For sale: island with gas

A game of brinkmanship is now under way, involving geopolitics as well as economics, as Cyprus seeks to play one of its few remaining cards, the recent discovery of an offshore gasfield (see article). The outcome is difficult to predict. Having come out as a strong critic of the depositor levy, Vladimir Putin, Russia’s president, now needs to show he can protect the interests of Russian elites abroad, according to Alexander Kliment of Eurasia Group, a consultancy. That argues for stepping in to help. Yet in recent months Mr Putin has also launched a public campaign to bring Russian offshore assets home. Even if Russia were to provide extra support (besides a hoped-for extension of its €2.5 billion loan beyond 2016 and lower interest on it), Mr Putin would strike a hard bargain in trying to secure control over the gas.

Any Russian help might be unacceptable to the euro-zone rescuers. First, it would mean a big extension of Russian influence (though the time to worry about that was when striking the weekend deal). And second, Germany in particular would be loth to sanction Russian help in the form of a loan, since this would add to Cyprus’s debt burden and vitiate attempts to put it on a sustainable footing.

If Cyprus fails to get sufficient support from Russia (which, after all, turned down pleas for further help last year), then two other possibilities remain. The first is that the stand-off between Cyprus and Germany proves impossible to resolve. To show that Germany and other creditor countries like Finland, not to mention the ECB, can say “no”, Cyprus might in effect be expelled from the euro.

That would be a moment of peril for the euro area, which seemed to have rejected such a course with Greece last summer. There are arguments that Cyprus is too small (and its banks less entangled with the rest of the euro area, bar Greece) to pose a systemic risk. The ECB’s commitment to buy bonds without limit might be enough to stop panic erupting. But this would clearly rekindle many of the fears that were so pernicious last year.

The more likely outcome is one in which the Cypriots still take most of their punishment, though sparing smaller depositors. As The Economist went to press, Cypriot officials were frantically drawing up a “Plan B” involving everything from gas-backed bonds to church-owned land to raids on pension funds.

A great deal of damage is already done. The harm will be gravest for Cyprus. The European Commission recently forecast that its economy, which shrank by 2.3% last year, would contract by 3.5% in 2013. That now looks like wishful thinking. A Greek-style slide (Greece’s GDP has contracted by 20% over five years) seems much more likely. By sabotaging the deal’s original projections, which saw Cypriot public debt supposedly reduced to 100% of GDP by 2020, that is likely in turn to necessitate a second bail-out.

The damage will extend well beyond Cyprus. Creditors to weak banks in other beleaguered economies will take note of the treatment meted out to Cypriot savers. Although a bank run outside Cyprus is unlikely, deposits in southern Europe may start jogging out of the system again (see chart 2). That will hamper attempts to loosen the credit squeeze in the periphery.

Most of all, investors will take note of the noxious politics of euro-zone bail-outs. When push comes to shove, national politics trump aspirations like Europe-wide deposit guarantees. Despite attempts to portray the deal as another “one-off”, that lesson will not soon be forgotten.

From the print edition: Finance and economics

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