Harsh Cyprus bailout terms set unwelcome precedent

Even if Cyprus gets its bank crisis patched up, the week's developments prove that the euro zone still has serious problems.

One thing that everyone can agree on in Brussels is that Cyprus is a minnow in the European fish pond, accounting for less than 0.5 per cent of the euro zone economy. In the words of the German finance minister, Wolfgang Schäuble, the island is "not systemically important".

That judgement may return to haunt the minister. While he is right in economic terms, the Cyprus banking crisis is likely to cast a long shadow over the political future of Europe.

It has been clear for the past six months that Cyprus's banks were heading for insolvency. With the banking sector vastly overblown compared to the country's economy, the government could not bail out the banks, and had to go cap-in-hand to the euro zone for help. But for months there was no agreement between Nicosia and its partners - the European Commission in Brussels, the European Central Bank in Frankfurt, the International Monetary Fund in Washington and, most importantly, the German government in Berlin.

On Tuesday, the Cypriot parliament rejected the agreed bailout terms, to joyous outbursts in Nicosia: the plucky islanders had rejected the German diktat and had refused, unlike Greece's politicians, to become the poodles of Chancellor Angela Merkel.

Cypriot banks are closed until Tuesday, to prevent depositors laying siege to get their money out. That is one day after the European Central Bank's deadline for agreeing new terms for the bailout.

At issue is how much the people of Cyprus and the depositors in its banks will have to pay for being bailed out. Since 2010, it has been an article of faith in the euro zone that the taxpayer (mainly German) will not be offering any free lunches to countries with dodgy finances. For every bailout there must be, as the jargon has it, a local "bail-in". In this case, depositors in the banks were being asked to accept a one-time levy of up to 10 per cent to contribute to the banking rescue. This has been reduced to five per cent, only for deposits over €100,000.

In some ways, this makes sense. Why not pay a fee to get most of your money when the alternative is an IOU that may prove worthless, from a dead bank? The problem is that Cypriots feel they are being punished by an arrogant colonial power in northern Europe because they are small and had the temerity to try to turn their island into an offshore financial centre. No other country in the euro zone has had to suffer such harsh terms - a €5.8 billion contribution from a population of 800,000.

But here is the key issue: up to half of the deposits in Cypriot banks may be from Russians. With its low taxes, Cyprus has attracted billions of euros of Russian money, much of which is then legally recycled back into Russia.

Without doubt, much of this money was dirty in the 1990s and came to Cyprus to be washed clean. Since then, Cyprus has struggled to shake off a reputation for lax regulation, even though Russian money does not arrive in suitcases filled with used dollar bills, but by bank transfers.

For Mr Schäuble, who is 70 and a member of the Cold War generation, Cyprus has become a conduit into Europe of dirty money and unwanted financial influence. But the situation is not so clear: the Russian journalist Yulia Latynina argues that this is not a fight to keep out dirty money, but a fight over who gets to profit from it. Russian money is a lot cleaner now than it was in the 1990s, so other countries in Europe want to get their hands on it.

At this time of national crisis, the Cypriot finance minister flew to Moscow to seek help. If this is an attempt to blackmail the Europeans with the threat of Cyprus becoming Moscow's aircraft carrier in the eastern Mediterranean, it is unlikely to work.

The Russians are indeed angry that their high rollers - those with more than €100,000 in Cypriot banks - are going to have to pay a price for the bailout. But they are wary of putting many more billions into Cyprus - say by buying one of the failing banks - to rescue an offshore financial centre whose credibility is all but lost.

The euro zone limps on. Whatever the outcome of the Cyprus crisis, countries from Finland to Portugal are drawing their conclusions. The first is that Europe's progress from monetary union to political union is derailed. European elites have long recognised that a common currency, the euro, without some form of political union to coordinate economic policies, is unsustainable.

Yet the virtue of "solidarity" - that richer countries will help poorer ones, just as wealthier regions in any country support poorer regions - is increasingly an empty word.

Taxpayers in Europe's fiscally prudent countries, such as Germany, Finland, the Netherlands and upstart Slovakia, resent rescuing the southerners, who are portrayed as lazy and averse to paying taxes.

Meanwhile, there is no strong leadership at the European level, and all national leaders live in fear of their electorates. The clumsy handling of the Cypriot banking crisis cannot be separated from Mrs Merkel's campaign for re-election in September. She was hoping that German voters, fed on stories of southern idleness and Cypriot connivance with Russian oligarchs, would forget about the euro zone's difficulties for a few months. The insistence on a harsh element of "bail-in" by Cypriots and bank depositors may be good German politics, but it sets an unwelcome precedent.

For the southern countries, "Europe" is no longer a grand idea but a monstrous German machine. This never happened before, because Germany was hobbled by guilt for two generations after the Second World War. Now it is more confident and, benefiting from the euro zone which has given it a ready market for its exports, much richer.

So even if Cyp0rus's banking crisis is a minor squall, the handling of it has laid bare an unpleasant truth. The euro zone storm may have quietened down, but the way forward for Europe is even less clear now than before.

On Twitter: @aphilps