The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (56 page)

Yet Cyprus said
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– No. In the end, not only did the measure fail, but not one MP dared vote for it. Even those government MPs who wanted to vote for it were told to abstain. Cyprus was jubilant. Protesters partied in the streets outside parliament. Little Cyprus, a mere five-hundredth of the total Eurozone economy, had stood up to Berlin and Frankfurt.

I spoke to Andros Kyprianou, leader of the opposition AKEL party, as he triumphantly walked out of parliament after the vote. He was dismissive of the Troika. ‘They went much too far,’ he told me. ‘And according not just to us, but to international opinion, what they did was unjust and unfair.’ He insisted that Cyprus’s newly discovered gas deposits meant that it had ‘very big wealth’, a factor that had been completely ignored by the Eurogroup. I asked if the Troika should learn its lesson. ‘That’s what I believe,’ he replied, ‘and I hope that they will change their policies, because you cannot solve the problems of the economic crisis with the same prescription that lead to the crisis.’

Parliamentary democracy reigned supreme in Euroland, at least for a day or two.

The three broad stages of Cyprus’s attempt to escape the Eurozone’s particularly harsh adjustment programme might be characterised as: (1) Extend and Pretend, (2) Befriend (Russia), and then (3) Depend (on gas). The Cypriot government pondered a €3 billion raid on the pension funds of the public sector, and also on those of the banks and the state enterprises, to be repaid when needed by the proceeds from gas finds. This strategy entailed some heroic assumptions about a patch of the Mediterranean lying 160 kilometres south of the island. The results of one test drill on the Aphrodite Field, 1,500 metres below the surface of the sea, led the prospector concerned to claim that it had found €30 billion worth total Cypriot gas reserves – double what Cyprus needed for its bailout. Some external experts suggested that total Cypriot gas reserves could be worth as much as €300 billion, while others estimated that the commercially recoverable reserves were worth no more than €2 billion.

The Cypriot leadership hoped that the likelihood of some billions’ worth of gas reserves would change the equations on its debt sustainability. A sufficiently optimistic assessment might obviate entirely the need for a bailout. Certainly, all sorts of gas-backed warrants and bonds were considered as an alternative to borrowing from the EU. Even after it was clear depositors were going to be hit, Cyprus pondered offering long-term gas-backed IOUs as compensation. A hydrocarbon treasure trove undoubtedly lay in Cyprus’s territorial waters, but there were bigger issues at play. The major oil and gas companies were not putting in large bids for exploration. After all, Cyprus had been something of a trouble spot, and who was to say when trouble might blow up again. The 1960s had seen bloody fighting between the Turkish and Greek communities on the island. And then in 1974, a coup by Greek nationalists intent on union with Greece prompted a Turkish invasion. The result was the partition of the island, with the Turks proclaiming the internationally unrecognised Turkish Republic of Northern Cyprus, and the Greeks concentrating in the south. The line of partition – the so-called Green Line – runs right through the capital, Nicosia.

Across the rooftops of Nicosia you can see the different flags, the monuments and the minarets that symbolise the split. At street level, it’s difficult to detect the divide –until you stumble into the border guards. Off limits for nearly four decades, some streets are still deserted. This no man’s land – the UN buffer zone – contains an airport terminal, car dealerships, and even an Avro Shackleton aeroplane; everything here is frozen in time. From the Turkish-controlled side, on top of a casino with views across both sides of the divide, a senior official points south. ‘They used to come here for their gambling,’ he tells me. ‘Now their entire economy is a casino.’

Cyprus had forged a close relationship with Israel, which also had an interest in the prospects of extracting natural gas in the eastern Mediterranean, and in developing its export capacity. Relations between Israel and Turkey, the ultimate bogeyman for Greek Cypriots, had been frosty since 2010, when the Israelis had used armed force to intercept a Turkish relief convoy heading for Gaza. But now, just at the very same moment as Cyprus’s financial fortunes hit rock-bottom, relations between Israel and Turkey began to thaw. Turkey had also announced a peace deal with separatists in its Kurdish areas. Turkey was securing allies, extending its influence in the region, and looking for energy to fuel its booming economy. In ordinary circumstances, Turkey’s pipeline network would offer the perfect export route for Cypriot gas. Turkish ministers make the point regularly. But since the Turkish invasion of 1974 and the proclamation of the Turkish Republic of Northern Cyprus, the internationally recognised, Greek-dominated Republic of Cyprus in the southern half of the island has snubbed all overtures from Turkey.

