Cyprus bail-in revisited: consequences for small economies

1. The news

European Commission draft documents leaked and released on the FT web site are offering a different picture from the previously released details of the bail-in.

First and foremost, in 9 days the bill has spilled over by EUR 6 billion amounting to a EUR 23 billion shortfalls to gap over a 3 years period. The additional burden falls on Cyprus, the total reaching EUR 13 billion.

Second, it will be entirely born by the deposit-equity swap at the new Bank of Cyprus (i.e. post acquisition of Laiki deposits), which nearly doubles to EUR 10.6 billion from EUR 5.8 previously: EUR 5 billion in 9 days (30% of 2012 EUR 17 billion GDP) is quite a number…

Third, Cyprus will sell “excess” gold reserves for a total consideration of up to EUR 400 million: I like the term “excess” in a world of ever devaluing fiat currency and “excess” represents 70% of its 13.9 t of gold! Since the leak, Cyprus has denied they intended to sale gold: what is contained in the report is an hypothesis, of course…

Fourth, bond holders under Cypriot law will be “encouraged” to roll over up to EUR 1 billion that mature until 2016, meaning that the EZ countries and the IMF will only provide EUR 700 million. In 2011 this “encouragement” was deemed by rating agencies (for whatever credibility they have) to lead to a selective default (rating agencies must have learnt from politicians rhetoric: one meets its commitments or one doesn’t; “selective” is bullshit), not talking about a credit event for CDS. Why what was meant to apply to Greece would not for Cyprus?

Fifth, like all assumptions made about Greece by the EU, the ECB and the IMF proved wrong, these will prove wrong for Cyprus: the economic situation will worsen much more than expected the 8.7% real GDP fall in 2013 and 3.9% in 2014. The debt/GDP ratio will go way above 130% in 2015, and not the 126% projected.

2. Cyprus other route

Cyprus lost its independence, like any over indebted country will, France included, not being able to meet its commitments.

To lose its independence, Cyprus had a better course of action: quickly negotiating joining a ruble zone and offering Russia a naval base in Cyprus plus offshore gas rights. Cyprus would have lost its independence but Cypriots would have been better of.

Geopolitically this would have been a coup for Russia: it will loose its naval base in Syria and would have replaced it with an even more strategically positioned one. Russia would also have enjoyed privileged access to Cyprus gas, further surrounding the EU. This also would have open the way for other disappointed countries with the EU to join the fray like Serbia; and eventually why not Greece. The Orthodox church is a powerful cultural and historical link between all these countries.

Cyprus cannot be kicked off the EU (well, European politicians and eurocrats are used to twist and carve treaties and laws to their own advantage), and therefore it would have allowed Russia to have a foothold in the house.

In any case, this would have been a trump card in the hands of Cyprus in its negotiating positions with the troika.

3. The future of small countries

The crisis has demonstrated that all countries in the EU are not equal in rights despite what is claimed (not surprising, it has always been the case: big boys bullying feeble ones). Rules do not apply the same way depending on size: France has hardly ever abided by Maastricht criteria, and always got away unarmed (we are nearing the end of it, since eventually facts are always right over rhetoric). Greece was slammed (they lied, so they got what they deserved), Cyprus walked over and Luxembourg is bullied.

Cyprus and Luxembourg are criticized for over relying on the financial sector. I do not know what makes Germany, France or the US to impose a business model to small countries whose size limits their ability to enjoy a well diversified economy. If they do not like money fleeing, they should offer a fiscal environment where money is happy at home: there is no tax haven if there is not tax hell. With France’s banks over 3 x GDP (more or less Cyprus post bail-in), the financial sector is much too leveraged. In the case of France, the media are increasingly reporting that young educated French national are going abroad to find a job (40-50,000 in 2012 – when one calculates the heavy cost of education and no return from those leaving the country, it will become unbearable at some point). These larges countries should first put their home in order before lecturing others. A few examples: Delaware money laundering machine where the beneficiary owner of a company does not need to be disclosed or the specific local laws that make it very difficult to get rid off an incompetent board or special protections against takeovers; France with its free zones, special tax treatment of Corsica or no income tax in French Polynesia to name a few; and what about the UK with the Channel Islands, The Netherlands with its holding tax efficient regime, etc.

Small to medium size countries where the financial sector allowed them to prosper are increasingly subject to bullying from large ones, the latter specializing in finding scapegoats for their own economic sins.

We are entering a world where democracy is much talked about as never before, but where reality contradicts the words. Small European countries beware, you have been warned.

Source:

European Commission: Assessment of the public debt sustainability of Cyprus

http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf

European Commission: Assessment of the actual or potential financing needs of Cyprus

http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/Estimate-of-financing-needs-ESMT-art-13-v09042013-1.pdf

Reuters: Cyprus to sell around 400 million euros worth of gold

http://uk.reuters.com/article/2013/04/10/uk-cyprus-bailout-gold-idUKBRE9390NW20130410

Tax Havens, Politics and Scapegoats (3/3)

Scapegoats

On the question of transparency, which seems to be central to discussions regarding tax havens, the OECD established a Framework for a Collective Memorandum of Understanding on Eliminating Harmful Tax Practice where:

Each party will ensure that its regulatory or tax authorities have access to information regarding beneficial owners of companies, partnerships and other entities organized in its jurisdiction, including collective investment funds, and to information on the identify of the principal (as opposed to agent or nominee) of those establishing trusts (settlors) and foundations under their laws and those benefiting from trusts and foundations.

