The Cyprus Bail-out: Challenges, Opportunities and Lessons from Greece
13 December 2012 | Philip Ammerman
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.
 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
 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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