In the north they felt that they had done all that they could to restore harmony on the island. Under the Annan Plan, the UN sponsored a vote on the establishment of a federation of two states as the ‘United Republic of Cyprus’. Separate referenda were held in the north and the south in April 2004. The vast majority of northern Cypriots (65 per cent) voted for the plan, but in the south, only a minority (24 per cent) were in favour. The European Union felt a little tricked, as during the negotiations on Cypriot membership of the EU, solving the divide had been one of the EU’s conditions for allowing Cyprus to accede – which it formally did in May 2004, just a week after the referenda. The EU began to allocate aid to northern Cyprus, even though it was still occupied. At the time, Cyprus was booming and Turkey was suffering in the aftermath of an IMF rescue. Nearly a decade on, the view from the north was that the boot was firmly on the other foot. Turkish officials struggled to balance concern about the prospects in the south with outright
Schadenfreude
. rsen Küçük, who is the leader of the Turkish Cypriots and calls himself prime minister (though this title is disputed in the south), said, ‘Of course, I see this as the accumulated effect of many years [of their system]. I can say that the juncture they now find themselves at, has not come as a surprise to us.’

By 2013, Turkey’s economy was booming, pumping extra aid, tourism and investment into the north. Students from Turkey and developing countries, finding the West increasingly inhospitable, flocked to northern Cyprus to study. The economy was growing at 2 to 3 per cent per year, and the government set a target for 5 per cent. When I drove through the north, I found myself on brand-new motorways, speeding past numerous luxurious villas built for Turkey’s new elite. When I arrived at the north coast, I stumbled across something extraordinary on the beach: piles of giant steel pipes, made in China. They were for an 80-kilometre pipeline that was to pump drinking water from a reservoir on the mainland of Turkey directly into the homes of northern Cyprus. A young graduate engineer called Fatima was overseeing the project. A dam and a pumping station were being built too, and these would also produce hydroelectricity. When finished, the north will benefit from 75 million cubic metres of water per year for drinking and irrigation, sourced from the rains falling on the plateau of Anatolia. The south will have its gas. The Turkish Cypriots think their water wealth will be a crucial bargaining chip in any reunification talks.

‘Natural resources belong to both communities – Turkish Cypriots and Greek Cypriots,’ rsen Küçük told me. ‘Looking at Cyprus as a whole, there are two important economic opportunities here: gas and water. The gas needs to be utilised in the most economic way possible and conveyed to Europe through Turkey.’ On the one hand, Turkey made it clear that it would not countenance the south using its gas as a security to pay the debts of its banking system. On the other, it felt that the south’s predicament had created better conditions for unity and a lasting peace. ‘My opinion is, thinking logically, and considering the people in both countries and caring for their livelihoods and welfare, this could lead to relatively more positive developments,’ Küçük told me.

Perhaps that’s why Küçük told me that depositors were welcome to put money in the banks in the north, which were ‘safe, stable, very healthy and strong’. Finance minister Ersin Tatar took me on a walkabout of Nicosia’s Old Town. At the Ledra border crossing he peered over no man’s land, noting that in the Turkish part of town the banks were open and the economy was growing, while in the south there were plans for capital controls. The Green Line felt like the Default Line between ‘western Europe’ and the fast-growing emerging economies. It has to be said that Mr Tatar did not actually know at the time how much deposit protection existed for this prospective tidal wave of safe-haven deposits flooding into his breakaway republic. Still, at that moment, foreign deposits in the banking system of an internationally unrecognised sovereign entity did appear safer than those in the European Union banks a few hundred metres away.

Back in the south, the calm response of Cypriots gave way to panic when local media reported that Laiki Bank was about to be wound down after the parliamentary
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. Long queues formed outside Laiki’s cash machines. The branches were still not open. The banks started to limit the size of daily cash withdrawals, previously over €600. The limit eventually came down to €120. At Limassol port the cargo terminal began to back up with stranded containers full of imports that could not be paid for. Retail supply chains stopped functioning. Shops and restaurants accepted credit-card transactions at their own risk. Exporters of halloumi cheese could not pay their suppliers. Economists normally say an economy has ‘stalled’ if it has stopped growing. In Cyprus the economy had stalled in the truest sense of the word. It had stopped. It had suffered a heart attack.

