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The Cyprus Bail-out: Challenges, Opportunities and Lessons from Greece


13 December 2012


In late November 2012, the Cyprus government announced that a deal with the “Troika”—the representatives of the Eurozone, the European Central Bank (ECB) and the International Monetary Fund (IMF) was close. Although the final package had not yet been announced or voted by the time this article went to press, enough information has been announced to enable an evaluation of the Cyprus austerity programme and its likely impact on the wider Cypriot economy.

This article evaluates the basic elements of the Cyprus bail-out package and compares how this programme and the fundamental economic situation of Cyprus compare with that of Greece. It concludes that if implemented properly and proactively by Cypriot public authorities, this programme will have severe short-term recessionary impacts, but over the long term could restore the competitiveness and a disciplined fiscal framework to the Cypriot public sector.

It will not, however, completely resolve the fundamental risks and structural challenges faced by the Cypriot economy either in its domestic economic operations, or in its role as an international financial centre. And it contains significant implementation risks which will spill over into the general economy and affect future national priorities, including the development of the offshore oil and gas sector.


1.      Economic Background


1.1    Gross Domestic Product

The gross domestic product (GDP) of Cyprus in the market value of all final goods and services produced in Cyprus within a specific calendar year. GDP in expenditure terms is calculated as:

GDP = Private Consumption + Gross Investment + Government Spending + (Exports-Imports)

The GDP figures used in this analysis are based on market prices[1] as this gives a more accurate reflection of what the average household or company is experiencing.

It should therefore be obvious that any drop in government spending and gross investment, or any increase in taxes which reduces disposable income, will have a short-term negative impact on gross domestic product unless accompanied by supplemental polices.

Between 2000 and 2011, Cyprus’ GDP rose from EUR 9.76 bln to EUR 18 bln, an increase of 84%. Government expenditure rose from EUR 1.58 bln to EUR 3.61 bln, an increase of 128%. In contrast, private consumption rose by 88% over this period, and gross investment by 71%. This imbalance in the growth rates of private and public expenditure is a main reason behind the excessive deficit procedure faced by the country.

Table 1: Cyprus GDP by Category, Market Prices, EUR mln

Cyprus’ GDP is dominated by a handful of sectors, lead by real estate and construction, which in 2011 accounted for EUR 3.12 bln, or 17% of total GDP, down from 20% of GDP in 2008 at the height of the construction boom. Public Administration, Social Security and Defence Spending, in contrast rose from 8% of GDP in 2000 to 10% in 2011.

Table 2: Cyprus Current GDP by Activity, EUR mln

Cyprus Statistical Authority (CYSTAT)                                                                       * Estimate

Table 3: Cyprus Current GDP Share by Activity, %

Cyprus Statistical Authority (CYSTAT)                                                                     * Estimate

In addition to illustrating the relative weight of sectors such as property and public administration, Table 3 illustrates one of the main challenges faced by the Cypriot banking sector, and Cyprus’ strategic focus on becoming an international business and financial centre. Despite large financial deposits in Cyprus worth 400% Cypriot GDP, very little of this money is currently invested productively in Cyprus. As a result, there is relatively little impact on GDP, beyond the impact of higher employment and higher wages in the banking sector.

This means that in terms of risk, Cypriot financial institutions are exposed not only to the domestic economy, but also to deposit flight risks and non-performing loans from outside its borders. This is exactly why the recapitalisation costs of the Cypriot financial sector are so high, as will be discussed in Section 1.3.


1.2    Public Finance


Figure 1: General Government Expenditure as % GDP

According to Eurostat, Cypriot general government expenditure as a share of GDP is 47%, above Germany (46%) or Malta (43%), but below Greece (49%), France (56%) or Denmark (58%). It is important to note that while tracking absolute government expenditure is important, this says little about the quality, productivity or return on investment of such expenditure. One of the main problems in Cyprus is the expansion of such expenditure (and consumption) without a proper regard for public sector productivity.

Cyprus’ public finances have shown a dramatic expansion of public expenditure together with a worsening of the relationship between expenditure and revenue. In 2000, Cyprus recorded total public expenditure of EUR 3.6 bln and a deficit of EUR 229 mln (2% GDP). By 2011, government expenditure had risen to EUR 8.3 bln, and the deficit had risen to EUR 1.132 bln (6% GDP). This represents a rise of 129% in public sector expenditure, which is a phenomenal increase for a country without a substantial expansion of population.[2]

Figure 2: Central Government Revenue and Expenditure

The largest increase in public sector expenditure is in staff compensation, which rose from EUR 1.3 bln in 2000 to EUR 2.9 bln in 2011 (a rise of 118%) and in social transfers, which rose from EUR 0.89 bln in 2000 to EUR 2.62 bln in 2011 (a rise of 192%).

