Cyprus rescue – a lesson for Malta

Cyprus, the fair isle of Aphrodite and the abode of just 800,000 people was up to a few years ago hailed as a minor economic miracle. The International Monetary Fund described the country's performance before 2008 as a "long period of high growth, low unemployment, and sound public finances". As can be expected, Cyprus - like Malta - suffered a recession in 2009, but it was the mildest in the eurozone.

Up until last year, its principal industry of tourism was doing well, and this included many Brits who make Cyprus their second home for a few weeks in summer. Some even bought seaside properties while the banking sector flourished and grew with a horde of Russian investors who were very welcome. So while other members in the Med - including Greece - were suffering from a nasty cold, the smart citizens of Cyprus continued to enjoy pina colada drinks on the sandy beaches. But the bubble burst, and it may be pertinent to explain why things went so wrong... who stopped the party?

During the past decade Cyprus struggled to avoid the notion of a place with easy access for money-laundering. Among the booming numbers of foreign visitors were thousands of Russians, attracted by steady political connections with Moscow that went back decades - namely, a shared Orthodox faith, and a banking sector that not only didn't ask too many questions, but commonly pays interest rates of 6% and upwards. The cherry was on the cake, and the Russians like picking it, as it combined easy access to friendly banks coupled with a beautiful Monte Carlo setting.

The five star hotels in the seaside city of Limassol can easily be mistaken as a Mecca for rich Moscovites driving the latest Porsches and sipping pink champagne gently poured over ample servings of Beluga caviar. Top restaurants offer menus in Russian and the popular daily Russian newspapers are freely available - it is home from home for the rich and wealthy. It may not be fair to continue to pick on Cyprus, as it did a good job to clean the stables and reform its rules when it decided to join EU in 2008.

Indeed, many rules on money laundering and tighter controls by Central Bank over financial institutions were set in place. Not unlike Monaco, then, Cyprus has become something of a jet-set place attracting high net worth individuals who carved out a place in an island blessed with its beautiful azure sea.

Moving on, we read that an estimated €20 billion of the €70 billion on deposit in Cyprus belongs to Russians. Those deposits helped the banking sector grow beyond all reason, just like in the case of Malta, the remote gaming industry flourished in just a decade to become the largest European hub. Not unlike Malta, its financial sector is disproportionately high, as was observed recently by one of the international rating agencies. For Cyprus, the assets of banks were equivalent to 835% of annual national income out of which a large dosage was composed of loans made to its cousins in Greece. These formed part of the kernel of an industry worth 160% of Cypriot GDP.

The ethnic bond with Greek fraternity was part of the reason for such a cosy relationship and it is now obvious where the contagion originated which has sunken the island into economic instability.  Nobody saw it coming, but when the value of debts owned by the Greek State was slashed to one fourth of its original value, the effect was nothing but disastrous. The cocktail of negative events coupled with a slow economic growth due to international recession was proved fatal. No antidote was prescribed, even though for a short while the influx of Russian money has sugared the pill and provided an artificial remedy. The government's response made things worse. Former president Demetris Christofias, the Soviet-trained leader of the nominally Communist AKEL party, was unwilling to introduce austerity measures. On the contrary, acting in complete denial he declared that he could not see the point of government aiming to balance its budget so it happily continued to follow the 'Money, No Problem' style - let the devil take the hindmost and Aphrodite's child will continue to spend lavishly on welfare benefits and pensions. Acting in a profligate manner was the preferred antidote to fight austerity program which had stricken the Greek populace. But the chicks came home to roost and as has happened in Spain and Portugal the first tell tale signs were the sharp drop in property prices with a corresponding halt in the indigenous construction sector. The shortfall reached €17 billion but to borrow this amount would have pushed the debt to GDP ratio to 190%, so as a compromise Germany and Finland said that Cyprus had to find more money to reduce the bailout , from €17 billion to €10 billion. This culminated in the ubiquitous idea to impose a levy on all residents - a cruel way to bridge the gap.

So is the honeymoon with the Aphrodite lovers over? Yes, as one observes that last January, according to the media, nervous savers withdrew some €1.7 billion from Cypriot banks amid fears that some kind of levy on deposits was coming. Now a few weeks later nobody did believe their eyes when they see the mad rush by depositors who frantically started drawing precious cash from various ATMs. The banks in Cyprus had a run on their ATMs and all closed their counters until the situation cools down.

The day of reckoning arrived when a €10 billion rescue package  was announced last Monday with euro area partners and the International Monetary Fund and this included a one-off levy on deposit, an unprecedented step in the eurozone crisis. Such a one-time levy is expected to raise €5.8 billion and will hit all residents (including foreigners with bank accounts). Those with less than €100,000 in their accounts will have to pay a one-time tax of 6.75%, those owning beyond the threshold will lose 9.9%. In a sweetener, the authorities said that depositors can access all their money except the reserved sum to be paid on account of the levy. The announcement broke with previous practice that depositors' savings were sacrosanct and sent a shock wave across the eurozone, causing the euro to tumble and markets to dive.

Parliament is meeting in an emergency session to vote on an alternative plan to soften the blow particularly to smaller savers, by increasing the tax in case of the richer depositors having balances higher than €100,000. The government has postponed a vote on the topic while overseas commentators have voiced their concern saying this amounts to legalised robbery. Still, parliament will discuss the compromise to  try to mitigate the burden on small savers with a smaller rate say by changing the rate from 6.75% to 3.5% and increasing the top rate from  9.9% to 12.5%. The important thing is that the financial contribution reaches of € 5.8bn and the corporate tax rate goes up from 10% to 12.5% (matching exactly that of Ireland).

The government defended it stance saying the island has no choice but to accept the bailout with the levy on deposits, or else go bankrupt.

As can be expected the fat deposits are invariably held by Russians, who will bear a heavy burden. To give an example one of the island's biggest infrastructure project is €300m marina under construction near Limassol city centre which is purposely designed to attract well-off  buyers with its two most expensive properties, priced at €16m and €14m, respectively sold off-plan to buyers from Moscow.

Undoubtedly, the EU and IMF rescue scheme has elicited an angry reaction from President Vladimir Putin who criticised the levy as unfair and setting a dangerous precedent. "While assessing the proposed additional levy on bank accounts in Cyprus, Putin said that such a decision, should it be made, would be unfair, unprofessional and dangerous," Kremlin spokesman Dmitry Peskov told reporters. Critics say this was a harsh punishment on a small country that accounts for just 0.2% of European output. The worst fear is that savers in other, larger European countries (eg. Italy and France) become nervous and start withdrawing funds. It is pertinent to quote a US economist Paul Krugman who wrote in The New York Times: "It's as if the Europeans are holding up a neon sign, written in Greek and Italian, saying 'Time to stage a run on your banks!'"

To conclude one may ask - does the story have a message for Malta's own financial services industry? The answer is certainly in the affirmative... we have to be very careful to tread cautiously as the sheer attractiveness of our own tax regime and our banking stability may in the short term succumb to temptation to harbour slush funds that may be eager to seek a safe harbour.

Certainly, as we are not immune to the economic sickness that has cursed the beautiful island of Aphrodite so all service providers and financial institutions on the fair isle of Calypso need to beware of strangers bearing heavy leather bags.

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The writer is a partner in PKF an audit and business advisory firm