Clearly, the State of Delaware in the US does not comply.

The very interesting study conducted by Bruce Zagaris, a Partner of the Washington based law firm Berliner Corcoran & Rowe, demonstrates the double standard applied:

Some U.S. states, such as Alaska, Delaware, and Nevada, have enacted asset protection laws to attract persons, especially foreigners, seeking protection from creditors. (…) Delaware has advertised that its new trust law ensures “confidentiality of information and records.”

At least two other states, Montana and Colorado, have offshore banking laws designed to attract foreign investors by offering tax exemptions, confidentiality, and ease of establishing accounts and doing business. (…) especially the fact that Colorado's was enacted in 1999, after the release in May 1998 of the OECD's initial report on harmful tax practices.

(…)

The state of Delaware also is trying to attract business based on its laws and reputation as a domicile where corporate debtors can quickly obtain bankruptcy.Virtually no OECD country requires corporations to keep ownership information on file with a central or other governmental authority on a routine basis, except for certain types of corporations, although the OECD HTC MOU requires the targeted countries to do so.

Interesting enough, On June 23, 2008, Brazil's Congress published Law 11,727/2008, which, effective as of January 1, 2009, will amend Brazil's transfer pricing regulations and expand the legal definition of tax havens. The surprising news in all of this is that it is widely believed that these changes were made specifically so that the exotic state of Delaware could be designated as a tax haven, or at least a jurisdiction with the characteristics of one.

Paul Mason, from the BBC, analyzed what happened at the G20 meeting in London regarding the OECD list. It appears that last minute negotiations occurred between Sarkozy, Hu and Obama not to include Macau in the grey list of the OECD. But, hold on, wasn't it the OECD that was establishing the list independently...? This BBC story is worth reading!

So, all countries attending the G20 meeting escaped in one form or another to be named and shamed, whilst the usual small countries were used as scapegoats for the crisis. Making the public (read the voter) thinking that tackling tax havens and putting them under the control of large deficit countries will solve the crisis, is ludicrous.

Clearly tax havens make tax hells losing tax receipts; this is however a drop in the ocean of accumulated budget deficits over the years from lax budget spending (voting bribery?) and poor public governance, governance hailed however by the very same politicians as the new Graal of the New World Economic Order (don't misread: I very strongly support governance in general and corporate governance in particular as well as I believe its lack of it is one of the roots of the financial crisis).

In addition, imagine what would happen to tax rates, if low taxation jurisdictions did not exit. Already, The US, the UK and Ireland announced an income tax increase; this is only the beginning of the tunnel. And why blaming countries that are managing their budget in a proper way and do not need punishing taxation?

What to conclude?

First, China showed once again its power on the international stage and will become more and more assertive
Second, Continental Europe is firing a bullet in its foot as usual: the reading of the OECD list is self explaining.
Third, the US and UK continue successfully to divert attention away from their backyard: do what I say and not what I do...
Fourth, the G20 meeting and the preceding negotiations about the OECD list showed the lack of transparency and governance from countries that insist on them, and discredited the OECD.
Fifth, Large countries found their scapegoats: small, well managed countries that offer high living standards to their populations; instead of following their path, they point the finger at them as responsible for the financial crisis (one of the two causes of the crisis was outlined by President Sakorzy in October as being tax havens - a joke! -).

Tax Havens, Politics and Scapegoats (2/3)

Politics

It seems that we are going towards the legitimation of the the strongest, biggest financial centers and tax havens while smaller countries and territories are stigmatized.

Indeed, the OECD found that its definition caught certain aspects of its members' tax systems (most developed countries have low or zero taxes for certain favored groups). Its later work has therefore focused on the single aspect of information exchange. This is obviously a flawed decision. This single criteria for defining a tax haven is inadequate and goes against common sense, but is politically expedient because it includes the small tax havens (with little power in the international political arena) but exempts the powerful countries with tax haven aspects such as the USA and UK.

For example one of the most permissive location for business is the State of Delaware in the US (where Joe Biden, the current Vice-President, was a senator). Let’s review it quickly:

• 43% of companies on the NYSE are incorporated in Delaware (over 400.000 companies i.e. +/- 1 company for 2.5 inhabitants and growing)
• Significantly low income tax levels (below 6%)
• No need to disclose the beneficial owner of assets (Delaware having passed the test of transparency, no jurisdiction should be included in the OECD list)
• Partnership taxation laws which make it favorable to non-US entities, typically allowing taxation at 0% where the partners are registered in non-US jurisdictions
• Anti-hostile takeover legislation and strong protection of companies’ management
  

If you want more detailed information, go to the State of Delaware official website

To summarize and according to the State of Delware web site:

"Corporations choose Delaware for the following reasons:

1. Ease of incorporating,
2. Business-friendly climate,
3. Fast services provided by the Secretary of State's Office and
4. Delaware's Court of Chancery. (Our Court of Chancery is well known for its ability to issue timely decisions on complex corporate matters, and its wealth of case law ensures consistent answers to corporate questions.)
If you form a corporation in Delaware, you are required to pay an annual Franchise tax to the Delaware Department of State for the privilege of incorporating in Delaware. Franchise Tax is based on the number of the corporation's authorized shares and costs a couple of tens of dollars."