Table 4: Public Finance and Expenditure Categories

Source: Cyprus Statistic Authority, Economic Indicators

Government forecasts for 2012 deficit are EUR 851 bln in 2012 (as of 13.09.2012), or 4.7% of GDP. Public debt is forecast to rise to EUR 15.42 bln (85% forecast GDP), in part due to the emergency recapitalisations of Laiki Bank and other public borrowing.

What is worrying about these results is the fact that the central and local government has recorded a consistent deficit since 2008, which has only been transformed into a surplus in a single year (2008) due to balancing of social security surpluses. Yet these surpluses have been falling steadily, from EUR 614 mln in 2008 to EUR 231 mln in 2012 (forecast), rendering the deficit unsustainable.

Table 5: Public Deficit and Debt

Ministry of Finance, Excessive Deficit Procedure Report, 13/09/2012


1.3    The Cypriot Banking System

A key issue confronting Cyprus is the viability of the Cypriot banking system. Although excessive attention has been focussed on the write-down of Greek government bonds (GGB) held mainly by the Bank of Cyprus (BOC) and Laiki (Popular Bank), the problems affecting the banking sector are far more complex, and structural in nature.

The main Cypriot domestic banks (primarily BOC and Laiki) expanded rapidly into Greece and other countries in the 2000s. These banks not only made ill-judged investments in Greek government bonds, but have a vast array of non-performing loans (NPL) in Greece, Cyprus and other countries. While the GGB write-down has been fully priced as a result of the 2011 Private Sector Involvement (PSI) and the 2012 buy-back currently underway, the exact NPL volume is unknown. More seriously, there is abundant evidence from our consultancy assignments that Cypriot banks have been doing everything possible to avoid classifying certain loans, particularly mortgages or property-backed loans, as non-performing.

By nature of Cyprus’ position as an offshore [3] company and banking centre, Cypriot banks (domestic and foreign) are used by a wide range of corporate clients to “recycle” funds, usually through transfer pricing, dividend movements, inter-company loans, asset purchases or other transactions. As a result, the volume of assets and liabilities in the Cypriot banking system is far in excess of the actual demands of the domestic economy. This has four important impacts:

  1. It increases systemic risk, in that a sudden withdrawal of foreign deposits increases demands for shareholder equity and other Tier 1 capital reserves.

  2. Cyprus has capitalised on its status as a low-tax offshore banking centre. A key ingredient for this success is its reputation for economic stability and deft financial management despite a number of challenges such as the Turkish occupation and EU accession. This reputation has been negatively affected in the last 2 years due to the management policies of the current government. As a result, the risk of capital transfers to more stable domains has increased. The fact that many Cypriot banks and service providers have tended to see Russian customers as “cash cows” and charged extortionate pricing in a variety of areas has caused a number of key investors to re-think their commitment to Cyprus.

  3. It exposes Cypriot banks to upstream risks in the main countries of operation of its international clients. Despite extensive know-your-client requirements, the visibility most Cypriot accountants or banks have over their international customers is in fact very limited.

  4. It enables lower-productivity domestic banking operations to be subsidised by higher-value international banking operations. The Cypriot domestic banking sector is highly unionised, over-branched, and includes very expensive loan and banking terms: this is no coincidence, given that until recently this system could be cross-subsidised by higher margins on international operations. The exact costs of this system on the Cypriot economy merit further study, but the fact that even before the crisis, Cypriot banks were usually starting corporate loans at LIBOR +4% and packing on high “study fees” and other charges is indicative of the high costs to companies and households.

These systemic issues are clearly evident in the Central Bank of Cyprus’ Monetary and Financial Statistics (MFS), published in November 2012. Table 6 consolidates information from three main sources:

  • Deposits and loans in the Cypriot banking system (excluding the Central Bank of Cyprus) are drawn from the MFS (November 2012);

  • Current GDP from 2005-2011 is drawn from Cystat (data accessed on 2 December 2012);

  • The 2012 GDP forecast is provided by the Ministry of Finance’s Excessive Deficit Procedure Report (13 September 2012).

