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Cyprus: The worst is yet to come

March 26, 2013: 9:27 AM ET

Despite an eleventh-hour deal, the fallout from the Cypriot crisis is far from over.

By Cyrus Sanati

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FORTUNE -- The banking crisis in Cyprus is far from resolved and will almost certainly morph into a far more serious sovereign debt crisis in the near future, threatening investors around the globe. The revised bailout agreement hatched over the weekend will still leave the island nation's banking-centric economy in ruin, thus limiting the government's ability to meet its future debt payments.

In order to avoid another Greek-style economic meltdown, Eurozone officials would be wise to construct a more practical bailout -- one that at the very least avoids nuking the Cypriot economy. Failure to do so will not only condemn Cyprus to years of misery, but it would also put the Eurozone one step closer to a painful breakup.

The markets breathed a sigh of relief on the news that a deal had been struck regarding the Cypriot bailout. European and U.S. markets initially popped in Monday trading, but quickly gave up their gains as investors started to get their heads around the agreement. That is not surprising given how atrocious this deal is for Cyprus.

The hastily put together bailout still forces the nation to come up with 5.8 billion euros to qualify for a badly needed 10 billion euro loan, which will come courtesy of the European Union and the International Monetary Fund. But instead of raising the money by "taxing" bank accounts of all sizes (as what was terribly proposed last week), the plan now calls for taxing only those accounts that exceed the nation's deposit insurance limit of 100,000 euros. It also calls for the wind-down of Popular Bank (Laiki, in Greek), one of the nation's largest banks, shoving all the big depositors' cash into a so-called "bad bank" where depositors could possibly lose everything.

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While it is good to see that the depositors with less than 100,000 euros in the bank will be protected, the deal is still pretty terrible for Cyprus. That's because the financial sector accounts for 45% of the nation's GDP and employs 70% of its workers. By basically stealing money from bank depositors, the government (under pressure from the EU, IMF and the European Central Bank), is basically destroying the credibility of an industry where credibility is a necessary condition to be successful. Would you trust your money in a Cypriot bank if you had over 100,000 euros in your account? Would you trust it if you had five euros? Probably not on both accounts.

It is unbelievable that the Cypriot government would agree to any "bailout" that would hurt the credibility of its main industry. Banking is not some scarce natural resource; depositors can move their money to another bank in another tax haven at any time with similar perks. Cyprus became a banking hub because it set itself up as a place to park large amounts of cash quietly and safely. Now it is basically saying to its clients that it isn't safe to deposit one cent.

Much has been talked about the amount of Russian money in the Cypriot banking system and how the island is a money laundering hub for its oligarchs. That may be true to some extent, but there is still plenty of legitimate money, yes, even legitimate Russian money, in Cypriot banks. In total, Russians have an estimated 24 billion euros stashed in Cypriot banks, which is more than a third of the nation's total bank deposits of around 69 billion euros, according to Moody's.

Russians are drawn to the island thanks to a range of favorable investment laws and the fact that 40,000 Russians call Cyprus home. Cyprus and Russia have a double-taxation treaty that limits taxes on a number of investments like a 5% rate on interest and a 0% rate on dividends and royalty payments.

The island's close proximity to Russia, EU status, friendly people, shared Christian Orthodox traditions, and great weather made it one of the best places for Russians to store their cash outside of the country.

But all of that means nothing if Cyprus taxes those deposits at 40% or even 100%. Theft is something Russians don't take kindly to, and it is highly doubtful that Cyprus can get away with this cash grab. Russia will surely move to cancel its double-taxation treaty with Cyprus to protect Russians from parking one more ruble in Cyprus. A mass exodus of Russian money will basically destroy the Cypriot banking industry overnight as it would drain whatever capital they had left. That 10 billion euro bailout would be eaten up in a flash filling the hole left by the Russian withdrawals. Thousands of jobs would be lost overnight, plunging the nation into a recession of unimaginable proportion.

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It gets worse. With Russian money out you can bet that the nation's other main industry, tourism, which makes up 20% of Cypriot GDP, will also take a bit of a hit. Having your money stolen doesn't make you want to relax on the beach with a Mai-Tai or spend hundreds or even thousands of euros per night to stay at one of the five-star beach resorts dotted around the island. Many of those resorts, especially those around Limassol (nickname "Limassolgrad"), were built specifically for the well-off Russian traveler in mind. Most have Russian-speaking staffs complete with boutiques featuring flashy designer clothes meant to attract Russia's nouveau riche.

