Thursday, March 21, 2013

"Round Trips to Cyprus" - Prof. Paul Krugman

I wish I knew more about Cyprus, its economy and, above all, its financial sector. That's why I don't write about Cyprus (except for the recent 'stupidest and most potentially destructive Eurogroup decision since this crisis began three years ago', as Prof. Varoufakis correctly called it in his blog).

I wonder if those who write about Cyprus really know that much about its economy and, above all, its financial sector. Articles appear from time to time which bring to light entirely new aspects where one wonders why they haven't been brought up by those who took decisions and justified them.

For example, the Cypriot financial sector is unisono being described as 'overblown'. That is probably correct but there was a recent article which showed that if the Cypriot financial sector is overblown, you ain't seen nothing yet until you look at Luxemburg.

The Cypriot financial sector is unisono being described as being home to enormous amounts of black money from Russian oligarchs and that much of that money was invested in Greek bonds. Thanks to Prof. Krugman, I now know that Cyprus has being doing more with Russian money than only buying Greek bonds.

In his latest blogpost titled "Round Trips to Cyprus", Prof. Krugman explains that Cyprus is the single largest foreign direct investor in Russia! Here is what he writes:

"Still trying to wrap my head around the Cyprus situation; what makes it so interesting (as in “may you live in interesting times”) is the role of the island as a tax, regulation, and law enforcement haven.

It’s not just about the Russian connection, but that connection is really huge. Here’s another metric: Cyprus is, according to official figures, the largest single foreign direct investor in Russia — this from an economy roughly the same size as metropolitan Scranton PA. What’s that about? The FT explained it a while back:

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”).
And a key aspect of the current mess is that the Cypriot government isn’t willing to give up this business. That’s why solutions like converting large deposits into CDs haven’t been on the table; once round-tripping Russians know that they can find their money trapped for long periods, they’ll go find another treasure island.

My guess is that in the end Cyprus can’t reclaim the round-tripping business — and once it decides that it can’t, a resolution will become much easier. But they’re not there yet."

Well, that adds an entirely new perspective to the situation. How many other new perspectives might there be out there which should be considered before taking rash decisions about this, that or the other?

PS: and here is another blogpost from Prof. Krugman with a lot of sensible stuff.


  1. I definitely wouldn't say I "know" cypriot banking. Like most others, I'm just researching on the internet. I do know the island though, and have been following the developing stand-off on the bailout for a few months now.

    The bbc gave a good roundup of russian business reaction to cyprus.

    Two quotes I particularly liked:

    "[Izvestiya] also suggests that, as "Russia's financial kidney", the country's banking system also performs the useful function of dealing with money of dubious origin."


    "Considering that most of the funds transferred to Cyprus are dodgy, their owners understand perfectly well that should their assets be frozen, it will be quite problematic for them to defend themselves in court," Trud says.

    It sound like the russians themselves are pretty clear about what role the cypriot banking system plays in their economy, for all the talk in cyprus of them having rigorous controls against money-laundering.

    1. I have added a PS to the above article. Read it. Most interesting!

  2. Yes. Krugman has in that second column got beyond his habit of german-bashing, bathed in the data, and summarised concisely.

    For non-native speakers wondering about the headline: "Fubar" = "F*cked up beyond all recognition".

    Which does appear to sum up the situation quite well. Meantime, the ECB have for the first time made their ultimatum to cut ELA support public.

    Cyprus only has four days to put together any alternative, ratify it and send it off to the eurogroup. Not looking good.

  3. I am still intrigued by Prof. Krugman's statement that Cyprus is the largest direct foreign investor in Russia. Who in Cyprus is holding those investments? Two scenarios from my time in Argentina come to mind.

    First, Argentines held billions of dollars offshore in bank acounts. When they wanted to invest money in Argentina, they did not directly bring back their own money, fearing that, in case of trouble, the Argentine government might do something to their own money. So they asked banks to make 'pass-through loans' to Argentina: the lender of record was an offshore bank but in actual fact that bank was lending the Argentines' own money. The reasoning was that the Argentine government might mess with equity of Argentines but that they would think twice before messing with foreign lenders.

    In this scenario, the foreign bank had no credit risk. If the loan to Argentina would not get paid, it could take the money from the Argentine standing behind the 'pass-through loan'.

