Cyprus, levies, loans and human nature

More often than not, humans behave in a psychologically and socially understandable way which, alas, turns out to be quite irrational. As behavioral economists, based on the ground-breaking research of D. Kahneman and A. Tversky, have demonstrated, economic decisions do not always make sense. Widespread reactions to the Cypriot combined bail-in and bail-out are a prime example thereof.

Last Friday, right before a long weekend in Cyprus, the Eurogroup decided, on behalf of the so-called Troika – including the European Commission, the European Central Bank and the International Monetary Fund – and in conjunction with Cyprus' new centre-right president Nicos Anastasiades, to apply a one-time "stability levy" to all Cypriot deposits to complement the €10 billion bailout loan its European partners were offering to stabilize the dramatic financial situation of this divided Mediterranean island.

What started as an atrocious injustice for small savers – with initial plans asking for a 6.75% levy on all deposits under €100,000 (theoretically fully guaranteed by the Cypriot government and Europe's planned Deposit Guarantee Scheme) and just a 9.99% levy on deposits over €100,000 – now looks like a one-time wealth tax for richer Cypriots and non-Cypriots alike, which will have to foot the bill to the tune of €5.8 billion via a levy that will surely shave at least 10% off the balance of all deposits below €500,000 and up to 15% of those of the wealthiest.

A 12.5% levy was precisely what Germany was asking for from the start, in order to punish speculators and money launderers that had found a home in the poorly regulated and overly generous Cypriot banking system, with interest rates for ordinary deposits averaging over 4.5% (or even more for much-favored Russian customers). It now appears that it was Cypriot president Anastasiades the one insisting on spreading the levy to ordinary savers to "lower the burden on the wealthy" and try to prevent them from fleeing Cyprus as a low-tax banking haven.

Be it as it may, everybody is talking only about the injustice of this planned "lab experiment" with the Cypriot people, that unduly punished honest working-class people (and the rich) in a way no other previously rescued European country had faced. Further from that, the Eurogroup showed undue toughness in not offering a more generous direct bailout and forcing the Cypriot people to pay for it heads on. In other words, our economic short-sightedness made most people, including the press and many pundits (with some honorable exceptions), forget that a bailout package is no more than a loan that needs to be returned with interest, not a donation.

Cyprus’ GDP hovers around €18 billion. It has just received an €10 billion bailout. In other words, they will have to eventually repay a loan amounting to 55% of GDP, or around €13,000 per capita – plus the corresponding yearly interest. Please note that this amount (minus interest) equals a one-time levy of 13% on a deposit of €100,000 (or 10% over €130,000), of course assuming that each and every Cypriot had such savings.

As economists have extensively and reliably proved, debt-to-GDP ratios of over 90% severely reduce growth prospects. Public debt already stood at 81% of GDP in 2012: add a further 55% and the number turns into a scary 136% of GDP, not even counting the projected deficit for 2013, which should amount to a further 4-5% of GDP. What if the EU had been really generous and offered an all-encompassing rescue package of €16-17 billion? Well, in that case, public debt at the end of 2013 might reach a nightmarish 180% of GDP, or €43,000 (plus interest) per capita. Plus, unsustainable debt means austerity measures and budget cuts, and most Europeans know what this recipe entails: rising unemployment, more poverty and the loss of the sadly unappreciated multiplier and accelerator effects of government and public sector investment.

Let's just spend a few lines comparing it with the "standard bailout" of the Spanish banking sector, agreed in June 2012, to the tune of a €60 billion rescue package (or 6% of Spanish GDP). Being a loan and not a donation and coming before the actual implementation of the Eurozone banking union, this hefty amount was debited into the public debt accounts. Spain is currently paying a yield of around 5% for standard 10-year notes and between 3 and 4% for shorter-maturity bonds, so interest payments for this extra debt would amount roughly €2 billion per year during up to 10 years, thus raising the actual bill to almost €80 billion.

