And now with an offshore tax twist.
Standard & Poor’s cut Cyprus to A- on 30 March (one day after cutting Greece further into junk). The risk is all about Cypriot banks’ exposures to Greece, especially in the two main lenders Bank of Cyprus and Marfin Popular Bank. S&P analyst Benjamin Young recently went a bit further, and stress-tested bank losses from a default.
The resulting numbers are enlightening to walk through.
Current and stressed exposures are summed up in this pair of charts (click to enlarge):
As can be seen, minus Greek shipping finance, there’s €28.3bn Greece exposure in Cypriot banks, or 156 per cent of GDP. All Cypriot banking assets total 925 per cent of GDP, so it’s quite a large proportion we’re talking about here. Actual bond holdings appear fairly small though, at €5.8bn.
The recoveries game, again
The stress here firstly involves Cypriot banks facing 10 per cent losses on their Greek loans. If that sounds familiar, S&P says it’s nearly identical to the assumptions used in Ireland’s most recent bank stress test.
But the projected Greek government bond losses are especially fascinating in their implications for other sovereigns bailing bondholders out post-default.
Now, S&P’s 50-70 per cent loss rates on defaulted Greek bonds correspond to the 50-30 per cent recovery rates embedded in Greece’s current rating. However, a 50 per cent recovery is also around where Greece credit default swaps are pricing right now, and is therefore quite a handy yardstick. Thirty per cent recovery from Greece is more like the Argentine or Russian defaults, for comparison’s sake.
What’s really striking, though, is how all this volatility in Greek recoveries has a disproportionate effect on rescue costs for the Cyprus sovereign. Recovering half from Greek bonds leads to Cyprus putting three per cent of GDP into banks both through recapitalisation or funding backstops.
However, recovering a third increases that to 10 per cent of GDP, taking Cypriot debt to 90 per cent of GDP, according to S&P. None of this factors in domestic loan deterioration in Cypriot bank books.
So yes, Greek contagion is very bad for Cyprus, and as damage from contagion increases, it seems to be exponentially bad.
Seeing as Cyprus is a eurozone state and all, there’s not a small possibility these costs will end up being borne by other member states, either.
It ain’t just Greece, though
But as we know from Ireland, when the banks are too big for the sovereign, you eventually get depositor flight – particularly from corporate or non-resident deposits.
Cyprus, like Ireland, has long been an attractive tax haven for these deposits. Non-resident deposits account for 144 per cent of Cyprus’ 2011 GDP, S&P says, when you include deposits from the subsidiaries of foreign companies channelling funds through the country for tax arbitrage purposes. In fact it seems to finance a good old chunk of the Cypriot current account.
S&P warns that such high external financing levels can turn out vulnerable in a crisis but also makes this absolutely irreplaceable insight on where the deposits originate:
More than anything else, what seems to drive nonresident deposit levels in Cyprus is the price of oil (see chart below); when oil prices are high, the levels of nonresident deposits in the Cypriot banking system increase. This link occurs through CIS [Commonwealth of Independent States] commodity-based shell companies that deposit transactional balances of their CIS-based legal subsidiaries engaged in oil, mineral, and metals exports, often involving transfer pricing and other tax minimization strategies. The Central Bank of Russia classifies Cyprus as the largest single source of FDI in the Russian Federation, with a total of $41.7 billion in cumulative inbound FDI into Russia’s non-financial sector between 2007 and 2010 (over 2.7x German levels)… Cyprus is also counted among the top FDI investing nations in several Central Asian countries (likely Russian capital reinvested via Cyprus, a process known informally as “round-tripping”).
Which rings a bell or two.
On page 249 of Treasure Islands, Nicholas Shaxson’s excellent book on the global offshore tax system, we find this interesting nugget:
Having gone out of its way to welcome wealthy Arabs in the 1980s and rich Japanese and oil-rich Africans in the 1990s, the City has more recently, with the help of conduit havens like Cyprus, aggressively courted Russian oligarchs, providing them with bolt-holes beyond the reach of Russian law enforcement. By April 2008 a hundred companies from the former Soviet Union’s Commonwealth of Independent States (CIS) were listed on the London stock exchange…
Small world or what.