Cyprus: It's All About Trade and Politics

Markets were shocked over the weekend when news of depositors taking it on the chin in the bailout of Cyprus leaked. The proposed bailout, although it looks increasingly likely to be revised to protect smaller savers, includes clauses that would make depositors in Cypriot banks pay a levy as a percentage of deposits in exchange for new equity in the Cypriot banks.Many are questioning the methodology of this sort of a bailout, or as it is being termed, a bail-in. However there is much more going on in the background. Cypriot banks are a unique case study of what happens when oligarchs taking advantage of tax havens flex political muscles only to see their efforts fail in the end.

Look at how the bailout process in Cyprus has evolved over the past half year or so: over the summer, Cyprus was seeking a bridge loan from Russia to fill a 5 billion euro capital void in its banks with the EU set to put up an additional 15 billion euros to make the total bailout 20 billion euros. However, negotiations broke down as Russian and EU leaders could not agree on a deal.

Many investors who do not know the nature of the Cypriot banking system may wonder just what Russia has to do with a small island in the Mediterranean. As many may or may not know, Cyprus was looked at as a tax haven for rich investors, specifically Russian billionaires, looking for a cheap, safe place to stuff money off-shore.

Cyprus fits the bill, as a peripheral EU nation with the safety of the euro as a backing a cheap tax rate on foreign deposits. In fact, many business signs in Nicosia, the financial capital of Cyprus, have bilingual corporate signs, both in the local language and in Russian.

So how does all of this play in to the bailout?

Well, there are two very intriguing aspects of the bailout story: the first based on the EU simply wanting to punish Russian leaders for not getting a deal done last year; the second simply acting as strong-arm political tactic to win better terms of trade with Russia.

As mentioned, many of Russia's billionaire oligarchs have parked cash in Cypriot banks, as reported by many news sources including Bloomberg. In fact, Cyprus' banking sector is seven times its GDP, well above the EU average of about 3 times and trumping the U.S., where banking assets are but a fraction of GDP.

Thus, the EU could simply be trying to force Russia to give in, to give up more money, to come to its side of the bargaining table. If the EU can prompt Russia to, in exchange for relaxing the levies on deposits, extend a bridge loan to Cyprus as previously discussed, then the EU could in the end remove the levies completely in exchange for Russian support in a bailout.

This makes sense two-fold: the Russian oligarchs have significant deposits in the banks so the EU should not shoulder the entire burden. Also, it brings back the previous proposal of a joint bailout between the EU and Russia.

However, the EU could also be strong-arming Russia for better trade terms. As of now, Russia is the second-largest exporter to the EU, behind China. Of the nearly 200 billion euros in imports from Russia by the EU in 2011, 82.9 percent of the imports, or about 166 billion euros, was from Russia's raw materials and energy exports. Thus, the majority of Russian exports to the EU were necessary raw materials with which the EU is not itself endowed.

After a recent, large trade deal, the EU could be back for proverbial seconds. In a search to secure cheaper or more amounts of precious and valuable raw materials, the EU could simply be strong-arming, forcing Russia's hand to protect its oligarchs, who hold much political sway domestically, to prevent these levies from being enacted.

The future is yet to be written. However, the mass corruption that surrounds this deal and the intricate links between the Cypriot banking system and the Russian elite raise many red flags and will make this entire bailout, or bail-in, process that much more complicated. Stay tuned for more details.