These data show that in 2012, total loans by Cypriot financial institutions to Cypriot and non-Cypriot companies, households and the Cypriot government totalled EUR 71.42 bln, or 393% of forecast 2012 GDP.

Although the loan-to-deposit ratio is estimated at a relatively secure 102%, these numbers illustrate the fundamental risks to the Cypriot financial system: that Cypriot bank Tier 1 capital cannot begin to cover the potential risks of depositor flight or non-performing loans. The fact that Troika negotiations are targeting a EUR 10 billion bank recapitalisation is indicative of the potential scale of the problems in the Cypriot financial system. (see Chapter 2).

And with the credit rating of both the Cypriot government and the Cypriot banks slashed to junk status, it is apparent that attracting new shareholders or extending sovereign guarantees on market terms will be equally difficult.

Figure 3: Loans and Deposits in the Cypriot Banking System

Table 6: GDP, Loans and Deposits

The MFS also reveals a well-known fact: that certain Cypriot companies and households are highly leveraged. Table 7 shows the loans by institutional type (loan stock) as of December of each year except 2012, where October is used.

This shows a dramatic increase of loans to companies, where the debt stock rose from EUR 12.1 bln in 2005 to EUR 33.2 bln in 2012) and to households, where it rose from 12.9 bln in 2005 to EUR 26.5 bln. The main component of household lending is household loans, reflecting the fact that many Cypriot families participated in the housing boom. By October 2012, company debt rose to 183% GDP, while household debt rose to 146% of GDP.

Table 7: Loans by Institution

Another way of looking at leverage is by calculating net assets, i.e. deposits less loans. Given the high deposit base, it is more interesting to look at net assets, even though this does not given an accurate picture of individual debtors or creditors. The net asset calculation in Table 8 shows that companies are the most highly indebted, with over EUR 11 billion in loans after deposits have been deducted.

Table 8: Net Assets in the Cyprus Banking System

Another point to consider is that the net asset balance of domestic residents has been rapidly worsening. In 2005, domestic non-financial institutions had EUR 24.9 bln on deposit and EUR 25.0 bln in loans, for net assets of EUR -131 mln. By October 2012, domestic non-financial deposits rose to EUR 43.5 bln, but loans rose to EUR 52.8 bln, for a net liability of EUR -9.4 bln.

Net assets in the Cypriot banking system were solely accounted for by non-Cypriot residents in October 2012. This illustrates the indebtedness of domestic companies and households, and illustrates how dependent the Cypriot banking system is on foreign depositors.

Table 9: Net Assets in the Cyprus Banking System by Owner

Net Assets* by Owner EUR mln

Dec 2005

Dec 2006

Dec 2007

Dec 2008

Dec 2009

Dec 2010

Dec 2011

Oct 2012

Domestic Residents









Other Euro Area Residents









Rest of World









* Net Assets = Deposits – Loans Central Bank of Cyprus

This very simple analysis of official data points to serious imbalances in the Cypriot banking sector. Together with the write-downs of Greek government bonds and the higher risk of non-performing loans, it is obvious that the Cypriot banking sector has transformed itself from being a driver of the Cypriot economy to a source of strategic weakness. This is why, as we will see in Chapter 3, the greatest share of the bail-out (EUR 10 bln) is allocated for bank recapitalisation.



2.      The Cyprus Bail-Out

The Cyprus “Bail Out”, or the extension of emergency loans from the Troika in exchange of austerity as a condition of the loans, has not yet been agreed by the time this article as gone to press. Although the conditionality document was released to press (see link here), the implementing laws have not yet been voted, and negotiations between the Government of Cyprus and the Troika continue.

Furthermore, the precise terms of the loan agreement remain undefined. Press reports[1] indicate a loan agreement of between EUR 14 and 17.5 billion is under consideration, and that the following loans are being negotiated:

  1. EUR 10 bln will be used for bank recapitalisation
  2. EUR 6 bln to refinance existing government debt between 2013-2016
  3. EUR 1.5 bln to cover state deficits.

The Cypriot Minister of Finance, Vassos Shiarly, has indicated that an interest rate of 2.5% and a loan term of 30 years are being considered.

The precise level of the loan volume depends on an audit of Cypriot banks currently being implemented by PIMCO, which will be available in January 2013.

Prior to considering the loan conditionality, it is worth considering the difference and similaries between the Cypriot and Greek bailouts.

Greece requested an emergency loan from the IMF and Troika in January – February 2010. Prior to this request, there was no mechanism within the Eurozone for providing emergency financial assistance to an EU government. The Greek loan request was therefore the first such engagement undertaken by the Eurozone, and was done without an adequate European policy mechanism in place.

