Cyprus and Russia Did Not Just Break Up

On March 19, Michalis Sarris, Cyprus’ finance minister, flew to Moscow for emergency talks aimed at saving the island’s outsized banking sector from collapse. In exchange for a loan extension and new financial aid, the story goes, Sarris offered Russia trade preferences in the energy sector, gas exploration rights, and controlling shares in Cypriot banks. Two days later, he left Moscow empty-handed. Up against a wall, on March 25, Cyprus and the EU agreed on a bailout package that will help pay the country’s bills but will also deduct billions of euros from the savings accounts of wealthy Russians and leave billions more of Russian assets frozen in Cypriot banks. 

To many Western observers, Moscow’s unwillingness to take Sarris’ initial offer appears to be a huge strategic blunder. It seems inexplicable that Cyprus’ most heavily invested economic partner -- and the largest source of foreign deposits in the island’s banks -- would refuse a deal on such apparently favorable terms. All the more confusing is Moscow’s apparent decision to forego a chance to solidify its strategic foothold, given Russia’s geopolitical ambitions in the eastern Mediterranean. 

There are three likely explanations for Russia’s behavior. First, it is not clear that there was ever a credible deal on the table. Second, Russia did not believe that a last-minute agreement could change Cyprus’ fate. And third, Russian losses from the collapse of the Cypriot banking sector will not be catastrophic. Put simply, Moscow’s decision to turn down a deal with Nicosia was in Russia’s long-term interests.

Cyprus’ current troubles were triggered by the eurozone debt crisis. The island’s banks accumulated a host of toxic assets from their Greek branches and lost much of their capital during the restructuring of Greek debt. As a result, total bank liabilities are five times larger than the nation’s GDP -- a ratio almost four times the EU average. Without an independent monetary policy or the financial means to pay down the deficit and save the banks, Nicosia requested a 17.5 billion euro bailout from Brussels earlier this month. 

Wary of rescuing the island’s unsustainably large banking sector, the troika of eurozone bailout creditors -- the European Commission, the International Monetary Fund, and the European Central Bank -- insisted that Cyprus raise 5.8 billion euros before it could qualify for their proposed 10 billion euro bailout. On March 16, Cypriot officials unveiled a controversial plan to raise these funds through a one-time tax (or “haircut”) of 6.75 to 10 percent on all savings accounts. After a wave of popular protests and the Cypriot parliament’s rejection of the plan, the ECB threatened to cut off all emergency financial support by March 25. Desperate, Cypriot officials turned to Moscow for help.

It remains unclear what Cyprus asked for and offered Russia. Sources close to the talks told Russian press that Sarris came to Moscow unprepared, with neither firm numbers on the size of a potential aid package nor any concrete proposals that could serve as a baseline for negotiations. The rushed talks didn’t help either: any potential deal between Cyprus and Russia would have required weeks of negotiations, rather than the few days that remained before the ECB’s ultimatum expired. In addition, the eurozone troika sent clear signals that it did not want Russia to be the savior of an EU member state, and German Chancellor Angela Merkel explicitly warned Cyprus against securing a side deal. As a result, even if a bilateral agreement could be made, Moscow had reasons to doubt Nicosia’s ability to honor it. Given these challenges, a bargain would have been exceedingly difficult to strike.

Based on press reports, it seems the proposed deal offered little benefit to Russia. Nicosia requested a five-year extension of a 2011 Russian loan of 2.5 billion euros and an additional 5 billion euros of support, in the form of a private investment fund in gas and banking assets. But Russia’s two largest lenders -- Sberbank and VTB Group -- had little interest in acquiring banks that will likely be restructured as part of a eurozone bailout deal. The Russian gas and oil giants Gazprom and Rosneft, meanwhile, were reluctant to negotiate investment in offshore tenders under such a compressed time frame, before seismic survey work could be completed. An offer of trade preferences for Russian companies in Cyprus’ energy sector was not enough to sweeten the deal.

There is an emerging consensus within Russia that Cyprus’ days as an offshore tax haven are over and that change has been on the horizon for some time. Early warning signs appeared in 2010, when Nicosia requested its first 2.5 billion euro loan from Moscow. The total assets of Cyprus’ domestic credit institutions have been declining ever since, dropping from a peak of 100 billion euros in 2010 to 83 billion in 2012 -- a difference equivalent to Cyprus’ total GDP. Russians are also aware that the coming EU bailout of Cyprus will fundamentally alter the status quo. The EU has clearly signaled its intent to shrink Cyprus’ oversized banking sector and to end the island’s status as an offshore financial center for rich Russians.

Facing a stark choice between losing a lucrative tax haven and throwing more money into a bottomless pit, Russia picked the strategy that it hopes will minimize its potential losses. Russian assets in Cypriot banks total approximately ten billion euros and the most recent projections of Russian losses are four to six billion euros. That is troublesome, but minor compared to the other problems Russia is facing right now: the flight of capital cost the economy 44.5 billion euros in 2012 and 63 billion in 2011.

To be sure, Cyprus is part of the financial infrastructure routinely used by Russian companies and the bailout will change how they do business. Yet many see this adjustment as inevitable and overdue. The current reliance on Cyprus originated in the early 1990s, when Russia’s financial system was in disarray, payment in foreign currency was nearly impossible, and the ruble was inflated. Seeking financial security, many Russians opened offshore accounts. The country’s financial system has since stabilized, but the use of offshore accounts has stubbornly persisted.

In December 2012, President Vladimir Putin declared “deoffshorization” as a central policy priority. In keeping with this objective, Prime Minister Dmitry Medvedev has proposed “domestic offshore” zones in the far eastern regions of Russia. This is not a new idea: Russia already has over 20 special economic zones, which offer tax benefits on investment and business income. So far, however, most of these zones have had trouble attracting investment. Low taxes do not compensate for Russia’s lack of adequate property rights protections, independent judicial branch, or stable business climate -- the core reasons why so many Russians open offshore accounts in the first place.

But the EU’s growing opposition to Russian investment has created a new opportunity to lure capital back into Russia. The president of the Euro Group, Jeroen Dijsselbloem, has suggested that the Cyprus experience may serve as a model for future EU-led Eastern European bailouts. ECB officials have also reportedly warned Latvian banks not to accept outflows of Russian capital from Cyprus. Thus, Russian investors are finding it increasingly difficult and risky to park their money in the West.

Still, all this does not mean that Russia’s days in Cyprus are over. The dismantling of Cyprus’ banking sector and the subsequent decline in foreign investment and tourism are bound to push the country into a deep and protracted recession. Newly discovered gas bounties offer a possible path to recovery. But maritime borders and exploration rights remain a major point of contention. As Cyprus braces for hard times, its growing demand for external political support and technical expertise will compel it to rebuild ties with its former patron, whose wealthiest citizens may now become the “big, angry shareholders” in Cyprus’ future. Sweetheart deals on energy and even naval basing rights are possible. In the end, Russia’s exodus from the island of Aphrodite may prove brief.