A Historical Perspective of Cyprus’s Banking Sector

After reading statement after statement from EU officials on Cyprus these past two weeks, one thing seems pretty clear to me: They loathe Cyprus’s large financial sector.

This reminds me of their ire over Ireland’s 12.5% corporate tax rate. Recall, when Ireland negotiated its bailout, German and French officials did all they could to force Ireland to raise its coveted rate. German Finance Minister Wolfgang Schäuble told his fellow fin-mins Ireland’s low rate “can’t stay like this,” arguing it was necessary to raise public revenues. But the more they all talked, the more their true feelings became clear: Ireland wasn’t playing fair. The low rate was “uncompetitive” with the rest of Europe, and Ireland should “harmonize” it near the prevailing eurozone rate. Handicap itself, level the playing field, and stop hogging all the multinationals—let everyone else share in the financial rewards of foreign investment.

Fast forward to March 2013, when Schäuble let the world know Cyprus’s model of “attracting capital with low taxes and lax regulation” doesn’t work. The problem, to him and others, isn’t just that Cyprus has a bloated financial sector whose banks made imprudent decisions—the problem is the sheer amount of foreign capital. In their view, I suspect, by offering easy tax treatment and a light regulatory environment, Cyprus wasn’t playing fair with the rest of Europe. And much like they wanted Ireland to raise taxes in the name of fair play, they want Cyprus and the eurozone’s other financial havens to handicap themselves—synchronize taxes and regulations with the rest of Europe to promote a more equitable distribution of foreign capital. Or, more simply, stop hogging all the foreign money.

And so eurozone officials’ distorted view of competition is once again laid bare. They either can’t or won’t understand why countries would want to better themselves. If they actually stopped and considered Cyprus’s motivations, I suspect they just might champion its tax and regulatory model.

Put yourself in Cyprus’s shoes circa 2002. You’ve had a rocky history—at times you’ve been occupied by the Assyrians, the Egyptians, the Romans, the Byzantines and the French. The Ottomans invaded in 1571, and you spent 300 years under their thumb. The Brits took over in 1878, and you didn’t get your precious independence until 1960. But 14 years later, the Turks invaded. The conflict devastated many communities, and Turkey occupies the northern half to this day. For 39 years, you’ve had a divided land with an occasionally violent demilitarized zone bordering your capitol. As a result, you’re not the most attractive target for foreign investment.

Still, economically, you get by ok. Because your island is really a big rock, you can’t produce enough food to feed everyone, but you have strong trade relationships with Mediterranean and European countries, so you can import everything you need. You have few natural resources, but you do have one big asset: the sun. British and other tourists love escaping the rain for a few weeks, and you’re their most logical destination—traveling to your sunny island is easier and cheaper than jetting to the Caribbean. Thanks to tourism, you have a pretty decent services sector.

But there’s a downside. Tourism’s pretty volatile, and it doesn’t promote much domestic investment—it’s not really a high growth industry. Business investment popped in the 1970s and 󈦰s, but it fell back in the 󈦺s. Your government at the time tried to compensate with higher state spending, but that model’s hardly sustainable—you need more viable domestic commerce in order to keep growing over time.

So you do the smart thing and deregulate. Slash your corporate tax rate from 25% to 10% to attract more businesses, and you free up your financial sector. You also sign more than 20 treaties abolishing double-taxation on Cypriot investments—now, foreigners are free to invest in your country and repatriate the profits tax-free. These changes help foreign investors look past the internal strife and realize you’re a pretty darned good place to invest. Sure, they don’t all actually invest in Cypriot businesses, but even those who simply deposit their money in your banks help out—the growing banks help support your entire economy and provide a key source of jobs. And sure enough, private investment in Cyprus skyrockets over the next few years.

Simply: Deregulation and a favorable tax code enabled Cyprus to remain economically viable—exactly what eurozone officials should want for every member-state. If they’d forced Cyprus to “harmonize,” they’d have robbed it of the chance to grow over the last decade, and they’d force every Cypriot to have an inferior quality of life.

And now, by forcing measures that hollow out Cyprus’s banking sector, eurozone officials are likely disabling its near-term recovery and condemning the nation to several very difficult years as it tries to shift from a financial services-based economy to something else, like energy. Such shifts should never be engineered by force—especially not in a free society. The eurozone’s strongest when every member-state can compete and grow freely.

But officials don’t see this—now they’re too busy finger-pointing at the eurozone’s other financial havens, Luxembourg and Malta. A word of advice: Instead of trying to force other nations to handicap themselves, look at their motivations and applaud them for doing their best to grow and compete with the rest of the world. And then, make yourselves more competitive, too—then everyone wins!