Although the existing policy mechanisms, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) remain in place, European policy-making remains sluggish and ineffective, and is characterised by political disputes and a central bank with strict limitations on its purchases of primary or secondary market sovereign debt.

Table 10 compares the starting-points and initial bail-out mechanisms for Greece and Cyprus at their respective starting points.

Table 10: Comparison of the Cyprus and Greek Initial Bail-out Plans




Date of Bail-out

December 2012 – January 2013

May 2010

Current GDP at date of application

EUR 17.98 billion

EUR 227.32 billion

Debt : GDP Ratio

71% (end 2011)

129% (end 2009)

Main reason for bail-out

Public sector suffered a credit rating downgrade as a result of Greek exposure: Cyprus government has been shut out of international debt markets for 18 months


Private sector banks require recapitalisation due to losses on Greek government bonds as well as non-performing loans in Greece and Cyprus

Public sector cut off from international debt markets; unable to refinance or roll-over debt from private lenders

Initial Bail-out Volume[2]

EUR 17.5 billion

EUR 110 billion

Bail-out : GDP Ratio



Initial Eurozone interest rate on Loan



Loan Term

30 years

7 years

Quality of Public Statistics

Sound (until present)

Unsound: the 2009 deficit was revised from an initial estimate of 3.5% to 12.5%. Public debt was also found to be “stocked” in off-balance sheet entities, namely semi-governmental organisations.

How can we evaluate the two countries?

Although Cyprus appears to have a better starting point going into the crisis (debt:GDP of 71% at end-2011) versus Greece (debt:GDP of 129% at end-2009), it has additional debt obligations as a result of bank refinancing needs. Should the EUR 10 billion slated for bank recapitalisation be provided via the sovereign, i.e. via a sovereign guarantee, and thus accruing to public debt, Cyprus’s debt:GDP ratio will skyrocket to 127% of GDP in 2013, not counting the 2012 and 2013 deficits.

Both countries lost important political credibility, although Cyprus has a better chance to regain trust. In Greece, initial credibility under George Papandreou in the spring of 2010 was lost when the wider system debt was consolidated in late 2010, and when successive PASOK ministers tried to “game the system” and avoid reforms. In Cyprus, credibility was lost by the delays introduced by President Demetris Christofias in 2012, as well as in unclear signals as to whether Cyprus was in fact negotiating for a loan, or seeking other sponsors, including additional bilateral loans from Russia.

Both countries are suffering from a solvency and a liquidity crisis. The liquidity crisis stems from the fact that both governments are shut out of international credit markets due to a low credit rating. The solvency crisis stems from investor fear that even if liquidity (i.e. loans) were forthcoming, the public debt after the bail-out may be too high to service properly. Greece has already defaulted on its loans, with private sector creditors suffering a 52% write-down in 2011. Cyprus has not defaulted, but has had to take emergency measures to borrow money from semi-governmental organisations and emergency liquidity assistance (ELA), and its is by no means certain that it will be able to meet the terms of its bail-out agreement.

Most importantly, both countries suffer from denial as to the root causes of the crisis. In both Greece and Cyprus, the public sector has become a massive source of corruption and patronage. As such, it constitutes a drain on national economic output, with high public expenditure enforced on spending commitments with a very low productivity or return-on-investment. Crucially, political parties of all ideologies have engaged in the same system for years, using public sector jobs and contracts as a means of enrichment, and of rewarding their supporters. Today, there is no national consensus or vision of national competitiveness or the roles of the private and public sectors.

The fact that there is no national consensus or vision also means that a large share of the population has a fundamental misunderstanding of basic economic concepts. Popular debate in Greece and Cyprus is characterised by sentimentality for bygone years, and by a fear of foreign conspiracies. Thus, many Cypriots believe that the current economic crisis is a ploy by foreign powers to seize Cyprus’ energy reserves, while many Greeks believe that Germany (an unwilling creditor) is once again an occupying power. This is extensively reflected in press, demonstrations, and political party statements. Yet without a national consensus based on economic reality, a real restructuring will be possible.

