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Cypriot Bailout Reverberates Beyond the EU

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During the weekend, the European Union, the International Monetary Fund and the government of Cyprus discussed a bailout for the banking sector of the islands. If approved in the current form, this would be the first European bailout where depositors carry some of the burden, since the agreement includes a special tax on bank deposits in Cyprus. This tax generated controversy in Europe and Russia, and the details are still being discussed.

Cyprus was forced to request a bailout to the European Union and the International Monetary Fund in late 2012, due to its exposure to Greek debt. The Cypriot bailout was controversial from the start. 

For one, the previous Cypriot government refused to implement economic reforms, including the privatization of state-owned companies. Most important, several European governments questioned that the bailout would be used to protect the obscure Cypriot financial sector and mainly Russian depositors. It is believed that Russian deposits account for between one-third and -half of all Cypriot deposits. This was a particular source of concern for Germany, a country where bailouts for other eurozone countries are often unpopular. 

The negotiations were recently unlocked by two events. First, the previous Cypriot government was replaced by Nicos Anastasiades in the February elections. The new president promised that the first step of his government would to close the bailout agreement. Second, Cyprus accepted the creation of a special tax to be imposed on bank deposits to raise part of the money needed for the bailout.

This decision shows the number of domestic and international interest surrounding the Cypriot bailout. The special tax on deposits allows the Cypriot bailout to be more tolerable for German voters. Germany will hold general elections in September, and Angela Merkel is looking to show a tough stance toward the countries of the European periphery. While this strategy can work at home, it has international risks.

This tax could generate distrust in the Cypriot banking sector, increasing the risk of a bank run. The bailout could also weaken the Cypriot government, which is less than a month old. Most important, this tax may weaken the relationship between Russia and the European Union. These relations are already strained by other issues, such as the EU's energy policy and the situation in Syria. 

This could particularly affect the relation between Russia and Germany — one of the most important bilateral relations in Europe, as a stable relation between Berlin and Moscow is key for the stability in Northern Europe. Moreover, Germany is Russia's main natural gas costumer in the Continent. There are reports that Moscow and Berlin held a series of phone conversations over the weekend, so there is a possibility that both countries are working in coordination. 

The situation in Cyprus could also rekindle the debate over the role of the European Union in granting bailouts to its members — something that is under criticism by both euroskeptic parties and domestic populations in several EU members.

Cyprus is the third smallest economy in the eurozone, but its geographic position in the eastern Mediterranean and its links with Russia make the island more strategic than what the size of its economy suggests. Of the European countries that have received bailouts, Cyprus is probably the case where a greater diversity of interests is at stake. 

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