    The second scenario was the the Argentine would have the money in an offshore company and then that offshore company would show up as the foreign investor with the Argentine remaining anonymous. Again, the reasoning was that Argentina would be careful not to mess with foreign investors.

    What are the implications for Cyprus?

    If what Prof. Krugman talks about are really investments from Cyprus to Russia, they are investment and not loans. It is unlikely that banks would make investments. Instead, the investment would be made by a Cypriot anonymous company funded with its own liquidity. In this scenario, there would be no consequence on loans/deposits of Cypriot banks. Money comes in from Russia and returns to Russia.

    If those foreign investment were actually loans from Cypriot banks (backed/collateralized by deposits which Russians have in the name of a Cypriot anonymous company), this would be quite different. The Cypriot bank would have a loan to Russia but no risk. In case of trouble with the loan, it would make an offset to the deposit of the Cypriot anonymous company.

    Why is that important? Because the deposits shown in the balance sheets of Cypriot banks might not be 'freely available deposits'. They might serve as collateral for loans. If you cut those deposits, the collateral for loans declines and the bank's risk increases from zero to somewhere; something which the bank definitely does not want to do.

    So it would really be key to learn more about those bank deposits, particularly the question how much of those deposits are 'freely available, unencumbered deposits'.

    And the most interesting question would be: who are those Cypriot investors who show up as foreign investors on the Russian side?

    1. Very nice experience of yours. During the crisis a month Argentina before the country collapse around 23 b $ transfered to foreign accounts, i remember well? These was a huge mistake from banking authorities there which brought about bankrubtsy.

      the adress above in page 6/8 say that Luxembourg has 2500% the size of banking sector.

      When we impose rules (credible for me) in one country we should also watch if those rules will imposed as general principles everywhere?

      Or where there is a poor there is and his fate

      your wife will know! (όπου φτωχός και η μοίρα του)




  4. Fascinating stuff about Cyprus.

    In the meantime..

    "Eurozone economic downturn deepens. Purchasing managers’ survey dents hopes of early rebound."

    Damn, why doesn't the private sector borrow? And why don't these damn foreigners buy European products? Because the government must, MUST, run surpluses.

  5. More on Russian round trips to Cyprus and the British Virgin Isles, Round-tripping of Russian foreign investment via Cyprus

    CK (in Singapore)

  6. Interesting stuff, interesting thoughts.

    Following that FAZ-Article, Putin is in an interesting dilemma as well:
    On the long term he would like to dry up the cyprus tax heaven, but on the short term he dont want to get lost the russian money.
    If he would save the country, he would legitimize it as a tax heaven...
    "Mit deutschem Vokabular gesprochen ist Zypern eben so etwas wie Russlands marode Landesbank: Eigentlich wäre der Kreml froh, wenn es die Insel gar nicht gäbe und das Geld in Russland investiert worden wäre – aber es ist so viel Geld dort, dass der Schaden für die russische Wirtschaft durch einen „Untergang“ Zyperns immens wäre. Selbst wenn ein schwer zu beziffernder Teil des russischen Kapitals nicht aus legalen Quellen stammt, sondern aus Geldwäsche oder Steuerflucht. Aber hier geht es auch um den möglichen politischen Schaden für Putin, denn die Eliten, auf die er sich stützt, dürften keine geringen materiellen Interessen auf Zypern haben.

    Aber das ist eben längst nicht das ganze Problem: Russische Firmen, auch Staatsunternehmen, wickeln ihre Geschäfte über Zypern ab, wegen dem Marktzugang zur EU, Möglichkeiten zur (legalen) Steueroptimierung oder aus (nicht unbegründeter) Furcht um die Rechtsicherheit ihrer Gelder im russischen Heimatland. Putin hat diesen Offshore-Charakter der russischen Wirtschaft in letzter Zeit wieder lauter charakterisiert – und würde darauf am liebsten mit Verboten reagieren und nicht mit der Verbesserung der Standortqualität Russlands. Letzteres würde einen Reformelan voraussetzen, der im Kreml derzeit nicht beobachtet werden kann. Zypern zu helfen, ohne mit der Wimper zu zucken, würde Putins eigene Rhetorik konterkarieren.

