The Shadows of Cyprus
by Steve Visscher, Mawer Investment Management
I travelled to Cyprus about ten years ago. It’s about twice the size of Prince Edward Island and home to approximately one million people. Life seemed simple in Cyprus. Food was fresh and the Mediterranean views were spectacular. From what I could gather, tourism and agriculture were the primary means to earn a living. Playing chess or dominoes were popular ways to spend the evenings. I haven’t heard much about Cyprus in the last 10 years…until the last week. What happened?
Put simply, Cyprus is facing the same harsh reality that some of its larger EU members have faced. The government has been spending far more than it was collecting and the nation’s financial institutions were in need of a bailout. The EU, ECB, and IMF came to the rescue, but their assistance came with stipulations. Cyprus would have to raise funds and share the burden of their financial largesse. Policymakers proposed that Cyprus should impose a tax on all bank accounts within the country. As expected, politicians in Cyprus found this condition to be unacceptable, and at the time of writing, they are negotiating modifications to these conditions.
Global equity markets declined immediately after this news emerged. Though Cyprus is a relatively insignificant player in the EU economy, investors were concerned that this tax on bank deposits might be imposed on other EU countries. Naturally, this threat would dissuade citizens from holding deposits with financial institutions domiciled in troubled countries. The withdrawal of these deposits would simply exacerbate the challenges that these financial institutions already face.
But does the potential imposition of a tax on bank deposits in Cyprus signify that European policymakers intend to impose similar conditions for other countries?
We’re not so sure. A research report from National Bank estimated that Cyprus has the 2nd largest shadow economy in the Eurozone, with an estimated 26% of its GDP derived from activities that circumvent or avoid government taxation. In layman’s terms, cash only transactions are common in Cyprus. So asking Cyprus to raise funds by imposing higher sales or income taxes not only misses this significant component of their economy, but may just drive more activity underground. If your ability to enforce tax legislation is weak, then imposing a tax on bank deposits may be a more effective way to share the burden.