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Europe, Cyprus and Russia Playing Deadly Game of Chicken

Stocks and currencies continued to see-saw today based on the latest news (or even rumors) coming out of Cyprus. Plan A (the EU led bailout with haircuts for depositors) was rejected by the Cypriot Parliament; Plan B (magic money from Russia) has been, so far, rejected in Moscow; and Plan C (magic money from the Moon?) obstinately refuses to take shape. So we seem to be headed back to a Plan Cy, which is really a modified form of Plan A, a European-led bailout with some sweeteners for small depositors in Cyprus.

Maybe. A lot of stock traders seem to think that the crisis is just brinkmanship, and that someone—the Europeans, the Russians or the Cypriots—is going to blink before the Cypriot banking system vanishes in a puff of sour-smelling black smoke on Monday when the ECB pulls the plug on the liquidity infusions that have been keeping Cyprus’ financial system just this side of death. Or maybe, traders hope, even if Cyprus goes, the aftereffects will be small.

The basic truth here is that nobody wants to throw good money into the Cypriot financial system. The EU doesn’t want to bail out Russian oligarchs, Russia doesn’t want to lend more money to the country whose dumb financial decisions (Cyprus banks invested heavily in Greek bonds, the poor boobies) have created a major financial crisis. And Cypriot savers don’t want to pay the costs of the bad financial management and regulation that have turned their local banks into the laughingstock of Eurasia.

As a result, Cyprus has been wandering from pillar to post looking for a fairy godmother willing to wave a magic wand and turn its pumpkin of a banking system into a beautiful, glittering coach.

A quick recap of where we stand: Last Wednesday, after having rejected the EU’s scheme to force savers in insolvent banks to take part in a “bail-in” (a delicious euphemism for a mandatory tax on people’s savings), Cyprus embarked on a search for a “Plan B.” The quest involved all sorts of schemes, many involving the Russians. There was talk of a bond sale against future profits of untapped offshore gas fields, with Russian Gazprom figuring prominently in the deal. (The FT‘s Nick Butler threw a bucket of cold water on the gas deal earlier in the week.) There was also talk of Cyprus’s two largest illiquid banks being hacked apart and reconstituted, with all of the “good” assets going to a bank in which Russians could then invest.

Yesterday, the EU rejected those machinations as insufficient. EU and Russian policymakers appeared to be coordinating on this. The FT writes:

In remarks that seemed a departure from aggressive rhetoric earlier in the week, Dmitry Medvedev, the Russian prime minister, appeared to sanction the EU’s exclusive leadership of the Cypriot situation.

In a joint press conference with José Manuel Barroso, president of the European Commission, following a two-day summit between Russia and the commission, Mr Medvedev said: “We have not closed the door. We have not said we are not willing to discuss anything, not willing to hear anything . . . But we are ready to discuss different versions of support for this state [Cyprus] . . . only after a final scheme is developed with the participation of the states of the EU and Cyprus.”

So much for “Plan B”, then.

None of this is to say that Europe’s performance in this crisis has inspired confidence. Barroso’s impromptu two-day summit with Medvedev shows that, as has usually been the case, the EU is in crisis control mode, careening from precipice to precipice, just barely avoiding falling off the edge. Yes, the Russians appear to be to sitting tight as the Cypriot parliament debates the latest proposal, wherein up to 40 percent of Russian deposits would be used to recapitalize the banks, but it’s not at all clear that Moscow is ready to take this kind of treatment lying down.

Russia’s strategy is murky—which is probably exactly the way the Kremlin wants to play this. On the one hand, Russia is refusing to help the EU solve the problem by offering more money; on the other, it is rejecting the EU’s demands that Russian depositors in Cypriot banks take large hits. Some think the Russians have fecklessly misplayed their hand. Alternatively, as Felix Salmon suggests, the Russians are pushing for a Cypriot collapse, after which Russia can step in as a white knight and pick up what’s left of the country at a bargain price.

Cyprus itself is a strange place. It’s a small island, but its Greek inhabitants (the only ones involved in the current financial meltdown, as the Turks on the island are under a breakaway government without international recognition) are used to staring down the world. The UN, the EU, and the US all begged the Greek Cypriots to compromise their issues with the Turks; Cyprus said “no deal.” Cyprus is in a tight spot, but the Greek Cypriots seem to like their large, deeply shady, and until very recently extremely profitable financial sector. They know that an inglorious exit from the eurozone would hurt, but they also know that staying in the eurozone at this point means years if not decades of austerity. Their best strategy seems to be to try make their own collapse so expensive and annoying that Russia and the EU will somehow collaborate to sweeten the deal.

There are really only three things in this whole mess that strike us as indisputably true. First, Cyprus has managed to get itself into an unholy mess, and there is no good way out. Second, Europe’s dysfunctional monetary and banking system is a danger to Europe and to the rest of the world. Third, Europe’s leaders are completely out of their depth, and the Cypriot bank meltdown is only one item on a growing list of important international issues that the EU is bungling.

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