Moscow’s Mysterious Move on Cyprus

In today’s age of austerity it’s rare to hear a national leader defend offshore banking havens. But that was just what Russian President Vladimir Putin did last week when he denounced an EU-IMF plan to eviscerate private bank accounts in Cyprus as “unfair, unprofessional and dangerous.” Prime Minister Dmitry Medvedev called the move “outright theft” and some top Russian bureaucrats have even talked of punishing European companies doing business in Russia for their governments’ actions. “Moscow will be looking for ways to punish the EU,” Alexander Nekrasov, a former government adviser, told reporters last Friday . “There are a number of large German companies operating in Russia. You could possibly look at freezing assets or taxing assets. The Kremlin is adopting a wait-and-see policy.”

On one hand, Putin’s indignation is understandable: by the IMF’s estimate, Russia depositors account for up to 25 billion euros, a third of the Cypriot bank accounts over 100,000 Euros which will be frozen as part of a new restructuring deal agreed Monday. And many non-Russian commentators agree with Putin that raiding private savings risks undermining confidence in Europe’s banking system as a whole.

But what’s striking about the Kremlin’s spirited opposition to the raid on Cyprus’s banks is that the island is Russians’ preferred destination for hiding and laundering money. In effect, Putin has been standing up for the rights of Russia’s tax avoiders.

Cyprus’s loosely regulated banks, the ease of incorporating companies and a favorable double-taxation treaty with Russia have made the tiny Mediterranean island a lynchpin of Russia’s shadow economy since the early 1990s. Many large Russian corporations have subsidiaries incorporated there; much of the Russia’s steel industry is owned by Cypriot-registered companies (for example the Magnitogorsk Iron & Steel Works, built as one of the centerpieces of Stalin’s First Five Year Plan, is now owned by the Nicosia-based Mintha Holding and Fulneck Enterprises; Severstal, Evraz, and Novolipetsk Steel are also Cyprus-owned.)

While these arrangements may be perfectly legal, Cyprus has also been the center of many Russian tax avoidance scams that most certainly are not. The most notorious scam is known as “transfer pricing,” where a Russian company sold goods to one of its own subsidiaries based in Cyprus at a knockdown price, allowing the company to show zero profits or even losses to the Russian tax authorities. Meanwhile the Cyprus companies would then sell the goods on at market pricing, keeping the profits safely offshore and paying low Cypriot taxes on their gains. Oligarch Mikhail Khodorkovsky was jailed in 2003 for avoiding $23 billion in taxes on his Yukos oil company using Cyprus-based transfer pricing and other accounting scams (Khodorkovsky didn’t deny that Yukos used offshore companies to lower their tax bill—but argued that the schemes were legal at the time.)

Light regulation and a no-questions-asked policy quickly made Cyprus’s banking system a favorite destination for Russians wanting to take their money—both legal and illegal—out of the country. Foreign banks are not allowed to open branches in Russia (though they may open independent subsidiaries), and Russians remain wary of their own banking system after currency crashes in 1992 and 1998. By the Russian Central Bank’s estimate, around $350 billion has left Russia since 2008 (though capital flight from Russia is expected to fall to just $50 billion in 2013). Small wonder that by 2012, Cyprus’ banking sector had swelled to seven times the island’s GDP.

What makes Putin’s defense of Cyprus all the more strange is that the Kremlin has ostensibly been trying for the last year to “de-offshorize” the Russian economy. Earlier this year the Duma passed laws banning State officials from owning foreign bank accounts (though they did allow bureaucrats to own overseas properties.) And State-run media named and shamed several high-profile Duma deputies who had concealed luxury properties in Miami and Dubai in their mandatory declarations of assets.

Indeed last week it even seemed possible that Moscow, not Brussels, would come to the aid of Cyprus. The logic, on the face of it, was tempting: for a mere 10 billion euros, Russia could dictate terms to Cyprus’s financial sector and effectively create a convenient offshore satrapy inside the European Union. Ten billion is small change for oil-rich Russia—for the sake of comparison, last October Putin pledged a whopping $770 billion to boost Russia’s defense industries over the next 10 years. Yet in the end, Russia’s central bankers turned down the Cypriot finance minister’s pleas for a bailout, even as the Cypriots dangled a gas exploration deal as collateral. One reason is that the Cypriot government’s debts are already likely to top 140 percent of GDP by the end of 2013, according to the IMF. Another is that with the collapse of confidence in the island’s banking sector the chances of the Cypriots repaying Russian loans (they already owe Moscow 2.5 billion euros) seem increasingly doubtful.

In other words, the Germans balked at using taxpayer money to bail out Russian oligarchs—but the Russian government also balked at bailing out feckless Cypriot bankers. In the end the only concession Russian Finance Minister Anton Siluanov made to the beleaguered Cypriots on Monday was to agree to ease the terms of Moscow’s previous $2.5 million bailout to the island in 2011. Putin and Medvedev may have denounced the EU-IMF’s enforced “haircut”—but in the end they, too, were reluctant to subsidize the banking industry which has helped siphon billions of dollars from the Russian state. Whether the demise of Cyprus as an offshore center will help Putin curb his country’s rampant tax evasion and capital flight is another question.