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

13 December 2012 | Philip Ammerman

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 = 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

Factor                                             Cyprus                                         Greece

 

Date of Bail-out                            December 2012 –                       May 2010

                                                         January 2013

Current GDP at date of              EUR 17.98 billion                        EUR 227.32 billion

application

Debt : GDP Ratio                        71% (end 2011)                            129% (end 2009)

 

Main reason for bail-out          Public sector suffered a             Public sector cut off 

                                                     credit rating downgrade            from international debt

                                                      as a result of Greek                    markets; unable to

                                                     exposure: Cyprus                        refinance or roll-over

                                                     government has been shut       debt from private

                                                     out of international debt           lenders

                                                     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

Initial Bail-out Volume[2]     EUR 17.5 billion                           EUR 110 billion

 

Bail-out : GDP Ratio                97.3%                                            48%

 

Initial Eurozone interest        2.5%                                              5%

rate on Loan

Loan Term                               30 years                                         7 years

 

Quality of Public                    Sound (until present)                 Unsound: the 2009

Statistics                                                                                        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