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The Geopolitics of the Cyprus Crisis

25/03/2013 13:19 GMT | Updated 23/05/2013 10:12 BST

Europeans were shocked last week to learn that Eurozone financial chiefs were thinking the unthinkable: confiscating funds from the deposit accounts of ordinary Cypriot savers as part of a bail-out deal. The money in such accounts is supposed to be guaranteed by governments even in the case of bank collapses, not to be a piggy bank that can be raided at will to shore up the national balance sheet. Southern Europeans, who have been forced to become adept at reading the writing on the wall, were worried that a dangerous precedent would be set for their own futures.

Don't worry, comes the cheery reply from Brussels - Cyprus, which only joined the Eurozone in 2008, is a special case. And this is true. The country has a financial sector eight times the size of its economy and half of its bank deposits are in the hands of foreigners. Cyprus, which has the third smallest GDP in the Eurozone, is the biggest source of foreign direct investment into Russia in the world because Russian corporations and individuals rout money through the island's banking system as a tax avoidance strategy. Moody's estimates that Russian corporate deposits in Cyprus total nearly $20bn.

These intimate ties between Cyprus and Russia help to explain why the Cyprus bail-out negotiations have been so unusually fraught and have broken previous taboos. With substantial Russian interests at stake and the country in an assertive mood, what are ostensibly talks about the future of Cyprus and the Eurozone have become enmeshed in a complex geopolitical dance involving Moscow, Brussels and Berlin.

Berlin could have pushed a bail-out agreement that targeted only rich Russian depositors in Cypriot banks, leaving the deposits of pensioners and the middle-class alone. Some commentators have questioned why Germany seems so keen to protect the interests of Russian oligarchs, even at the expense of ordinary savers, and pushed for a soaking of Russian deposits in Cyprus. This would certainly have made political sense within the European Union, where the political if not the actual capital of wealthy tax dodgers is at an all-time low.

But to begin explicitly targeting foreign money for confiscation to paper over the Eurozone's ever-widening cracks would have not only have encouraged foreign capital to flee an already dangerously under-capitalized banking system but would also have exacerbated growing tensions between Moscow and Berlin. This is something that Germany wishes to avoid. As the euro continues down a path of grinding austerity and low growth which will either last for decades or eventually pull the currency union apart, policymakers in Berlin can ill-afford to alienate one of their most important economic and energy partners outside the EU. The Russian and German economies have significant complementarities, with Russia needing German capital and Germany seeking cheap imports. And while the Russian economy may not be the most dynamic in the world, it is at least solvent, something which cannot be said for an ever-growing list of Germany's European trading partners.

Cypriot leaders, meanwhile, in despair at the terms being offered by the masters of the Eurozone universe, have travelled to Moscow to seek a solution to their problems. They pushed for a broad deal, even offering to turn over natural gas rights in return for Russian funding. Had Moscow accepted the deal, it would have gone a long way towards turning Cyprus into a Russian client state, which is a measure of the level of desperation in Nicosia. It also reveals a new type of risk that the Eurozone has introduced to the shores of the Mediterranean - geopolitical.

By threatening to sour Russian-EU relations and even propel an EU member state into the arms of Moscow, the currency union is reviving tensions between old antagonists. Russia turned Cyprus away, either hoping to score an even better deal if the country fails to reach an accommodation with Berlin or - more likely - gambling that EU leaders will ultimately make the relatively small amount of funding that Cyprus needs available in the interests of avoiding a default and saving the Eurozone. Russia does not want to unduly antagonize Berlin either, especially over a prize as small as Cyprus. But the broader lesson is that the complex geopolitical dance between Russia and Germany has dictated the response of both to the crisis in Cyprus, further marginalizing the interests of ordinary people and revealing the ever-widening democratic deficit at the heart of the European Union's response to the debt crisis.

Meanwhile Cyprus, a smaller country even than Greece, faces a grim future as either a Russian client or an only slightly brighter one following the dictates of Berlin, the IMF and the European Central Bank, all of which are pursuing agendas that have scant regard for the immediate needs of ordinary Cypriots. On such shaky foundations is the new European order being built.