The average Russian traveler spent around 115 euros per day on holiday in Cyprus last November, more than any other nationality surveyed by the Cypriot government. That is nearly double that of holiday-goers from relatively well-off places like the United Kingdom and more than double what tourists from the Netherlands and Ireland dropped on their vacations. The super-rich Russians don't stay at hotels; rather, they own large, usually gaudy, beachfront estates. Nevertheless, they still drop thousands of euros per night at discos and restaurants entertaining friends and business contacts in the VIP area complete with bottles and models.

To be sure, tourism in Cyprus will probably never die. But the amount spent per day will probably fall given the pullout of Russian cash. Riots on the streets in Nicosia, Cyprus's capital, while far from many of the posh resorts, are still close enough to deter even the most seasoned of travelers, Russian or not, from making the voyage.

Let's take a step back for a moment and try to put some perspective on all this mess. The amount of drama and international intrigue associated with this latest chapter of the Eurozone crisis seems a bit unreal when you consider the amount of money we are talking about here. The Cypriots asked for around 17 billion euros to basically get back on their feet. While that sounds like a lot of money, it is really a pittance when compared to the size of, say, Italy's total debt load of around 2 trillion euros. The 17 billion euros needed by Cyprus to essentially save the island's entire economy from collapse and avoid contagion fears of a banking crisis spreading across Europe was equal to roughly 0.14% of the EU's GDP of 12.1 trillion euros. That's so low it's sort of unreal. Angela Merkle probably spends more on beer and pretzels on an annual basis.

But seriously, this is not a lot of money we are talking about here - so why are we talking about it? Some believe the Cypriot bailout could be the model by which future EU bailouts are done -- such as those expected in Spain and Italy. Others say that this could cause major strain in Russia-EU relations.

While those are important, the big red flag here is the almost sickening degree of callousness the EU and the ECB have shown for one of their most vulnerable members. It is downright appalling that the troika would demand Cyprus come up with 5.8 billion euros out of thin air, while just 0.05% of EU GDP is equal to 30% of Cypriot GDP. It is equally appalling that Mario Draghi, the head of the ECB, who said he would do everything to save the euro last summer, basically gave Cyprus one week to accept the deal, or else he would cut off emergency funding to the nation's banks. That would be like Federal Reserve Chairman Ben Bernanke telling the U.S. government to come up with $4.7 trillion from somewhere in a week, or else he would shut off the printing press.

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Moral hazard claims here are understood but irrelevant given the level of the damage that will be inflicted on Cyprus if it goes ahead and does what the troika wants and guts its financial sector. We are talking about wiping out around half of the nation's GDP overnight while adding 10 billion euros ('cause the troika wants their money back) pushing the nation's debt load to around 25 billion euros, or a little over 100% of GDP.

How can Cyprus make its debt payments now? It only brought in 1.95 billion euros in tax receipts last year, 3% less from the year before. You wipe out an industry that contributes 45% to the nation's GDP and hurt another worth 20%, you are going to see a major decrease in tax revenue and a subsequent spike in the nation's debt-to-GDP ratio. French bank Society Generale sees the Cypriot economy contracting by 20% by 2017. That seems ridiculously optimistic. What are all the Cypriots thrown out of work going to do? Minerals, which after the Second World War made up 60% of the nation's exports, have pretty much all been mined at this point. Offshore drilling for natural gas seems promising, but it is not labor intensive. In any case, all the work will need to be done by a foreign multi-national with experience. Olive picking and fishing seem out of the question, right?

It is remarkable that the troika would put Cyprus in this position, but it is even more remarkable that Cyprus would go along with it. Indeed it may make more sense to simply bail on the euro and find more creative ways to get through this mess on its own. While that would mean defaulting on its sovereign debt, it would do so with some semblance of a banking sector still intact. Capital controls instituted by the island will eventually cause a "Cypriot euro" to be worth far less than a euro from the continent, so it may be worth going all the way and saying goodbye to Brussels. It could just default on the debt held by its EU "friends" and forge closer ties with Russia, the U.S., the Middle East, or even China. There is no way that it will be able to service its debts with its economy impaired, so why not just skip ahead a few chapters? Instead of asking for a bailout to pay for the first bailout, why not just literally bail on the EU now?

We have just begun to see the fallout from the Cypriot crisis, and it is far from over. The deal struck at the eleventh hour over the weekend isn't going to work, and the Cypriot people aren't going to just lay down and take it. This is not a good model for a bailout; rather it seems like a great way to lay the seeds of the EU's eventual demise.

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