The EU included a new measure in the debt deal with Cyprus: a special tax on bank deposits. The EU argues that this necessary in order to stabilise the euro zone. However, this de facto confiscation of a part of the Cypriot bank deposits massively destabilises the whole Cypriote banking and payment system and might have a contagion effect on other peripheral countries. The question is why the EU demanded this measure and what would have been alternatives?

The Cyprus pre-crisis growth model was based on finance and tourism whereas manufacturing industries hardly exist. The country attracted foreign capital by low taxes and lax regulation. About 37% of all bank deposits originate from abroad, particularly from Russia and Greece. However, it was not only the inflow of external deposits that permitted Cypriot banks to expand rapidly. The access to external credit was very crucial as well. The Cypriot banks developed very close links with Greece. Therefore, Cyprus has been the country that has been most seriously affected by the Greek crisis. The Cypriote banks have been doubly hit by the Greek crisis. On the one hand, they have felt the negative effects of the deep Greek recession which has been massively aggravated by EU imposed policies. On the other hand, the uniform debt cut for the Greek state debt hit the Cypriote banks with their large holdings of Greek loans particularly hard.

Due to the high reliance on banking and the close economic relations with Greece, the economic situation deteriorated rapidly during the last year. Contrary to other governments in the euro zone periphery, the then left-leaning Cypriot government negotiated hard with the officials of the EU and the IMF and looked for alternative funding in Russia. The government of Dimitri Christofias was able to arrange a loan of 2.5 bn euro with Russia which was interested in the financial stabilisation of Cyprus. However, this did not prove to sufficient in the end. Though EU official say that they do not like the Cypriote economic model, they have not had any objections against the similar Irish economic model that is likewise based on low corporate taxes and lax financial regulation. However, the Irish financial investors have originated mainly from EU countries whereas, in Cyprus, there have been substantial capital inflows from Russia. In Syria which is in the direct neighbourhood of Cyprus EU and Russian policies clash. In view of the gas fields that have been detected in the sea around Cyprus, the EU does not seem to be too happy about the rather close Cypriot-Russian links, either.

In the Cypriote presidential elections in February 2013, the right wing candidate, Nicos Anastasiades, won due to the deteriorating economic situation. The electoral victory of Anastasiades cleared the way for a deal with the EU. Discoursively, EU official harped the melody of dubious Russian money in Cyprus. However, they were rather silent on the role of European banks and companies in the financial expansion of Cyprus. Immediately before the deal was struck, Luxemburg’s prime minister, Jean-Claude Juncker, ruled out a debt cut for Cyprus. A serious debt cut would be exactly the measure that could bring relieve to the island.

In addition to the standard austerity prescriptions of EU and IMF, the two organisations – on the special instigation of IMF chief Christine Lagarde and the German Minister of Finance Wolfgang Schäuble – forced a special tax on bank deposits on the Cypriote government. According to the original formula, that might still be changed, a tax of 6.75% is to be levied on deposits below 100,000 euros and a tax of 9.9% on deposits above 100,000 euros. This measure seems to have two aims. First of all, a contribution of foreign creditors is to be avoided. This aim is in line with the hitherto EU/IMF policies that have consistently favoured the external creditors and put the burden on the peripheral countries. Secondly, the measure seems to be tacitly aimed against the Cypriote-Russian business links. The Russian Minister of Finance, Alexander Siluanov, criticised that, though the Euro Group and Russia had agreed on a coordinated approach, the EU had decided on the special tax without consulting Moscow.

The Cypriote depositors were shocked by the measure. They tried to withdraw money from their account. However, the Cypriot central bank immediately froze the accounts. Given the distrust of the depositors, it is likely that a partial freeze of accounts will continue for some time. Thus, the Cypriote payment system will be disarticulated what will have fairly disastrous consequences for the whole economy. The trust in the financial system will be shaken for many years.

The Cypriot government faces serious difficulties to make the parliament pass the law on special tax on bank deposits. It tries to assuage the opposition to the measure by proposing to exempt small depositors from the tax while increasing the tax rate on huge deposits.

The lesson from Cyprus will certainly be understood in other peripheral euro zone countries. It will make depositors make think twice whether to leave the money in their accounts or not. Therefore, even some international bankers are preoccupied. The chief economist of Morgan Stanley, qualified the measure as precedent case that might have “systemic consequences”. A further destabilisation of the banking system in euro zone countries seems to be likely.

EU officials claim that there was no alternative to the measure. However, the government of Iceland has shown how an alternative could work. In 2008/2009, the government in Reykjavik nationalised the overextended banks of the country. It guaranteed the deposits, put the emphasis on the continuation of the domestic activities of the banks and made the (external) creditors share the enormous losses. This has created enormous tensions with the governments of Great Britain and the Netherlands where the banks from Iceland had been active, but these measures jointly with a devaluation of the currency of Iceland limited the social costs of the crisis and permitted a relatively early recovery. The government in Reykjavik was pushed into this relative progressive direction by strong social protests. And it enjoyed a larger degree of space for manoeuvre: The economic structure of Iceland is stronger than in Cyprus and the country is not member of the EU.