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March 27, 2013

Moscow's Cyprus Defeat

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Cyprus has agreed on a bailout with its international creditors—but the effects will have geopolitical and economic implications for Russia-EU relations.

Under the deal announced Monday, Cyprus will pay its share of the bailout by taxing bank deposits exceeding €100,000—a large proportion of which come from Russia. The Popular Bank of Cyprus will close, sending its accounts under €100,000 to the Bank of Cyprus. Accounts over €100,000 from both banks, which have no insurance protection under EU law, will be taxed at “an estimated 30% to 40% haircut on assets, far greater than the original 9.9% levy.”

In Russia’s eyes, the EU’s initial proposal was no better. Its suggestion that the haircut cover insured deposits under €100,000 would have hit Russian and British investors hard, since they constitute the majority of investors on the island. The Cyprus crisis also highlights the far-reaching effects of Russia’s corrupt financial flight.

Professor Leonid Grigoryev, Chair of International Economy in the Higher School of Economics in Moscow and a former World Bank official blasted that proposal as a violation of Cyprus’ sovereignty—and one would undermine trust in the banking system, and was unfairly harsh toward Russians and the British. Of course, the heavier tax rate on deposits of over €100,000 was especially irksome for Russia because Russian money reportedly accounts for up to €20 billion of the €35 billion of foreign money in Cypriot banks.

Many Russian “grey” and legitimate firms transact business under Cyprus’ EU umbrella, the business-friendly Anglo-Saxon legal system (the legacy of the British Empire), and sunny climate.

Yet, Professor Grigoryev, says that in the long term, the Russian investors may forget the Cyprus “haircut” and return to the hospitable island after the current financial storm subsides.

Russians also worry that this proposal may become a model for the future restructuring of heavily leveraged Portuguese, Italian and Spanish banks.

Russian officials and media have decried the EU for “beating up on the Russians” and the Cypriots. Russian President Vladimir Putin called the tax on deposits “unfair, unprofessional and dangerous.” Prime Minister Dmitry Medvedev called it “completely absurd,” adding Monday that “the stealing of what has already been stolen continues,” as Russian depositors’ money is taken to pay for Cyprus’ bailout.

With the amount of Russian money and influence in Cyprus being disproportionately high, journalists have taken to calling the island “part of the [Russian] Federation.” The two economies have deep ties, including an avoidance of double taxation treaty. Russia stands to lose heavily as the financial crisis hurts Cyprus’ economy. Already, cautious investors have begun pulling money out of Russia because of the instability in Cyprus and its link to Russian capital. And, having reached a deal with the EU, Cyprus is now intent on restructuring its previous multibillion-euro Russian loan from 2011.

Putin and Medvedev are up in arms over more than the bailout deal’s damage to Russian capital. It also undermines their geopolitical aspirations vis-a-vis the island. As Bashar al-Assad’s influence in Syria wanes, so too does Russia’s influence in the Eastern Mediterranean and the Middle East. The viability of its naval presence in the port of Tartus, Syria, is also in question.

Moscow explored the idea of a naval base in Cyprus, which since the time of ancient Greece and Rome had been a key to controlling naval access to Egypt and the Levant. As part of a bailout deal, Russia also wanted a piece of action in the large offshore gas fields.

Russia may now turn a vengeful eye toward the EU for its part in forcing the levy on Russian deposits on Cyprus and weakening its influence. In Putin’s view, the EU is eroding potential energy deals, stealing Russian money, and impeding Moscow’s bid for a naval base and more influence in the region. Unsurprisingly, hydrocarbons, money and geopolitical power are the name of the game in Putin’s Russia, and Russian-EU relations are likely to take a hit because of the bailout deal’s threat to this trifecta.

-Ariel Cohen, Ph.D., is senior research fellow in Russian and Eurasian Studies and International Energy Policy at the Heritage Foundation. Ben Tigay, a Heritage Youth Leadership Program member, contributed to this article.

First appeared in The National Interest.

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