  7. Perhaps also a helpful insight to the importance of cyprus for the inner-russian banking system:

    Banken geschlossen

    Inzwischen gilt jedoch vielen russischen Bankern nicht mehr das Gespenst der Zwangsabgabe als dringendstes Problem, sondern der Ausschluss Zyperns aus dem internationalen Finanzstrom. Alle Banken sind geschlossen, Russland kommt nicht an sein Geld. Die Rating-Agentur Moody's Investors Service schätzt die Forderungen russischer Banken an zypriotische Institute auf 12 Mrd. $ zum Jahresende 2012.. Dieses Engagement ist in den vergangenen Jahren stark gewachsen und nun so gross wie ungefähr 6% der Kapitalbasis des russischen Bankensektors (vgl. Grafik oben). Dieser ist stark zersplittert, und es darf vermutet werden, dass von den Hunderten kleiner Regionalbanken, die über das ganze Land verteilt sind, zahlreiche im eigenen Interesse oder im Auftrag von Privatpersonen und Unternehmen Geschäfte über Zypern abwickeln. Auch weil Bankgeschäfte in Russland sehr kompliziert sind, lenken viele im Lande tätige Firmen ihr Kapital über die «Clearing-Stelle» Zypern.

    Kapitalfluss eingefroren

    Es verwunderte deshalb nicht, als VTB-Chef Kostin am Donnerstag sagte, sein gegenwärtiges Interesse sei ein anderes: Zypern müsse so schnell wie möglich wieder den Zahlungsverkehr erlauben und die Abwicklung der Bankgeschäfte der Kunden zulassen. Nicht nur haben russische Unternehmen laut Moody's rund 19 Mrd. $ bei zypriotischen Banken placiert – auf Zypern domizilierte Firmen schulden Unternehmen in Russland (oft ihren Muttergesellschaften) enorme Beträge: Die Rating-Agentur schätzt sie auf 30 Mrd. bis 40 Mrd. $ per Ende des Jahres 2012 (bis zu 20% der Kapitalbasis russischer Banken).

    Normalerweise werden diese Gelder nach einiger Zeit wieder in ihre Heimat transferiert. Doch jetzt ist eine wichtige Station des «innerrussischen» Kapitalflusses eingefroren. Auch wenn Zyperns Banken wieder öffnen, könnte das Problem weiterbestehen – wenn gleichzeitig Kapitalverkehrskontrollen eingeführt werden, um einen Kollaps durch den zu erwartenden Ansturm auf die Guthaben zu verhindern.

    1. thanks. That's very interesting. It puts flesh around the phrase izvestia used a few days back:

      "Cyprus is Russia's financial kidney".

  8. Agreement in Cyprus the next hours?

    Mr Kastner why the plan for Cyprus does not include except from deposits, other types of invesments such as stocks or commodities ?


    1. I have just posted a new article at the end of which you can find Lee Buchheit's proposal for Cyprus. That is clearly by far the best one around and --- it includes no cuts whatsever.

      If you make cuts, you have to follow the risk awareness scale in the following sequence: shareholders, bonds holders, interbank lenders and professional depositors. The regular savers (i. e. up to 100 TEUR) must always be excluded from any cuts.

  9. sebastian_schroederMarch 25, 2013 at 5:53 PM

    Klaus, just a simple question. You know I am not from the business and also I have no special knowledge about Cyprus in particular.
    Cyprus is the biggest foreign investor in Russia, which means practically that money flows from Russia to Cyprus and back again. As I understood this works via companies that officially reside in Cyprus. Apart from the Russian aspect also plenty of German shipping companies (over 30) flagged out to Cyprus. As I understood those companies (Russian, German whatever) went to Cyprus for tax avoidance. Tax in Cyprus is 10% in Russia 20% in Germany 30%(?).
    Therefore from the 50 billion that flow back to Russia 5 billion did stay in Cyprus right? From the profits that the shipping companies made 10% stayed in Cyprus as well, and so on. Basically this must have ment an incredible amount of money available for the public hand. Since there was no need for Cyprus to reinvest this money into infrastructure, as the companies that reside in Cyprus don´t do business there practically, the question is where is all that money gone?