Under the current dramatic economic situation, the total number of active taxpayers among the Spanish working population stands at barely over 16 million (and decreasing). If we divide these 80 billion among the tax-paying, active population, we get that each non-retired taxpayer should foot a bill of €5,000. Even if we divide it across the entire population, the projected bill stands at €1,700 per person.

This would equal applying the initially-planned Cypriot levy of 6.75% to someone with a deposit of €75,000, or to anyone with savings of just over €27,000 in case we artificially divide the bill among all Spaniards, including children, the retired and the 26% of unemployed working population. If we use the first number, however, working Spaniards are already paying more than what an ordinary Cypriot, with less than €100,000 in savings, would have paid under the unfair and harsh levy scheme proposed last Friday. Of course, this is not to say that their current situation is enviable: on the contrary. Cypriots will also have to foot the bill for the additional €10 billion that the Troika is lending the nation in order to save its banks and this is, by far, the heaviest burden on the Cypriots – for the rich and the poor alike.

Pointing out the irrationality of the exclusive focus on the levy for depositors, outrageous as it might be, is not to say that we should consider the solution to be optimal. Far from it: curing illnesses that could have been prevented is never the best possible option, and the medicine employed always has undesirable side effects. The first and more obvious is that the image of the European Union, led by the seemingly omnipotent German government, has been badly tainted by an improvised, half-baked rescue that highlighted a worrying lack of internal solidarity and cohesion. The unhealthy exercise of finger pointing carried out by the Cypriot president and the German finance minister, now also including the Eurogroup itself, has only helped create further discomfort with the initial decision and hurt even more the feelings of those who still dare to feel European. Mending the initial abusive levy for small savers at the eleventh hour in face of parliamentary pressure will definitely not mend their image overnight in front of millions of scared Southern European taxpayers.

The second is the lack of justice and punishment for the ones who could have prevented this malaise but did nothing else than feeding it: the greedy bankers and politicians of this small and divided Mediterranean island. If the size of your financial system is 8 times that of your GDP, there must be something wrong. If your guaranteed deposit interest rates are almost double those of other Eurozone countries, there must be something wrong. If you bet over 60% of the GDP of your country on Greek bonds, there is definitely something wrong with you. If you lure Russian (and Israeli) undeclared income on a massive scale and spice it up with the lowest corporate tax rate in the EU (currently at just 10% and set to rise to Ireland’s much-maligned 12.5% if this clause of the March 16 deal if finally approved), you have all the ingredients for a massive crash fueled by offshore funds flushed into a banking casino economy. One has to wonder why a Russian company, Gazprom, allegedly offered Cyprus a debt restructuring deal to avoid the EU bailout. Companies operate out of self-interest, not for the public good. Of course, this offer had an even darker side, aside from helping fellow Russians whose savings in Cyprus might take a nice haircut: the private bailout would have been in exchange for the island’s gas rights. In other words, it all just looks way too shady.

However, nobody cared to regulate this casino until it was way too late, and a few people sure made hefty profits with this business. Will they pay for it? Or is are the EU, the IMF, the Eurogroup and everyone involved in the issue forgetting about them… either because they also feel the shame of culpability or, worse still, because these very clever people are above and beyond the law? Sadly enough, the only answer we can now give to this doubt of ours is the one given by the Financial Times’ Martin Wolf in reviewing a newly published book: bankers are intellectually naked (and, we might add, most politicians look rather naked to us, too).

Free trade agreements and nuclear trade-offs

U.S. President Barack Obama is carefully planning his upcoming visit to Israel and, with it, he is also complicating a negotiated diplomatic solution to the Iranian nuclear crisis and undermining the rather unusual efforts of the European External Action Service. 

On March 15, with no extra publicly available data to back the statement and no special provocative statements from Iran, President Obama warned that, despite the Iranian bomb could be more than one year away, a military option remained pretty much on the table.

