Opinion

James Saft

Learning from Cyprus

March 22, 2013

By James Saft

(Reuters) – Even if you have zero exposure to the euro, the sad tale of Cyprus teaches investors about important old and new realities.

This tutorial comes compliments of the tiny euro zone island off the coast of Greece, which has been a favored haven for billions of euros from mostly Russian investors but is now facing a financial meltdown.

First, there is still no free lunch. High-reward, low-risk investment products aren’t.

Second, off-shore havens for money may save you money in taxes but could well cost you far more in the end.

Third, financial repression isn’t a psychological disorder, it is the new way of the world. So-called financial repression is any one of a number of tactics which a government uses to capture any money from any available source to help it meet its goals.

These are lessons that depositors in Cyprus banks are learning to their cost. It would behoove international investors to take note as well.

Cyprus is a tiny country, far away and arguably someone else’s problem. U.S. investors might easily dismiss its troubles, even though they are huge. Still, they illustrate trends which will apply worldwide, even though they are highly unlikely to be replicated on anything near this scale in the United States.

Cyprus is struggling under the weight of a bloated and dangerously shaky banking sector which has grown to more than seven times the size of its economy, largely on the back of taking in off-shore deposits from wealthy Russians. While this is a risky business model for an economy under the best of conditions, it becomes a disaster when that huge banking sector invests heavily in domestic real estate and Greek debt, both of which have plunged in value.

A member of the euro currency, Cyprus first struck a deal with the EU and the International Monetary Fund for a bailout which included an involuntary contribution, called a levy, from bank depositors. This deal, now in flux, called for accounts under 100,000 euros to be snipped by 6.75 percent and larger accounts, many off-shore money, by 9.9 percent. Cyprus has been on an extended bank holiday since the bailout was first mooted, effectively trapping deposits.

Let’s be clear: there is no sign anything anywhere near this is going to happen in the United States, so cancel those freeze-dried food orders.

NO FREE LUNCH

While deposits in Cyprus banks are insured to up to 100,000 euros, and any policy which violates the spirit of that is an outrage, the truth is that depositors should have known better. And here I am not even talking about an in-depth analysis of a bank’s balance sheet, or even spending one’s time reading about the euro crisis and its potential knock-on effects.

There was a very easy way that everyone with money in a Cyprus bank could tell they were sitting at the end of a very long limb: the deal was too good. Deposit rates for euro accounts in Cyprus were recently at 4.45 percent, as against just 1.5 percent in banks in Germany. In fact, a depositor who put one euro each in a typical German and Cyprus bank five years ago would have enjoyed nearly twice the cumulative returns, according to central bank data.

Repeat after me: there is no extra reward without extra risk.

Much of the money in Cyprus banks came from Russia-based depositors. The Tax Justice Network estimates that there is some $21 trillion globally in offshore accounts, a figure which has grown sharply in recent years.

All of that money is today in more danger than it was a year ago, and very likely will be less secure yet in another year. First off, big centers are becoming far more aggressive in going after tax evaders, as shown in recent U.S. efforts to go after Swiss accounts.

As well, we live in a time of rolling bank crises. While you might do well to make sure that your bank is sound, ultimately your bet in a bank is a bet on the domicile, because those banks depend in turn on the backing of their governments. Offshore centers have large financial systems relative to their economies, and, like Cyprus, could easily be caught in situations where a banking crisis is beyond their ability to solve without seizing assets.

FEELING REPRESSED

Financial repression, which takes many forms, has historically been a popular way for governments to dig themselves out of debt holes. A prime way to do this is to keep interest rates artificially low – quantitative easing anyone? As well, governments can and do try to capture pools of capital by, if not confiscating it, then at least channeling it in ways which will be useful to the government in addressing its debt problems.

A great example of this is forcing pension funds to invest in government debt, or, as is being considered in Cyprus, in a kind of national fund.

Any roadblock to the free movement of capital is a form of financial repression. Cyprus, where depositors are likely to receive either shares or bonds issued by the banks in which they hold money, is a perfect example.

More of this is coming. My guess is you are better off at home than abroad, as it is harder to do voters out of their capital than honored guests, as the Russians have learned.

Bottom line on Cyprus is: don’t over-react, but don’t be surprised if more of this kind of thing happens.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft )

(This story is corrected with attribution in 14th paragraph to The Tax Justice Network from McKinsey & Co)

(Editing by Chelsea Emery)

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