Funny enough (well, not so funny) the Delaware Statutory Trust has been widely used for structured finance deals such as asset securitization.

Let’s review the politics during the G20 meeting and their interaction with the OECD list.

Tax Havens, Politics and Scapegoats (1/3)

Tax Havens

The G20, hailed as a success, was nothing more than a political gathering aiming at communication (see post "G20 summit and today's markets" April 2), the most for the French President, Nicolas Sarkozy, who threatened to walk away if he did not get what he wanted: tax havens MUST be scrapped since Sarkozy, in October 2008, identified them as one of the two causes of the financial crisis...

Here we are. The OECD published on April 2 a list of non or not co-operative enough countries or supposed to be. Funny enough, Uruguay, Malaysia and Philippines were on the black list: didn’t you know that these countries were tax havens? (they were moved, together with Costa Rica from the black list to the grey list on 7 April). Didn’t you also know that Hong Kong, Mauritius, Dubaï, Saint Barthelemy in the French West Indies or Delaware in the US to name a few were not tax haven?

Funny enough, the OECD makes a distinction between tax havens and other financial centers: are they tackling tax havens or something else? We will see this later on.

In any case, the credibility of the OECD has zoomed down to zero!

Remember, the fight against tax havens took a boost after 9/11; it was aiming at fighting more efficiently Al Qaieda and money laundering from crime in general.

Let’s go back to 1998 when the criteria where laid down by the OECD to pinpoint a tax haven. There are three criteria (the absence of a requirement that the activity be substantial was abandoned by the OECD in 2001):

1. No or only nominal taxes. Tax havens offer themselves, or are perceived to offer themselves, as a place to be used by non-residents to escape high taxes in their country of residence
2. Protection of personal financial information. This prevents the transmittance of information about taxpayers who are benefiting from the low tax jurisdiction.
3. Lack of transparency where one country can make it difficult, if not impossible, for other tax authorities to apply their laws effectively

In the next article you will discover how politics melted in.

G20 summit and today's markets

Markets reacted very positively to the G20 announcements (full press release). In essence:

• More regulation and overseeing of the finance industry, and for the first time hedge funds
• More money ($1.1 billion in all), in particular to the IMF that will treble its available resources to $750 billion and see its role strongly reinforced
• More transparency with tax havens

The rest is rhetoric and we will see how the details of today's decision develop. I however note that the reasons for the crisis (lax monetary policy, over indebtness, poor governance and incompetence) were in no way dealt with in the communiqué nor the solutions to cleanup banks balance sheets; this is left to each country to decide.

• More regulation is still vague on its form and implementation, whilst regulators should have done their job right in the first place: why should they be better in the future? I feel we need better regulation, not more regulation.

• More money? Fine, this will bring more well paid employment to Washington. At least it will leave governments not directly involved in baling-out some countries in Eastern Europe and elsewhere. After all, when one sees the disunity in Europe about the subject, it is politically easier and probably more efficient to let international organisations take care of it. Remember nevertheless that the $1.1 trillion (1) is not funded (2) will be spread over 2 years and (3) represents +/- 5% of all money committed by States individually and collectively as well by international organisations. However, this probably is the most interesting part of the summit.
  

• More transparency with tax heavens? Luckily the conference took place on the 2nd of April, but what a joke! The well-timed publication of the OECD progress report on tax heavens (dated April 2) would be quite fun if the matter was not serious. I could not find the Delaware and Nevada (US), St Barthelemy (France), Hong Kong and Macao (China), or Dubaï, and the list is far from exhaustive. Governance and equity should start with Head of States. True, politicians are back in force, and I am afraid, this is not good news for the future.

I am therefore not as enthusiastic as most commentators (where they waiting for the worse after postures played by some countries like France? - usual politician tactic to make sure they will show to their public (1) the conference is a success and (2) each of them is the victor). I however do not dismiss that the rally will continue for some time since the Conference did not end up in shamble.

Markets reacted positively to the summit, extending their early gain in Europe with Germany up +6.07% and the UK +4.28%. The Dow passed the 8,000 mark but did end up at 7,978, +2.79%.

The ECB surpised with a 25 b.p. rate cut to 1.25% vs a 50 b.p. the market was expecting. At the press conference, ECB president Jean-Claude Trichet did however say that the current level is "not the lowest limit", suggesting at least one more 25 b.p. cut.

The EUR rallied vigorously ending the day +1.7% at 1.3463.

Precious metals were under pressure with markets rallying and the G20 meeting announcing the sale of gold (limited amount however at approximately 5% of IMF holdings). Gold ended down 2.3% at 905.33/oz, off the lows of the day ($895.25/oz).