On a more discreet note, although equally important and closely related, last February 28, the U.S. Senate passed Resolution 65, calling the U.S. to provide support for Israeli strikes on Iran, aimed at preventing the Islamic republic from acquiring nuclear capabilities, in the form of military, economic and diplomatic backing.

To make things even more complicated, it all comes in the aftermath of North Korea’s latest long-range missile test, in December 2012, and third nuclear test, earlier in February, both taking place on the heels of the signature of a bilateral cooperation  agreement in the fields of science and technology – signed in Tehran on September 1, 2012 with both Iranian President M. Ahmadineyad and North Korean Chairman of the Presidium of the Supreme People's Assembly Kim Yong-nam present at the official ceremony – and allegedly supported by (and even carried out on behalf of) Iran, which has also successfully test-fired two different short-range missiles.

This conflict-geared agenda is undermining the efforts of other international players to defuse tensions and negotiate a palatable solution to the conflict over Iran’s nuclear plans. Most notably, the almost unprecedented proactive efforts of the often reactive European Union diplomatic arm to take the lead in negotiating a peaceful resolution to the Iranian nuclear issue are being not-so-subtly being put aside by the combined efforts of the revamped Netanyahu cabinet (now including a right-wing defense minister M. Yaalon) in Israel and its American ally.

It also comes at a complicated time for the European Union to answer back and hold its ground: after several months of preparatory meetings and negotiations, the European Commission has given the green light to launch talks leading to a comprehensive Free Trade Agreement (FTA) with the United States of America, Europe’s main trade partner, an agreement that would remarkably boost transatlantic cooperation and bilateral trade.

Signing this FTA not only makes economic sense for the sputtering EU economy, but also carries great diplomatic and geostrategic clout: amid notable cuts in defense budgets all across Europe – military expenditure across Asia has overtaken Europe’s for the first time in contemporary history – and fears that NATO’s role and capabilities are being undermined in the context of Washington’s much-trumpeted “pivot to Asia” , Europe’s democracies are trying hard not to become irrelevant in the multipolar 21st century.

When silence is the only sound coming from the European External Action Service and the loudest voices can be heard in the Directorate Generals for Trade and Economic and Financial Affairs, the only valid conclusion one can reach is that Europe needs to export its way out of the crisis and thus further improve its balance of trade, a discourse that has two clear implications for the involved parties. First, the EU enjoys a healthy and growing positive trade balance with Israel (up from under €3 billion surplus in 2009 to over €5 billion surplus in 2011 when combining trade in goods and services) and is not willing to see it vanish overnight. Second, free trade with the United States would notably boost European exports across the Atlantic, raising European aggregated GDP an estimated 0.5% per year, and any source of growth is now sorely needed. In the words of Mr. Vale de Almeida, EU Ambassador to the U.S., “it is good to see Europe perceived again in Washington as a source of growth, and we must seize the moment.”

Green light, therefore, from Brussels for Israel and the United States to take the course they consider more fit for the Iranian nuclear issue... of course, China and its strategic energy interests permitting.

Betting everything on China

How North Korea really aims at China with its threats against South Korea and the United States

Since its 12 December long-range missile / satellite launch and 12 February nuclear test – already its third, the most powerful yet and allegedly funded by and performed on behalf of Iran –, the Democratic People's Republic of Korea (DPRK) has been all over the news, most recently by threatening to cut all communication lines with Seoul and voiding the 1953 armnistice – one of the few elements that keeps the unstable peace in the Korean peninsula alive – in response to the passing of UNSC Resolution 2094, considered the most punitive to date (albeit not the harshest that could be imposed), which condemns North Korea's nuclear activities "in the strongest terms", imposes new financial sanctions, strengthens states' autohority to inspect suspicious cargo from the DPRK and imposes additional sanctions on individuals and entities.