Table 11: Major Political Parties and Support, Greece & Cyprus

Greek Parliament


# Seats

Cyprus Parliament


# Seats

New Democracy (ND)



Dimokratikos Synagermos (DISY)



Coalition of the Radical Left  (SYRIZA)

Extreme Left


Anorthotiko Komma Ergazomenou Laou (AKEL)



Pan-Hellenic Socialist Party (PASOK)



Democratic Party (DIKO)



Independent Greeks



Movement for Social Democracy (EDEK)



Chryssi Avgi (Golden Dawn)



European Party of Cyprus (Evroko)



Democratic Left (DHMAR)



Green Party



Communist Party of Greece (KKE)












Finally, both countries suffer from massive political fragmentation. In Greece, the traditional duopoly between left (PASOK) and right (New Democracy) which ruled the country since 1974 has shattered: today there are 7 parties in Parliament, and the leader, New Democracy, is only polling 22-24% in national polls. In Cyprus, a country of some 840,000 inhabitants, the Parliament has split into 6 political parties. This means that voting through politically-sensitive public sector restructuring as foreseen in the loan conditionality will be difficult, if not impossible.

These issues point to the fact that mastering the political dimensions of the public debt crisis, including the role of party patronage in the civil service as well as political fragmentation in parliament, will be a defining role in the success or failure of the Cypriot bail-out.


3.     Loan Conditionality


A fundamental part of any loan agreement is loan conditionality. This conditionality, outlined in a “Memorandum of Understanding on Specific Economic Policy Conditionality ” and usually referred in shorthand as “the Memorandum” (το Mνημόνιο in Greek), typically includes a list of structural reforms which much be carried out by the debtor government requesting the loan.

These structural reforms are usually quite controversial, particularly since they often include measures to cut government expenditure and weaken the positions of public and private sector unions and collective bargaining agreements.

Despite their controversy, however, many of them are usually logical and necessary to the proper regulation and function of a European government.

The main structural, fiscal and financial sector reforms in the bail-out as they are expressed in the current Memorandum are briefly reviewed here.

3.1    Financial Sector Regulation and Supervision

The key elements of this plan include the recapitalisation of Cypriot banks and the implementation of stricter liquidity concentration limits as well as stricter regulations. The main points include:

(a) A due diligence on non-performing loans (NPL) and capitalisation requirements. This is being implemented by PIMCO, and will be ready in January 2013.

(b) Implementation of liquidity concentration limits, notably of 60% for non-residents, and 50% for Cypriot sovereign bonds. These limits are intended to reduce exposure to future risks. A main risk for the Cypriot banking sector, and Cyprus’ general position as an international business centre, will be the extent to which the 60% limit for foreign residents affects deposits.

(c) Increasing the core Tier 1 capital limit from 8% to 9% by 31 December 2013. This is controversial, because it includes the following subordination clause:

With the goal of minimising the cost to tax payers, bank shareholders and junior debt holders will take losses before state-aid measures are granted. Before any state recapitalisation is granted, the Central Bank of Cyprus will require a conversion of any outstanding junior debt instruments into equity for the purpose of protecting the public interest in financial stability, including by implementing voluntary or, if necessary, mandatory subordinated liability exercises (SLE).

Given the scale of the recapitalisation being discussed (EUR 10 billion), this clause, should it be enforced, may cause high losses on existing shareholders, and is likely to be resisted.

(d) Changes are expected to strengthen Cypriot banks against non-performing loans (NPL). Given that most Cypriot households and companies are heavily indebted, the following clause appears fairly Draconian, and is certain to be resisted by politicians and a wider array of citizens:

Strong efforts should be made to maximise bank recovery rates for non-performing loans, while minimising the incentives for strategic defaults by borrowers. The administrative hurdles and the legislative framework currently constraining the seizure and sale of loan collateral will be amended such that the property pledged as collateral can be seized within a maximum time-span of 1.5 years from the initiation of legal or administrative proceedings. In the case of primary residences, this time-span could be extended to 2 years. The necessary legislative changes will be implemented by [end 2013], macroeconomic conditions permitting.

Other countries, notably Greece and Spain, have introduced legislation preventing banks from seizing primary residences. We expect similar legal protection in Cyprus.

One beneficial point, however, will be the enhanced scrutiny of NPL and general lending policy among community credit institutions. These institutions have, in general, been less transparent about their financial operations, and it is important that a clear picture of total debt and debt service be gained.

A final point in bank recapitalisation is the demand—reinforced by other EU Member States such as Germany—to enforce international laws against money laundering and transfer pricing. This is a key issue to mainstream European economies which need to gain higher tax revenue from their own economies, and are thus eager to crack down on what they perceive as unethical or illegal financial practises. This is an important point for the Russian and other international investors in Cyprus.


