheme is very simple: they will not be able to avoid the tax now but they will not come back to Cyprus later.

The CEPII (http://bit.ly/1002fkY ) and Paul Krugman (http://nyti.ms/160nR4x ) have looked carefully at this issue. Cyprus is an off-shore banking center for Russia. Flows are coming in and then are the sources of investments mainly in Russia (Cyprus is the second investors in Russia in terms of Foreign Direct Investment). In the CEPII article money laundering is not excluded by this mechanism. These operations are very profitable for Cyprus. For Russian investors, incentives to be in Cyprus reflect the fact that these amounts can be very volatile. With the above solution they could be frozen for 5 or 10 years. There are no more incentives then. Other off shore places could then substitute to Cyprus.

The two options are not compatible. Taxation on large deposits would lead to stop the off-shore business. But keeping this off-shore sector alive would renew the question of the financing of the rescue plan and in fine may be the place of Cyprus in the Euro Area.

For Cyprus the choice will be hard to do but they will have to choose. For the Euro Area the target must be to keep the 17 countries together but in that case European authorities have to found incentives that will convince countries to stay in.

The game has changed