    1. Remember that I am mostly guessing since I haven't done any research at all on Cyprus.

      I don't think the state gets involved at all in the model you describe. I see 3 parties: the Cypriot investor, the Russian investee and the bank through which the money flows.

      Suppose the Cypriot investor has Deutsche in Frankfurt as his only bank. He has funds in that account from whatever source and he transfers them to the Russian investee. From the Russian view, the foreign investor is still the Cypriot company and not Deutsche. Chances are that the Cypriot company will not have Deutsche as his only bank because there he would have to declare the source of his funds.

      So let's assume the Cypriot company has the BoC as his only bank. Let's use extreme language and say he deposits black money there, i. e. money which he somehow got out of Russia unofficially. Once the money is in his account at BoC, it has become white money. That he transfers to Russia to the investee. Again, from the Russian side, the foreign investor is the Cypriot company.

      Now, if he transfers more money into his account at BoC than he transfers out of it, or if profits from whatever source go into that account, that money has nothing to do with the state. It is simply a customer deposit at a Cypriot bank. If that bank gets liquidated, he has lost his money.

      The only link I could see with the state is the following. The BoC has to do something with the liquidity in the company's account so that it generates interest income and can pay interest to the customer. If the BoC buys Cypriot bonds with it, then the Russian liquidity would indirectly finance the Cypriot state.

      Somewhere I had pointed out the downside of Cyprus's role as a financial center. The more the Cypriot banking system attracts by way of liquidity (particularly foreign liquidity), the more it has to lend. And the more it lends, the more risk it has. The Cypriot banks, so I understand, had lent a lot to the state of Greece. When those bonds were haircut, the banks took losses. Had the banks survived those losses, the Russian investor would never have taken notice of that. When the bank fails, the Russian investor indeed takes notice...

    2. sebastian_schroederMarch 26, 2013 at 11:42 AM

      Thanks Klaus, I think I got that. Basically its money shifting from one bank account to another with the state not beeing involved.
      However I think the EU made a cardinal error to condemn (destroy) the whole business model of Cyprus at once. They should have split it up in 2 parts.
      1. The unhealthy banking system with unnaturally high capital inflow and high interest rates which made risky investment necessary.
      2. The Tax Avoidance business, which I find annoying, but is in no way illegal.

      With the current measure plenty of "flagged out" companies will loose money from their business account. Money that they need to pay wages, materials, goods, customers whatever. As a result I would assume that they are not amused. They will cancel their office, take their 2-3 office guys and move to Luxemburg and alike. Not to speak about any new investors to be interested to move to Cyprus.
      However these "flagged out companies" did pay 10% tax unless they are shipping companies which are just paying a tonnage tax.
      It would be interesting to know how much money Cyprus makes with those "flagged out" companies. I would assume, that even if the EU would have granted the full 17 billion Euro, and Cyprus would have agreed to raise step by step the business tax from 10-15 (or 20%)% within the next 5 years the deal would have been possible. It would have kept Cyprus attractive enough at least to keep the current companies on the island.

    3. I have said it again and again and again --- the losers cannot simply be defined by the amount of money they have in the bank. The differentiation between survivors and losers must be made differently!

      For sure, savers under 100 TEUR should be protected. Not really for rational reasons (rationally, they could well afford a 6,75% charge because they earned to much above-market interest before). Instead, for reaons of principle, precedent and, I should add, of pychology. If Cyprus on its own made a deposit cut, it would be a Cyprus decision. If it does so with the Eurogroup's consent, it becomes a European decision. Even in Norway, people will wonder whether that could happen to them, too, some time. In short, deposit insurance is something no one ever should play around with.

      Those over 100 TEUR cannot be thrown into the same boat. They have to be differentiated by the risk awareness they can be deemed to have had. Bond holders, interbank lenders etc. can be deemed to have full risk awareness. That's the first category to hit. And then the depositors themselves need to be differentiated whether or not they are 'professional market participants' or not.

      Everyone should feel good when the loss is carried by those who knew that they entered a risk. Everyone feels lousy then the loss is allocated to those who could not be aware that they had entered risk.

  10. I was extremely pleased to uncover this web site. I wanted to
    thank you for ones time due to this fantastic read!!
    I definitely savored every bit of it and I have you saved as a favorite to see new information in your
    web site.