Cyprus: It's Not About the Money, It's About the Politics and the Precedent

Investors fretting about Cyprus may be getting the wrong impression from the massive fears emanating from the small island in the middle of the Mediterranean. For reference, Cyprus is an island about the size of Rhode Island in the eastern Mediterranean Sea, about 600 miles from Athens, or the distance from New York to Detroit.

Previous flare-ups of the EU debt crisis have centered around significantly larger economies: first the trio of Greece, Portugal, and Ireland, then later Italy and Spain. Compared to the draconian affects of a potential Spanish collapse, Cyprus is nothing.

So, what then, is causing markets to tank? This can be explained by two key reasons: the politics of the bailout and the precedent.

EU leaders are setting a nasty precedent for any future bailouts in the Cyprus deal. By requiring depositors to pay a levy on accounts of significant size, the EU is not looking recoup lots of funding. In fact, the EU is only looking for about 5.8 billion euros in total revenue from these levies to make the total bailout 10 billion euros. The remaining 4.2 billion euros would come from Troika bailout funds.

The size of this bailout is dwarfed by previous bailouts. Recall the Spanish bank bailout from this past summer: EU leaders agreed to lend Spain a whopping 100 billion euros to bailout its ailing banks. This dwarfs the Cyprus bailout ten-fold. Thus, the numbers do not reflect the magnitude of the market reaction.

But the precedent does... The precedent of taxing depositors, who used to be thought as sacred and completely protected in previous financing deals for Spain, Greece, Ireland, and Portugal, is one that should scare savers to their bones. No longer, should the deposit levy go through, are deposits safe in the EU, a consequence that will go well beyond the small borders of Cyprus.

One of the key problems of the EU debt crisis is the deposit flight from peripheral nations to core nations, mainly Germany. These flows can be seen in the changing Target II balances of each country, effectively the cross-border money flows between countries. Thus, by scaring savers away from crisis-nation banks, the EU leaders are setting a nasty precedent that could cause savers, not just in Cyprus, but across the PIIGS nations, to pull money out, further crippling the weak banks.

Second, the deal is simply about politics, in this case on two fronts. First off, European leaders due for elections, mainly Germany's Chancellor Angela Merkel, can not appear to continually be giving in and bailing out each nation; the political cost of each successive bailout is greater than the last for these leaders. Also, the levy could be a way of punishing the Russians for not getting a deal done in 2012.

In September of 2013, Germany is set to have parliamentary elections, which could pave the way for the future of how Europe deals with its future crisis fighting measures. Surely, Merkel's opposition will run on an anti-bailout, anti-Europe platform. Thus, Merkel cannot appear weak in these negotiations; she needs to show that no longer will Germany foot the bill for profligate states running budgets that were in the end unaffordable.

Thus, in order to lock up her majority for the upcoming elections, Merkel has to take a very harsh stance against Cyprus. She needs to show that Germany is not the bank for Cyprus, Greece, and the like. She needs to play politics.

Meanwhile, Merkel, and the rest of the EU leadership, could simply be playing hardball with Russia. Last year, Russia entered intense negotiations with Cyprus to extend the small nation a bridge loan to keep the banks afloat and prevent the exact situation facing Cyprus right now.

But why Russia? Cyprus is to Russian billionaires what the Cayman Islands are to American billionaires: an off-shore tax haven, and in this case, it also gives the Russians access to cheap euro financing, a key reason why many of the Russian shell companies operate out of Cyprus. In fact, Cyprus even gives EU passports from Cyprus to some of these investors and most of the signs in Nicosia, the financial capital of Cyprus, are in Russian.

Last year, Russia was discussing an approximate 5 billion euro loan to Cyprus to prop up the banks, with the EU giving the rest. Now, Merkel and the rest of the Troika could simply be forcing Putin's hand to pay up the 5.8 billion euros instead of forcing the levies. Putin would have to act in this scenario because his political career would be dead if he allowed the oligarchs in Russia to face the 10 percent tax on deposits kept in Cyprus.

Thus, a final deal will most likely incorporate some sort of financing from the EU as well as a bridge loan from Russia. The deposit levies will be wiped from the records and Cyprus will become the latest EU nation to succumb to the will of its creditors.