Developed countries like New Zealand can learn from Cyprus; an economy overly dependent on its financial sector rather than the real economy, is vulnerable. And the rule of law exist in our minds as much as it does in laws, courts and banks. It’s like a handshake. If one sides looses faith in the deal, doesn’t matter how many law enforcers you have, the system collapses.

Does anyone really understand what the hell just happened in Cyprus? 

Disaster appears to have been avoided today with a ‘Plan B’ agreed. The draft deal, cobbled together over the weekend would see bank deposits under $100,000 untouched but the country’s second biggest bank close. It still has to be approved by euro zone finance ministers.

I’m not sure the global heart beat has dropped yet.

Footage of people who dress like us (ok, better than us) queuing to get their money out of ATMs because banks have shut up shop has been uncomfortable viewing. Especially as Cyprus had a relatively healthy per capita GDP compared to the rest of Europe before the crisis.

Then there were the ‘Hollywood’ scenes of the British government using its biggest Royal Air Force plane, the Voyager, to airlift about $1.3 million euros into Cyprus - not to save the small country you understand -  but to pay British soldiers stationed there, who risked missing a pay cheque.

This was the first time that the EU and the IMF thought it would be a good idea to ask people to dip into their own private savings to pay for a bailout. Cypriots said ‘buggar off’. They refused to accept that the centuries old distinction between private property and communal property in Europe should disappear.

 Bloggers like Barry Ritholtz argued that a ‘haircut’ on private deposits wasn’t such a bad thing. Local depositors would lose more money if Cyprus left the eurozone and their currency was devalued, he argued. Time to take a chill pill :

“Ask the Venezuelan depositors who had their currency devalued more than 40 percent a couple weeks ago. Then compare to the 6-10 percent deposit tax.”

But the Cypriot government couldn’t get people to accept that one of the most important articles of faith in societies like ours would be broken - that if you put your money in the bank it will be safe.

Cyprus and New Zealand are very different countries. Cyprus has been occupied by everyone from the Ottomans and the Egyptians, to the British; it’s been torn apart by civil war for decades (between the Turkish North and the rest of the Republic of Cyprus), and it has been hit hard by contagion from the Greek crisis.

In 2004 Cyprus joined the EU, and the Euro in 2008. At the time, the future looked good.

“For a small, open economy like Cyprus, Euro adoption provides protection from international financial turmoil”, said Jean Claude Trichet, the head of the ECB at the time.

 (cough).

So what went wrong? 

The success of all developed countries, including New Zealand, rests on trust that the rule of law will apply. If I pay my taxes, government officials won’t steal it. If someone owes me money I can take them to court to get it back. If I put money into the bank, the bank won’t use it to fund a bail out. The system works, not just because we enforce the law, but because we all believe the system works. Once that trust is broken, the house of cards falls down, and it doesn’t matter how many rules you have or cops on the beat, people panic and chaos follows.

No matter what the final Plan B looks like, people in Cyrus have lost faith in the banks.  

This is a disaster for the Cypriot economy. Rules and regulations matter, whether in New Zealand or Cyprus. Investors won’t take a punt on a country knowing that the rules of the game could change. That’s why the whiff of dodgy deals around Sky City matters. Perception that the rule of law applies or doesn’t, is reality.

People lost faith in the banks in Cyprus because they fell over. They fell over because of their over-dependence on Greek government bonds which went bust, and because the Cypriot economy was a disaster waiting to happen.

George Kerevan  in the Scotsman describes pre-crisis Cyprus as a giant off-shore tax-haven. “A sort of Switzerland with sunshine.”

French Finance Minister, Pierre Moscovici called it a “casino economy”.

Russian money in particular had flooded in, taking advantage of its tax-haven status. The financial system grew, and soon out-weighed other productive parts of the economy, like natural gas. The banks had to invest all that Russian money somewhere, so they brought up Greek bonds. Bad decision.

The disproportionate size of the financial sector made the economy vulnerable, and when the banks collapsed catastrophe hit.

Now Cypriot tax payers are being asked to pay to protect the bank deposits of wealthy Russians.

What happened to John Key’s idea to promote New Zealand as a financial hub for the world? Here’s hoping that idea never sees the light of day. 

Cyprus has shown us that financial sectors should exist to support the real economy (the industries and businesses that make stuff and create jobs). It should not be seen as a pretend sector in its own right.

It’s a shame that the financial crisis hasn’t been used as an excuse to clean up tax havens across the world. If global leaders focused on that as much as they focused on multilateral trade deals, we’d go a long way to stop Cyprus type chaos happening again. 

 

According to development economist Paul Collier, if you stopped corrupt African leader syphoning off the proceeds of oil and natural resources into Swiss bank accounts, developing countries would be better off by many millions of dollars.

The legacy of the Cyprus crisis is unknown. The Economist magazine has argued that the Cyprus crisis should be used as a excuse to introduce a united European banking system, which would create more confidence across the region, and therefore more investment.

What is alarming for countries like New Zealand is the lack of a strategy from the EU to deal with situations like Cyprus. Didn’t they see this coming? As Reuter’s Felix Salmon says, the response has been ‘all tactic and no strategy’ 

‘...and the tactic is a dreadful one: wait until the last possible minute, and then do whatever’s most politically expedient at the time. It’ll probably work, somehow, in Cyprus. But it won’t work forever.’

For that reason alone, countries like New Zealand should care about what happens in Cyprus.