3.2    Fiscal Consolidation – Pubic Sector Expenditure

An important priority is to achieve a fiscal balance, i.e. a general government surplus of 4% by 2016. This necessitates measures totallying 7.25% of GDP, implemented between 2012-2016, with the greatest measures (3%) taking place in 2013. The main points on the expenditure side will be highly controversial and resisted by the public sector:

(a) The deficit in 2012 is to be restricted to 5.8% GDP, or EUR 1.036 bln. This necessitates budget cuts worth EUR 42 mln to be undertaken in 2012;

(b) A main tool for the consolidation is wage and pension cuts among the public sector as follows:

  • EUR 0-1000                           0%
  • EUR 1001 – 1500                  6.5%
  • EUR 1501 – 2000                  8.5%
  • EUR 2001 – 3000                 9.5%
  • EUR 3001- 4000                   11.5%
  • EUR 4001 and above            12.5%

A further 3% across-the-board cut on all public sector wages is foreseen in 2014.

(c) All cost of living allowance increases, and all salary increases, are to be frozen to 2015 and 2016 respectively.

(d) Public sector headcount is to fall by at least 5,000 staff to 2016 by hiring freezes, recruiting 1 new worker for every 4 workers leaving the public sector, and by eliminating 1,880 posts. We anticipate that this last clause will be replaced or alleviated by recruiting 1 new worker for every 5 departures, or similar measures, as the political cost of public sector terminations is very high.

(e) Social transfers are to be reduced by abolishing redundant or overlapping schemes, but also by eliminating certain transfers such as Easter allowances and housing support.

(f) Reducing public sector employment allowances and benefits, such as business class airfare, per diem expenses, and taxing these allowances.

(g) Increasing the statutory retirement age by 2 years for public sector pensions, reduce contributions in various public and general pension categories.


3.3   Fiscal Consolidation – Pubic Sector Revenue

There are several main revenue measures listed:

(a) Increasing property tax revenues by updating the consumer price index from 1980 to 2012 to the property tax rates as follows:

  • EUR 0 – 150,000                        0 ‰
  • EUR 150,001 – 500,000              6 ‰
  • EUR 500,001 – 1,000,000           8‰
  • EUR 1,000,001 – above              10‰

These rates, while low during normal economic growth, will cause yet another burden on middle class households, which are already indebted and experiencing wage cuts. A 6‰ tax on a EUR 450,000 property, for instance, is EUR 2,700, which comprises a significant chunk of disposable income on most middle class households in a recession. Furthermore, this creates additional problems for the property sector,which is a major component of GDP, and which is already experiencing overcapacity and falls in property values.

(b) Extend the temporary contributions on gross earnings and pensions of the public and private sectors to 31 December 2016 as follows:

  • EUR 0 – 1,500                 0%
  • EUR 1,501 – 2,500          2.5%
  • EUR 2,501 – 3,500          3.0%
  • EUR 3,501 – over           3.5%

(c) Increasing the standard VAT rate from 17% in 2012 to 19% in 2014. Similar increases in a broad range of other taxes, such as fuel, cigarettes, motor vehicles, lottery winnings, public healthcare access and other public services are foreseen extending to 2016

(d) Increasing the bank levy on deposits from 0.095% to 0.11%. This makes already-expensive banking services in Cyprus more expensive, as it is certain that this levy will be passed onto depositors.


3.4    Pension Reform

Extensive changes to the general and public employees pension systems are foreseen. Most of these are necessary, in particular given the fact that until recently, public sector employees did not contribute materially to their own pension funds.

There are two clauses in particular which provide for a far-reaching reform, and which will be difficult politically to implement:

ensure that total annual public pension benefits for public sector employees and state officials do not exceed 50% of the annual pensionable salary earned at the time of retirement from the post with the highest pensionable salary of the official's career in the public sector and broader public sector ensure that pension entitlements that will accrue after 1 January 2013 are considered as personal income, thus becoming fully taxable also in the case in which they are received as a lump-sum payment.

If experience from Greece is any guide, we can expect widespread resistance to such a move, including a flight to early retirement under the present, highly beneficial terms for public sector employees (who retire with fewer years service, and with generous pensions usually calibrated to their salary from their previous year in service).

