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Cyprus: A tale full with economic lessons

Cyprus is a small Mediterranean economy with a population of 800 m that entered in EU in 2004 and joined the Euro Currency in 2008. It grew steadily in the beginning of the new millennium, and currently its GDPpc is at 92% of the EU. The composition of Cyprus GDP is based on services, reaching 81.2% of GDP, while industry 16% and agriculture is rounding 2%. Banking and tourism are the core services of Cyprus.

Crisis

In order to understand the crisis that drove Cyprus close to bankrupt, it is important to highlight that the island had few natural resources (gas in the Mediterranean will only be available to extract 2-5 years from now). To push national wealth up and attract capital inflows, legislation was made to the banking sector one major industry of the country. Low tax rates and the regulation attracted foreign depositors (37% of the total are from non-Euro countries), and the size of the banks reach 7.5 times the size of the island´s economy.

Since 2008, the year of the financial meltdown, the government deficit rose and with it the level of debt. The housing market started to show the signals of recession, and the banks see their balance sheets worsen due to non-performing loans. Private debt is at record levels, and deleveraging process made the recovery weaker.

Cyprus starts 2012 indebted, with a financial sector near collapse, and a need to finance its deficit of 6.4%. They first turn into Russia, which provides them a €2,5 bn  loan with an annual interest rate of 4.5% and maturity of 4.5 years, which helps the country survive 6 more months without much media attention, in spite of the increasing borrowing costs. Lesson 1 – If the size of the financial sector is relatively large to the size of the economy, sound fiscal policies are required since the burden of the financial sector failure will ultimately rely on it.

However, Greek debt restructuring gave a final death sentence to Cyprus financial sector. Cyprus’s two biggest banks, the Bank of Cyprus and Laiki Bank, held large amounts of Greek government debt and took a major hit in the partial default. The solvency itself was at stake. Russia is seen as another way out, but its Government denies providing with another €5 bn, even with economic opportunities attached. EU and IMF are the last standing. Cypriot Government knows that attached to the European financial aid comes strong conditionally regarding public finances and financial regulation. Lesson 2 – There is a permanent need to evaluate the contagious effects of measures taken by a country in a monetary union, because those will affect the other members.

(Beginning of) Resolution

June 2012 marks the beginning of a lengthy negotiation process that reached dramatic conclusions 10 months after. For the first time a Euro country imposes capital controls and heavy losses on uninsured depositors of troubled banks. Laiki Bank was divided in two: good bank and a bad bank (with all the toxic assets). Lesson 3 – Although belonging to a monetary union , capital controls can help avoid the self-fulfilling prophecy of the insolvency of a financial sector and can help a country to perform damage controls and eventually aid its recovery, by avoiding massive capital outflows.

A National Fund was created that included public and church assets. With this, Cyprus is able to self-finance a share of the €10 bn bailout (also called bail-in) that was agreed officially in 16th March 2013. The €10bn bailout comprise €4.1bn spend on debt liabilities (refinancing and amortization), 3.4bn to cover fiscal deficits, and €2.5bn for the bank recapitalization.

Advantages/ Disadvantages of the policy choices

Cyprus was the 5th country to ask a formal bailout to EU within the Euro zone, 5 years after the hit of the subprime crisis and 3 years after the beginning of the sovereign debt crisis.

The EU faced unprecedented challenges, but a monetary union with 17 democratic sovereign countries has a different response time. Nevertheless new measures (unimaginable a few years ago) come into ground – an European Fund to insure stressed countries  (ESM), a new Treaty regarding fiscal policies was signed and a new monetary policy by the ECB targeting  member states public debt in the secondary market with soaring yields.

In this torturous path that EU have gone through, Cyprus crisis was a decisive moment, for good and bad reasons. This was the moment when Europe decided to start input losses to junior bondholders and shareholders of troubled banks (which eventually would transform the way euro countries deal with troubled banks). But this was also the moment when Europe consider as an hypothesis to input losses on insured depositors, which lead to several hard days to stock exchanges, with banking shares taking a hit and also to worsen the confidence levels on the banking system. In spite of giving up on this solution, this was seen by the European people as a real possibility and economists fear that the next time a similar situation happen and a clear regulatory framework is not known to people, bank runs can happen again. Lesson 4 – Uncertainty brings unexpected costs to the economy.

Cyprus has to reduce the size of its banking system to the EU average of 3.5 times GDP, and this indicator was introduced in the Macroeconomic Imbalance Procedure (MIP) Scoreboard (collected by the Eurostat). Lesson 5 – This indicator is now present when European Comission evaluated the macroeconomic imbalances of a country, and it may help avoid future banking crisis in the euro. A wide range of indicators needs to be considered when evaluation the macroeconomic performance of a member state.

1

EU rules compliance before the crisis was not enough…

1

A high leverage economy together with a fall in the housing market did not help the economy in a presence of adverse shocks.

1

Unemployment soared with the burst of the bubble…

Bruno Dias                      Nº 670

José Campelo Ribeiro     Nº 645

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Author: studentnovasbe

Master student in Nova Sbe

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