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Cyprus – the next chapter of dysfunctional EU debt crisis management

Added 28 Mar 2013

By Costas Todoulos and Bodo Ellmers 

After more than a week of messy negotiations, the Troika (made up of the European Union, the International Monetary Fund and the European Central Bank) and the government of Cyprus agreed on a bailout package for Cyprus on 24 March. Cyprus is set to receive a €10 billion loan, on the condition that it shrinks its financial sector and implements austerity policies. Private bank deposits above €100,000 will be taxed at 40% in order to raise the additional €5.8 billion needed to stabilise the country’s de facto bankrupt banks.

Euro banking crisis chapter four  

Cyprus has become the fourth European nation to fall victim to a banking crisis that was caused by irresponsible lending and lax financial regulation – following on the heels of Iceland, Ireland and Spain. Cyprus’ status as a de facto tax haven also played a role in attracting huge amounts of foreign deposits, mainly from Russia and the UK, which inflated the banking sector to such an extent that lending reached 900% of Gross Domestic Product (GDP) in 2011.

Dysfunctional debt crisis management

As the bubble burst and Cypriot banks teetered on the verge of bankruptcy, the EU tried to avoid a disorderly default. However, the chaotic crisis management tragedy we witnessed over the past few weeks was obviously everything but an orderly debt work-out procedure. It is a striking fact that, five years into the Euro crisis, the EU has still not developed clear criteria, mechanisms and institutions to deal with debt crises in a fair and transparent manner.

EU crisis management continues to be a rather random process. Dodgy decisions are made in backrooms, with no transparency and accountability to the European citizens who ultimately have to foot the bill – either because they live in crisis countries and have to suffer from austerity programmes, or because their tax payments will ultimately fund the bank bail-out deals.

Severe governance gaps

Little support have come from the global level as the international financial architecture still lacks effective debt work-out mechanisms, a point that Eurodad and other debt campaigns criticised again and again over the past decade when developing countries suffered from debt crises. Such a debt work-out mechanism would be independent from creditors, cover all categories of debt and make binding decisions for all, in order to find a sustainable solution to debt crises as they arise. It would also assess the legitimacy of creditor claims, and pursue a human rights-based approach to debt restructuring, thus ensuring that public spending for essential services is safeguarded. The Cyprus case provides new evidence about how urgently such a new debt work-out mechanism is needed.

Towards evidence-based crisis management

The time has come for an evidence-based debt work-out. Cyprus received harsh treatment at the hands of its European partners, as they argued the crisis was self-inflicted. The small Mediterranean island has been the preferred destination of many overseas depositors over many years. Banking secrecy was high, tax rates were low. KPMG ranked Cyprus’ corporate tax regime as the most attractive in Europe. Some nicknamed the island the ‘unsinkable washing machine’, given that the origins of the deposits were in many cases unclear and illicit flows may have contributed a substantial share to its bad reputation.

A thorough debt audit would have shed clearer light on the origins of Cypriot debt and the Cypriot debt crisis. It would also have supplied decision-makers with better information for making sound decisions. Not least, it could have traced where all the money ended up and who profited from it. This should have been a prerequisite for fair burden sharing in crisis management, and for protecting the ordinary Cypriot citizens and EU taxpayers from footing the bill for a crisis they did not cause.

Safeguarding development from debt

The solution that was chosen for Cyprus will have negative impacts for the country’s population and development in future. The imposed austerity programmes will affect the living conditions of ordinary Cypriot citizens, in particular the most vulnerable people who are dependent on public services. Moreover, while the EU rightly stressed that the economic future of Cyprus cannot be based on a bloated financial sector, it forgot to provide an alternative. We have had better proposals for debt crisis management in a developing country context, where the international community asked affected countries to draft national development plans, and committed to support their implementation.

The solution chosen for Cyprus is neither optimal from a developmental point of view, nor is it sustainable. The bail-out loan will drive up Cyprus’ debt by an additional 60% of GDP, while GDP is expected to shrink due to the harsh austerity measures. It is just a question of time when the next round of crisis management is due. The only good news is that the EU will soon get its chance to prove it can do a better job next time.