4.      Likely Impacts of the Cypriot Bail-out

As this article goes to press, the Parliament of Cyprus is debating the first of several bills translating this loan conditionality into national law. The urgency with which the Parliament has finally turned to legislation is an indication of dire financial straits the country finds itself in. To a large extent, this situation has been caused by repeated financial and political miscalculations o the part of the governing parties, and the wider political and economic elite of the Republic.

Cyprus is now called to implement an extremely challenging reform programme which operates on several critical fronts:

  • At a time when the national credit rating has fallen to below-investment grade, Cyprus is called upon to implement a difficult bank restructuring which is estimated to cost EUR 10 billion, or 56% 2011 GDP, and may effectively wipe out existing shareholders. The fact that under current Troika policy, this amount will be guaranteed by the sovereign, and therefore added to Cyprus’ public debt account, will increase debt:GDP to 127% of 2011 GDP, not counting a public deficit of 3.5-3.9% GDP in 2012.
  • Cyprus is called upon to implement a public austerity programme involving expenditure cuts and revenue increases at a time when unemployment has breached 12% and both demand and price margins in major GDP segments such as tourism or property are weak. This programme has not been explained in detail, but we can say with a 90% probability that it risks exacerbating the recession in Cyprus, and making the recovery that much more difficult.
  • Cyprus is also called upon to implement historic changes in the employment and remuneration status of its public sector. This will be resisted by the public sector unions, which until now have constituted a major barrier to reform. It does so at the time of massive national political fragmentation, and a total lack of consensus on Cyprus’ competitive advantages and disadvantages in a global economy. The quality of political leadership in Cyprus on both sides of the ideological divide has revealed itself to be incapable of meeting the challenges of leadership in the 21st Century, and constitutes a major risk to Cyprus.
  • None of the policies in the Memorandum addresses the serious structural imbalances of the private sector economy, which include high indebtedness by domestic companies and households; an economic model dominated by high property values (leading to massive non-performing loans and false collateral valuations in the banking sector); and overcapacity in nearly all economic segments of the Cypriot economy. The worsening macro indicators likely to emerge from the bail-out will affect future national projects, notably the financing of the development of Cyprus’ oil and gas sector.

While it is too early to provide a macroeconomic model for the reforms, we believe that the following risks will manifest themselves in the next 18-24 months in Cyprus. We remind readers that these risks also translate into opportunities, under certain circumstances.

1. Implementation Risk: It remains to be seen whether the divided Parliament will pass the loan conditionality bills, and how these will be implemented. We expect three main symptoms which illustrate the implementation risk to this programme:

  • “Anti-Memorandum” parties will emerge, promising an end to the recession and to austerity, and seeking to capitalise on popular revulsion with the reforms. This will complicate the political dialogue and encourage backsliding on implementation.

  • Sections of the civil service may refuse to implement many of the reforms. Since independence, the British-trained civil service has proved one of the main strengths of the public sector. The last 10 years, however, have seen a notable “bureaucratisation” and politicisation, and it is possible that legal implementation will be slowed from within.

  • The worsening economic climate will lead to calls to water-down or change the  reforms, particularly for additional measures to be passed at the end of 2013-2014.

2. Political Risks: These are closely associated with implementation risks. It is noteworthy that in contrast to all other European countries that have undergone a bail-out, the opposition in Cyprus has been pushing for austerity measures, while the government has been resisting them. In fact actively campaigning against the “Troika”, with the current President at one point threatening to protest with the unions if certain measures were demanded.

National elections will be held in Cyprus in February 2013, and by all appearances, the current ruling party is already preparing its life in opposition with an active campaign against the austerity measures, with the full support of certain public sector unions. Moreover, an “independent” candidate has emerged, with the support of the Church, campaigning actively against the Memorandum.

It would appear that Cyprus will make rapid political commitments in the next couple of weeks, voting in the loan conditionality measures in order to receive the first bail-out instalments in January or February 2013. It remains to be seen how the loan will be disbursed, and whether additional conditionality will be required.

It is almost certain, however, that political support for or against the Memorandum will comprise the central elements of the next election, and that certain parties and politicians will invest in blind opposition for their individual political interest, but which goes against the wider interests of the state.

3. Economic and Fiscal Risks: A detailed financial assessment of Memorandum policies has not been released. However, we believe that the full impact of these policies will not have been adequately modelled. Recent IMF debates about the fiscal multiplicator effect of austerity expressed at the IMF Annual Meeting in Tokyo reveal that the impact of austerity may have a greater impact on GDP than previously thought. We believe that the similarities between the statist economy in Cyprus and that of Greece indicates that a high fiscal multiplier may be in effect. In this case, both the 2013-2015 GDP decline and unemployment may be higher than initially calculated.

