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Jan 31, 2013 | 11:15 GMT

In Europe, Conflicting Views Over Cypriot Woes

PATRICK BAZ/AFP/Getty Images
Summary

Tensions are swelling in the European Union over a possible bailout of Cyprus. The European Central Bank is looking to prevent new flare-ups of the eurozone crisis and demonstrate that countries in need will be bailed out responsibly. But Germany, Europe's largest economy and main contributor to EU bailouts, is in an election year and is wary of rescuing a system that has essentially been a hub for Russian money laundering. Berlin is unlikely to dole out funds without stringent conditions — ones that Cypriots would probably reject. Meanwhile, Russia, despite loaning billions of euros to Cyprus in 2011, has lost the appetite to single-handedly rescue the island again, especially since the European Union has begun scrutinizing the Cypriot banking sector more heavily.

With Russia reducing its involvement with the island, Germany and Cyprus will have to reach a compromise that allays the concerns of each country's constituencies. Growing international attention given to the Cypriot crisis could lead to a return of the market instability that rocked Europe for most of the past five years, making a quick resolution of the issue essential to the European Union.

Cyprus Locator

Cyprus is deeply connected to the Greek economy, which remains dependent on successive tranches of EU bailouts. Cypriot banks were particularly affected by the European financial crisis due to their large holdings of Greek debt (at the onset of the crisis, some 20 percent of Cypriot holdings were Greek assets). The Cypriot government in Nicosia has been pursuing international assistance for its banking sector for more than a year, estimating that between 9 billion and 11 billion euros would be required to recapitalize its struggling financial institutions. While such a bailout would be staggering for a diminutive country like Cyprus, it would pale in comparison to the 250 billion euros pledged to Greece by the European Central Bank or the 40 billion euros Spain received late in 2012. Nevertheless, the small size of the rescue has not kept the issue from becoming contentious within the European Union.

Russia's Waning Interest

For decades, the island has served as an offshore banking and money-laundering hub for Russian and Eastern European companies and individuals. Cyprus' accession to the European Union in 2004 reduced some of the country's appeal as a destination for capital due to the introduction of oversight from European institutions, but Nicosia's lax interpretation of EU regulations allowed the island's banking sector to remain intricately linked to Russia.

In 2011, with European institutions overwhelmed by the escalating financial crises in Greece, Portugal and Ireland, Moscow recognized that Cyprus had become essentially an extension of the Russian banking sector and loaned the island 2.5 billion euros. But Moscow has become much less willing to take on Cyprus' financial woes alone, stating repeatedly that it would participate only in a joint rescue effort with the European Union (while extending the maturity date of its previous loan).

Russia's shift on the issue can be attributed in part to the reorientation of Cyprus toward the European Union. Increased European scrutiny will likely eliminate much of the opacity and secrecy that made Cyprus so attractive to Russian off-the-books capital. Already, wealthy Russians have been increasingly transferring their offshore funds to other banking centers.

Germany's Concerns

In the past two years, European institutions have managed to at least temporarily put out the major financial fires threatening the countries on the eurozone's periphery, and tools have been developed to cope rapidly with most crises — especially those in countries as small as Cyprus. Germany's predominant role in these rescues has given Berlin considerable political weight in bailout negotiations.

In late 2013, Germany will hold general elections in which German Chancellor Angela Merkel and her political party are expected to face significant, though not insurmountable, challenges. German voters have become wary of providing financial assistance to what are perceived to be non-deserving nations. Cyprus' opaque banking sector and strong ties to Eastern Europe have become a campaign issue in Germany, with voters asking why their taxes should be used to protect capital tied to Russian oligarchs and organized crime. Such suspicions were fueled in 2012 by a leaked German intelligence report detailing the process through which Russian money is laundered in Cyprus.

Short of nixing the Cypriot bailout, the only solution for Berlin has been to demand that Nicosia prove that it is complying with stringent EU banking transparency and accountability rules. Germany is also insisting that the government implement austerity and privatization drives. Typically, such conditions have been demanded only of countries receiving full sovereign bailouts. But Berlin hopes such stringency will set an example for other peripheral eurozone members that may also need financial assistance.

So far, Berlin's conditions have been rejected vehemently by the Cypriot government, which itself is under heavy pressure from state unions that would be hard-hit by the austerity and privatization provisions. In February the government faces presidential elections, meaning the decision-making process will likely be paralized for another month.

Meanwhile, signs of disagreement within the European Union have surfaced. Mario Draghi, the president of the European Central Bank, criticized Germany's strategy of dismissing the importance of Cyprus to Europe's financial health while also pressuring Nicosia into accepting severe conditions. Brussels is concerned that such a hard line might exacerbate the Cypriot crisis once again and risk spooking markets and reigniting the financial crisis throughout the Continent.

Cyprus' Options

Cyprus itself has few options. While periodic small-scale issuances of debt have kept the country solvent, such an approach is not a permanent solution. Rather, a bailout of the island's banking sector seems unavoidable in the short to medium term. Seeking to avoid Germany's conditions, Cyprus requested another unilateral loan in 2012 from Russia, but its request was refused. This was due in part to the weakening of Russia's banking ties with Cyprus. But Moscow is also wary of undermining Berlin's campaign to pressure Cyprus into economic reform since Russia is seeking to strengthen its already significant economic and energy ties with Germany.

Still, Russia continues to maintain certain interests in Cyprus. The country occupies a strategically valuable position in the eastern Mediterranean, essentially bridging Europe and the Levant, and the island is valuable to Russia as a regional intelligence hub. Cyprus could also become a significant hydrocarbon producer in the future. Thus, Moscow is content to support an EU bailout, which, unlike a unilateral loan, would not disrupt Berlin's plans to sanitize the Cyprus banking sector and help build a more sustainable eurozone. Russia would also curry favor with EU institutions bent on minimizing the cost of a bailout — particularly as relations between Moscow and Brussels have soured recently due to the European Commission's probe into the monopolistic behavior of Russia's state-owned natural gas company, Gazprom.

But overall, the future of the island will be determined by Berlin and Nicosia. As more international financial attention is drawn to what has been a relatively minor issue, pressure will increase on both Germany and Cyprus to avoid creating the first European financial conflagration of 2013. A compromise will likely be reached as pressure increases, with Cyprus taking steps to increase the transparency of its banking sector and Germany reducing its pressure on Nicosia to enact large-scale cuts in the public sector.

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