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The Unspoken Truth about Cyprus

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In all the many words, spoken and written, concerning the Cyprus banking crisis there is one key concept that never comes up. This is odd because it is at the heart of the crisis and one of the primary reasons why the EU (by which I mean the Germans) have dealt with Cyprus differently to the other Club Med over-indebted country, i.e. Spain, Greece and Italy. There is a huge reluctance to get down and seek a solution to the island's problems. Cyprus has been let float out into the sea to sink or swim. What underlies this difference is hinted at but never quite stated - certainly not by the authorities and not in our "free press' either. But let's state it here and now. A large part of the Cypriot economy is based on its being an important tax haven.

Now tax havens are dodgy. They indulge in secretive practices and siphon off billions of tax revenues rightfully due to other countries. And it is inevitable that they are going to hide, within their jurisdictions, a degree of money laundering, tax evasion and outright criminal activity - and Cyprus is no exception. However, it is a fairly new tax haven, having really only developed since it became part of the eurozone for it was that membership that underpinned it tax haven activities.

Tax havens are not all the same and the way that a lot of tax havens establish themselves is by becoming niche players. The Cayman Islands specializes in hedge funds, Bermuda in reinsurance, and so on. Cyprus found its place as what is usually known as a "conduit'. Its place within the eurozone, with the added advantages of being partly Anglophone and having good historical contacts with Britain and the City of London, enabled it to fit this role ideally.

"Conduits' work mainly to help funds to be exported out of countries where the owners lack confidence in those countries to provide a safe and profitable investment. Typically this happens in, say, African countries where businessmen or administrators want to retire their wealth elsewhere. This is known as "capital flight" and it is very detrimental to the countries of origin, as they lose the possibility of that capital being invested in the country for its own benefit. Such capital flight money is in many cases accumulated by individuals through corrupt or criminal activities which are further reasons for hiding it abroad. Even if the money is legitimately obtained then the higher local taxes can often be avoided by sending the money out of the country to a low tax jurisdiction. The size of this "capital flight' from the Third World is huge and a major cause of lack of development there.

Tax havens in general advertise themselves as attractive jurisdictions for parking money by virtue of their tight secrecy laws. These laws typically make it an offense for any bank employee or anyone else to divulge the holdings of any particular company or person (especially non-residents) sometimes on pain of imprisonment. This is a reassurance, to those placing the money, that its origin it will never see the light of day. Where the idea of the "conduit' comes in is that the money having been banked in, say, Cyprus, is then part of a wider economic or currency regime -- in this case the EU and the eurozone. It would be difficult to place this money directly in say Germany as disclosure rules are far more stringent and so placing it in Cyprus is "getting it in through the back door". Once it has been accepted in Cyprus it can be moved around in Europe and elsewhere -- or could be.

This only works as long as Cyprus is fully integrated into the euro and this is clearly no longer the case. The ECB is refusing to bail out Cyprus's banks. It has bailed out banks in Greece and Spain but there is one clear difference. Spain and Italy are not tax havens. If the EU had bailed out the Cypriot banks they would be supporting the claims of all sorts of rogue elements who have parked their money in Cyprus.

More than this, capital controls have been imposed by the EU making it difficult or impossible to shift deposits out of Cyprus. This is truly extraordinary as the expression "capital controls" had virtually dropped out of the economic lexicon since most major countries abolished them in the 1980s. The EU may have had other reasons for taking this action but it certainly scuppers Cyprus's role as a "conduit' for funds coming into Europe. Its main qualification for being a tax haven has been wiped out at a stroke.

In the case of Cyprus, it is the Russians who have figured most strongly in the news recently as "investors" having money placed in Cyprus. The reason for the Russian presence is clear. The Russians claim the reason is that they find the country amenable for it shares their orthodox Christian faith. Whilst there may be a sliver of truth in this, the main reason is that they can expatriate money gained in Russia to Cyprus without questions being asked as regards to its provenance.

(Incidentally, the other major destination for Russian capital flight is the UK. It too has an open door policy where no or few questions are asked. It is easy to set up a company in the UK and the integrity of the directors is not checked out. There are high profile Russian billionaires in the UK but also many lesser figures. In addition to importing their cash piles we are also starting to import Russian turf wars with Russian citizens being gunned down leaving the British police grappling with virtually unsolvable murder cases.)

Cyprus has been compared with Iceland, whose banks went bust in 2009, and the Iceland model for recovery is cited as one that Cyprus might follow. One big difference is that Iceland was not in the eurozone and so could devalue its way out of the problem. But neither was it a tax haven -- it attracted funds by paying higher interest rates than, say, British banks.

In spite of the capital controls now in place, eventually the opportunity for taking funds out (even with losses due to government seizures) will come. But Cyprus's ambitions as a tax haven are gone for good. No one will ever trust its banks again. Not so far away, the island of Malta plays the same game as "conduit', so it is there to take up the business.

Being a tax haven was the main reason why the banking sector in Cyprus grew phenomenally, so much so that, before the crisis, it contributed 45% of the country's GDP and it had assets eight times the country's GDP. The loss of Cyprus's status as tax haven will be a colossal hit to the Cypriot economy as the all-important banking sector will be decimated. This is ignoring all the knock on effects such as the Cypriots not being able to pay bills due to funds being frozen or taking up to 80% losses on deposits. The future for Cyprus is dire indeed.

Of course, the vast majority of Cypriots are hard-working, honest people and few probably understood what the government, with EU cooperation, was doing in their name. They may have profited by selling goods and services to the Russians but that is not the same as facilitating money laundering. Cyprus, for whatever reason, indulged in a dangerous game conspiring with murky operators to enhance its tax revenues and economy. There are lessons for others to be drawn.

If this aspect of the crisis is not mentioned in the mainstream media, it is probably because they don't want to admit too clearly the important role tax havens play in all our economies. If the people knew the truth, revulsion would be very strong and could have unpredictable effects. For instance, people might starting asking how it is we allow big companies operating in Britain to avoid/evade billions of pounds of taxes through tax havens (aided by the City of London) whilst at the same time imposing a 'bedroom tax' on the poorest in our society.

The EU tolerates, and in fact encourages, tax havens, but it has given the clear signal that it will not bail out weak tax havens. Whatever you think about bailing out in general, it has surely got a point in this.

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