IT TAKES some doing to induce nostalgia for Jean-Claude Juncker. The prime minister of Luxembourg was the head of the Eurogroup of finance ministers when the bail-outs of Greece, Ireland, Portugal and Spain’s banks were agreed on.


Those deals now seem like a model of sure-footedness. A bail-out intended to rescue Cyprus and keep it in the 17-strong euro zone backfired so badly this week that the risk of the small island economy tumbling out of the single currency suddenly became real.


Although bond markets have remained fairly calm, bank shares have fallen (see chart 1). Even if exit can be averted, the botched bail-out has done a wrecking job on the frail Cypriot economy and beyond.
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The deal reached in the wee hours of March 16th in effect “bailed in” all the island’s bank depositors, insured as well as uninsured. The 9.9% levy on deposits above the €100,000 ($130,000) deposit-guarantee threshold alienated Russia, which exercises a lot of influence in the Cypriot economy, not least through big deposits held there by its businesses and banks. The 6.75% tax on guaranteed deposits sparked such an outcry in Cyprus that, even when the rescue package was sweetened with an exemption for accounts below €20,000, not a single MP backed it when it was put to the vote on March 19th.


Nicos Anastasiades, the new Cypriot president, quickly dispatched his finance minister to Moscow to see if Russia would come up with some cash. As The Economist went to press, no deal had been done and the island’s options were narrowing. Cypriot banks will not reopen until March 26th. Although cash machines are being refilled, banks cannot stay shut indefinitely. The European Central Bank (ECB) has said it will cut off funding for the banks after March 25th if a deal is not in place by then.


Whatever happens a run is likely when banks reopen. Locals will transfer their savings to deposit boxes and mattresses. Owners of foreign firms based in Cyprus because of its low tax rate and light regulation will try to move funds.


How did things get to such a pass? Cyprus’s financial mess was the hardest case that the euro-zone finance ministers, along with the IMF and the ECB, have had to tackle. Although the absolute amount of money needed, at around €17 billion, was small compared with earlier bail-outs, it was almost as big as the tiny Cypriot economy. That threatened to take Cyprus’s public debt to an unsustainable 145% of GDP at the outset, a sticking-point for the IMF in particular. More than half of the total funding needed—€10 billion—would recapitalise Cyprus’s bloated banks, especially its two largest ones, which together have assets four times as large as its GDP.


And fatally undermining the saleability of a full rescue to northern European taxpayers, the island’s banks were awash with Russian money, much of it said to be of dubious origin. (The reality is more complicated: although Cyprus is indeed home to billions held by Russian oligarchs and shady businessmen, its banks also hold scores of current accounts of ordinary small and medium-sized Russian firms.)


Despite the warning signs, the terms of the bail-out presented at the weekend’s Eurogroup meeting were a genuine shock, not least to the Cypriot delegation. For Mr Anastasiades, the outcome was humiliating. He had pledged in his inauguration speech only two weeks earlier that in no circumstances would depositors suffer a “haircut”. Yet that is precisely what he was forced to concede, despite weasel protestations that a tax on deposits is different.


That levy was needed in order to meet the German demand that the size of the overall bail-out, from the Europeans and the IMF, should be limited to €10 billion. The resulting hole, of over €7 billion, had to be filled by the Cypriots themselves. Since privatisation proceeds could contribute no more than €1.4 billion, the lion’s share, of €5.8 billion, would have to come from raiding the only source of ready cash, bank deposits in Cyprus, worth €68 billion at the end of January. (They were likely to be lower than that by early March as clued-up investors got their money out.)


The readiness of creditor countries to touch depositors was somewhat surprising, since with the exception of the recent wind-up of Anglo Irish, a failed Irish bank, they have been spared during the euro crisis for fear of a bank run. Far more extraordinary was the decision to hit insured as well as uninsured depositors.


The Cypriots had their own reasons for this piece of madness: their reliance on Russia, both financially and politically. Russian corporate and banking deposits in Cyprus were worth $31 billion late last year, according to Moody’s, a ratings agency—about a third of all deposits. Money flows the other way, too.