However, further from the passing of yet another UNSC Resolution (in fact, another resolution against North Korea, no. 2087, was adopted last January), the reelection of Barack Obama or the even more recent investiture of new South Korean President Park Geun-hye, the reasons behind the unusually bellicose behaviour of the Kim Jong-un regime, dialectically already surpassing that of 2010, which preceded the shelling of the allegedly disputed Yeonpyeong island, have to be found in the menacing attitude shift coming from China. The stakes are too high for the regime, which is now resorting to indirect brinkmanship negotiation tactics to make sure China has no choice but to keep supporting it.

Several warning signs are arising from China. Although the Chinese government's worst nightmare would be a North Korean collapse, which would trigger a flood of impoverished refugees crossing China's border and create a security nightmare until North Korea's nuclear weapons were found and secured, Beijing's stance has perilously drifted from near-unconditional support to a more critical stance. Two unprecedented moves reflect this potential attitude shift.

First, critical voices from inside China's Communist Party have been allowed to publicly question Beijing's support of the Kim regime. In one of the most resounding pieces, whose publication in the Financial Times guaranteed its international impact, Deng Youwen, deputy editor of the journal of the Central Party School of the Communist Party, asserted that the benefits of this privileged relationship are unclear: ideology-based relationships are dangerous, the Cold War is over and North Korea's strategic value should not be overstated, North Korea will not reform (i.e. will not open its economy to Chinese businesses looking for cheap labor) and Pyongyang is drifting away from Beijing (i.e. it does not follow anyone's orders). In fact, Deng was just voicing the concerns of a growing number of Chinese intellectuals and party members. Despite the obvious fact that trade with North Korea has helped revitalize the impoverished Northeastern provinces of Liaoning, Jilin and Heilongjiang, especially since the start of the Northeast Asia Project in 2002, North Korea has been testing China's patience for too long, and weariness is starting to show.

This leads us to the second change in China's behaviour vis-à-vis North Korea. Until recently, Pyongyang's only ally and regime guarantor refrained from actively supporting UNSC Resolutions against North Korea, unless in those related to the 2006 and 2009 nuclear tests. However, it all changed last December, when Chinese dilomats joined their U.S. counterparts to proceed with a UNSC resolution criticizing North Korea for its latest missile launch. As asserted by Kurt Campbell, this surprised and enraged Pyongyang and set the stage for the February nuclear test, a strong warning to China that North Korea has no interest in playing the role of vassal state (i.e. what Deng Youwen qualifies of "Pyongyang drifting away from Beijing"). Not surprisingly, China played an active role in drafting UNSC Resolution 2094, implicitly threatening the eventual enforcement of these strengthened sanctions. 

In the past, China-DPRK trade has even increased in the aftermath of UN sanctions, as implementing regulations passed by the United States, the EU and other states and trade blocks were put into effect but circumvented via China, which consistently failed to create detailed lists of forbidden imports of the luxury items that the North Korean elite craves. If China's attitude changes – and that is still to be seen, although there are some early promising signs –, the effects for the luxurious lifestyle of Kim's clique could be devastating, potentially triggering severe internal discontent and instability. Further from the economic benefits for the Chinese nationals engaging in trade activities with the Korean elites, Beijing is very much aware of the risk of regime collapse if trade or aid are severely cut down. Pyongyang knows it and is playing its cards to make sure China's fears overwhelm its desire to please the international community on the North Korean issue amid growing tensions tied to its trade surplus, growing military clout and territorial demands in the South China Sea and the Sea of Japan.

Professor Jennifer Lind has ably asked herself whether China will finally bite North Korea. The answer is still up in the air and, as she says, the significance of these recent developments should not be exaggerated, as the Chinese have still watered down the degre of punishment imposed against Pyongyang despite actively backing the sanctions. Plus, if past behaviour can be of help to predict the future, Chinese firms have, with Beijing's consent, consistently helped North Korea evade sanctions. So far, the only obvious fact is that Pyongyang is placing a strong bet on its fearful brinkmanship tactics, hoping they play into Beijing's fears of instability in its backyard. We can just hope that Pyongyang's China-aimed strong words and threats do not end up in violent provocations, which could eventually trigger a disastrous major conflict.