4. Sectoral Risks: Certain sectors are disproportionately affected by the loan conditionality. Property, hotels and restaurants will all be hit by higher operating costs through the higher VAT rate and the property tax. Segments dependent on consumer spending, such as retail, cosmetics, clothing and restaurants will be affected by lower disposable income due to higher taxes, recessionary effects and, in the public sector, wage cutbacks.

5. Financial Sector Risks: As strange as this may sound, it is not entirely certain what the EUR 10 bln recapitalisation of Cypriot banks is expected to achieve in microeconomic terms. The bail-out will have positive and negative impacts. On the positive side, the recapitalisation will eliminate the risk of a bank run, i.e. a rapid deposit withdrawal scenario which results in a bank closure or collapse. Yet there are any number of negative impacts:

  • The recapitalisation will significantly dilute existing shareholders, including Russian ones. This will affect private sector willingness to work with or invest in Cypriot banks for a long period of time to come.
  • The recapitalisation value amounts to EUR 10 billion, or 56% 2011 GDP, and will bring total debt:GDP to 127% (of 2011 GDP). This will in turn lower Cyprus’ credit rating still further and detract from foreign investor interest in Cyprus.
  • It is not certain whether the recapitalisation will result in further lending: the development impact, therefore, is very limited. Most Cypriot companies and households are over-leveraged: their current debt levels are already too high in relation to either their liquid assets or their income. Additional investments in property development are not realistic at the current time. Most companies face massive overcapacity in every segment. Loans for personal consumption are equally unattractive for the same reason.
  • The liquidity concentration measures announced, together with stricter money laundering enforcement, may signal an end to Cyprus’ attractiveness as an international financial centre. Unless foreign investors—particularly Russian ones—are assured that banking secrecy and liquidity limits will be respected for transfer pricing and wealth repatriation/reinvestment cycles, they will not hesitate to review other opportunities, particularly in Luxembourg, Switzerland, the British Channel Islands, or Ireland.
  • The exit strategy following the recapitalisation is unclear. Eventually, the government will have to sell its stakes in the Cypriot banking system, but it is not certain at all how long this will take, or what value is recoverable given the high bail-out value to banking assets and income.

While bank capitalisation is critically important, it is not an end in itself: this point does not seem to have been understood by the Troika, the Cypriot government or the managers Cypriot banking system.

It is urgently necessary that the government and the Troika clarify their stance on this issue, as well as on the wider issue of Cypriot bank competitiveness.

6. Offshore Sector Risks: Cyprus urgently needs to re-establish confidence in its role as an international business centre. Confidence in the Cypriot government has been shaken, and a number of companies are looking at alternative investment destinations. A range of collateral issues needs to be resolved, including title deeds for property, the high cost of banking, and the need to rationalise the domestic banking network while strengthening the competitiveness of international banking unit services.

The greatest risk is that which emerges from the cumulative effect of these risks. Cyprus confronts its greatest national project since EU entry: developing its offshore oil and gas sector. Unless confidence is rapidly restored and the new government is actively seen to be implementing a rational, internationalist economic policy, the high price of developing oil and gas infrastructure will be affected. This means that in addition to delays in development, the Cypriot government will have to pay more, or offer a greater share of production, reflecting the higher risk of investing in Cyprus.

Ultimately, the current government has been forced to sign a challenging bail-out deal. The next government will have to implement it. Unless a cross-party effort is made to address the very serious structural and fiscal challenges in the Memorandum but also in the wider economy (e.g. overcapacity, overleveraged households and enterprises, high costs), Cyprus may enter a downward spiral of higher recession, higher unemployment, and long-term capital flight. This creates a massive responsibilities for the current generation of political leaders, and it remains to be seen whether they will rise to the challenge, or revert to their normal behaviour.

[1] Tugwell, Paul and Eleni Chrepa: Cyprus, Troika Agree Bailout Terms, ECB Demetriades Says. Bloomberg. 30 November 2012. Accessed on 1 December 2012. Available at: http://www.bloomberg.com/news/2012-11-30/cyprus-troika-agree-bailout-terms-ecb-demetriades-says.html

[2] This is the upper range of loans reported in press: the specific loan volume has not yet been agreed. In Greece, a second bail-out of EUR 130 billion was agreed in the fall 2011, bringing the total volume to approximately EUR 200 billion (not all the first bail-out was disbursed).

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