According to Morgan Stanley, Cyprus provided $203 billion in loans, or 24% of total lending to Russia, between 2007 and 2011. When the Cypriot government lost access to the financial markets, it turned first to Russia, which lent it €2.5 billion in 2011.


In a bid to retain Cyprus’s appeal to Russians, Mr Anastasiades apparently wanted to keep the tax raid on depositors below 10%. Since the total value of deposits above €100,000 was an estimated €38 billion, that meant he could raise only €3.8 billion from them. So a 6.75% tax on the remaining €30 billion in smaller deposits was needed, in order to raise the missing €2 billion.


The deal quickly started to unravel, as it became clear that politics matters in Cyprus as well as Germany. With Cypriot MPs unwilling to endorse the deal, and Germany insisting that it would not budge on its terms, Cyprus turned once again to Russia. After arriving in Moscow, the island’s finance minister, Michalis Sarris, pledged to stay there for as long as it took to reach a deal.



For sale: island with gas
 
 
 
A game of brinkmanship is now under way, involving geopolitics as well as economics, as Cyprus seeks to play one of its few remaining cards, the recent discovery of an offshore gasfield.


The outcome is difficult to predict. Having come out as a strong critic of the depositor levy, Vladimir Putin, Russia’s president, now needs to show he can protect the interests of Russian elites abroad, according to Alexander Kliment of Eurasia Group, a consultancy. That argues for stepping in to help.


Yet in recent months Mr Putin has also launched a public campaign to bring Russian offshore assets home. Even if Russia were to provide extra support (besides a hoped-for extension of its €2.5 billion loan beyond 2016 and lower interest on it), Mr Putin would strike a hard bargain in trying to secure control over the gas.


Any Russian help might be unacceptable to the euro-zone rescuers. First, it would mean a big extension of Russian influence (though the time to worry about that was when striking the weekend deal). And second, Germany in particular would be loth to sanction Russian help in the form of a loan, since this would add to Cyprus’s debt burden and vitiate attempts to put it on a sustainable footing.


If Cyprus fails to get sufficient support from Russia (which, after all, turned down pleas for further help last year), then two other possibilities remain. The first is that the stand-off between Cyprus and Germany proves impossible to resolve. To show that Germany and other creditor countries like Finland, not to mention the ECB, can say “no”, Cyprus might in effect be expelled from the euro.


That would be a moment of peril for the euro area, which seemed to have rejected such a course with Greece last summer. There are arguments that Cyprus is too small (and its banks less entangled with the rest of the euro area, bar Greece) to pose a systemic risk.


The ECB’s commitment to buy bonds without limit might be enough to stop panic erupting. But this would clearly rekindle many of the fears that were so pernicious last year.


The more likely outcome is one in which the Cypriots still take most of their punishment, though sparing smaller depositors. As The Economist went to press, Cypriot officials were frantically drawing up a “Plan B” involving everything from gas-backed bonds to church-owned land to raids on pension funds.


A great deal of damage is already done. The harm will be gravest for Cyprus. The European Commission recently forecast that its economy, which shrank by 2.3% last year, would contract by 3.5% in 2013. That now looks like wishful thinking. A Greek-style slide (Greece’s GDP has contracted by 20% over five years) seems much more likely. By sabotaging the deal’s original projections, which saw Cypriot public debt supposedly reduced to 100% of GDP by 2020, that is likely in turn to necessitate a second bail-out.



The damage will extend well beyond Cyprus. Creditors to weak banks in other beleaguered economies will take note of the treatment meted out to Cypriot savers. Although a bank run outside Cyprus is unlikely, deposits in southern Europe may start jogging out of the system again (see chart 2). That will hamper attempts to loosen the credit squeeze in the periphery.


Most of all, investors will take note of the noxious politics of euro-zone bail-outs. When push comes to shove, national politics trump aspirations like Europe-wide deposit guarantees. Despite attempts to portray the deal as another “one-off”, that lesson will not soon be forgotten.