Contingencies were being drawn up for capital controls in Cyprus, as they had been in Greece the year before. In essence Cyprus already had temporary capital controls with the announcement of multiple impromptu bank holidays. These six days of unplanned and two planned bank shutdowns – making for twelve consecutive days when the banks were closed, including weekends – were already an extraordinary development. The last time bank holidays had been announced in a European country in order to restore financial stability was in the wake of the collapse of the Austrian bank Creditanstalt in July 1933. (Latvia in 2008 was the only event in Europe that gets close, but that principally involved just one bank.) In the USA, such bank holidays had not been called since the Great Depression of the 1930s.

I wondered if the Eurogroup geniuses who had set the Cypriot bank run in motion had ever read Roosevelt’s ‘fireside chat’, delivered on the radio in similar circumstances exactly eighty years previously: ‘It needs no prophet to tell you that when the people find that they can get their money – that they can get it when they want it for all legitimate purposes – the phantom of fear will soon be laid.’ Thus, in a statesmanlike way, Roosevelt used the broadcast media to boost confidence and douse the flames of financial panic. Sadly, no statesman of similar stature emerged in Europe during the Eurozone crisis. In 1933 Roosevelt stopped bank runs by creating deposit insurance. In 2013 the Troika created pent-up demand for a bank run by stopping deposit insurance.

It should not be forgotten that Cyprus, two years before its financial collapse, was largely untroubled, fairly wealthy, and certainly not a basket case. A measure of this is the fact that after the financial crisis began to unravel in Greece in 2009, Greek depositors transferred €5 billion into the Cypriot banking system, believing it to be a safe haven. But then, on 11 July 2011, the Cypriot economy was hit by something entirely unexpected – a massive explosion.

In January 2009 the US Navy had intercepted a Cypriot-flagged, Russian-owned vessel in the Red Sea. It turned out to be carrying ninety-eight containers of explosives from Iran to Syria. The vessel was escorted to Cyprus, and the US government leaned on the Cypriots to confiscate the cargo. The explosives were transferred to the Evangelos Florakis naval base between Limassol and Larnaca on the south coast of the island, where they remained for two years in what turned out to be entirely unsafe conditions. In the early hours of 11 July 2011, several of the containers caught fire, resulting in an explosion so huge that it created a crater some 600 metres wide, destroying virtually the entire naval base, and killing thirteen people, including the commander-in-chief of the Cypriot navy.

The explosion also knocked out the nearby Vasilikos power station, responsible for generating half the nation’s electricity. The country was hit by blackouts, and in Nicosia, in the height of summer, the air conditioning was off for several weeks. Cyprus had to import power from the Turkish north. The losses incurred amounted to 12.5 per cent of Cyprus’s total economy, punching a large hole in the nation’s public finances.

Cyprus’s prospects were being determined by random man-made disasters, with their roots in the squabbles of larger powers. And an equally damaging version of the same story was playing out in Cyprus’s banks.

When, in relation to Greece’s financial crisis, Chancellor Merkel of Germany insisted on her policy of ‘Private Sector Involvement’ (PSI; see
here
), Greece’s subsequent effective default on its sovereign bonds cost Cyprus’s banks, such as Laiki, almost the same amount as had been raised in deposits: in 2011 Laiki lost €2.3 billion on its holding of Greek bonds of €3.1 billion, while BoC lost €1.9 billion. So the losses made on a single trade by two banks cost the nation nearly a quarter of its annual economic output.

As a former Cypriot finance minister told me, ‘This was not a natural disaster. It was obvious, it should have been very clear to bankers and the central bank. For Greek bonds for the two years before PSI [2009–11] – you could see a daily and weekly fall in their value. The signals were there. This is where the Central Bank [of Cyprus] is at fault. It let the bankers here gamble safety and soundness on a single bet where the risk was clear.’ The former government blamed the then governor of the Central Bank, Anastasios Orphanides, for a familiar trait of central bankers during the boom: an obsession with monetary economics and interest rates, and a neglect of prudential regulation of banks. Orphanides in turn blamed the old government for its persistent deficits.