Download 1 Beware of German gifts near their elections: How Cyprus got here

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Beware of German gifts near their elections: How Cyprus got here and why it is currently
more out than in the Eurozone
By Alexander Apostolides,
Lecturer, European University of Cyprus1
Key points:
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The situation in Cyprus arose due to banking overreach, insufficient regulation,
excessive government deficits, poor debt management and collateral damage from
previous Eurogroup bailouts
The amount needed is small in absolute values, but large relative to the size of the
economy. The Troika was unwilling to fund more than 10bn Euros.
Extreme delay from the departing Christofias government and persistence from the
Troika led to the bailing-in depositors to cover the gap. An attempt to spread the pain
by suggesting a “shares-for-deposits swap” for all Cypriot depositors, (bailing-in even
insured depositors) was defeated in the Cypriot parliament.
In subsequent negotiations, insured depositors were unharmed: uninsured depositors
in the largest two Systemically Important Financial Institutions, Laiki Bank and Bank
of Cyprus were affected
Local debt default and forced rollover are part of the bailout, but as it currently stands,
holders of external debt are to be paid in full. The exception is the Russian Federal
Republic direct loan to Cyprus: the agreement is conditional it being restructured.
As a result of the above actions, Cyprus is left facing an unprecedented economic
depression; the link between weak financial institutions and a weak state has not been
broken, making a second bailout very likely.
Cyprus has capital controls, deteriorating financial situation and needs to defend itself
against local and domestic lawsuits that might overturn decisions. Cyprus is still
dangling precariously from the Euro exit cliff.
1. What happened in March 2013?
Cyprus has dominated news across the world since the early morning of the 16th of March,
when the Eurogroup and the recently inaugurated President of Cyprus, Nicos Anastasiades
agreed to a rescue deal that would include the bail-in of uninsured and insured depositors in
all Cypriot financial institutions2. The bailout Cyprus needed (for government debt expiration,
projected government deficits and supporting the financial system) was calculated then as
€17bn. The Troika of the European Commission (EC), the International Monetary Fund
(IMF), and the European Central Bank (ECB), was only willing to fund €10bn.
The reasons for the large gap between the Cyprus’ needs and the Troika’s desire were
twofold: Cyprus needed €7bn for the recapitalization of the financial sector, which Germany
1
Corresponding Address: 6 Diogenes Street, 2404 Engomi, Nicosia, Cyprus. [email protected]
P. Spiegel, “Cypriot bank deposits tapped as part of €10bn eurozone bailout” Financial Times (2013), 16th of
March
2
Electronic copy available at: http://ssrn.com/abstract=2260222
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was unwilling to pay; the IMF wouldn’t participate in a programme that would push the debt
of Cyprus into what it argued were unsustainable (i.e. Greek) levels. Thus the Eurogroup
demanded that Cyprus find the €7bn from the banking sector. Junior bank bondholders would
lose €1.2bn, and the remaining €5.8bn would be raised by bailing-in depositors.
The deal in the 16th of March led to all depositors in Cypriot financial institutions being
affected and not only those in the banks that needed urgent recapitalization. Those who had
deposits over the insured €100,000 would have 9.9% of their deposits converted into shares
of the financial institutions which would receive their deposits to recapitalize. Surprisingly,
insured depositors were also affected, having 6.75% of their deposits similarly affected.
The decision to bail-in even insured depositors was immediately regretted by the Eurogroup,
and the resulting rejection of the bailout from the Cypriot Parliament saved the Eurozone of a
lot of blushes3. While the Cyprus government scrambled to find alternative solutions, the
Eurogroup made clear that a decision not including a bail-in of depositors would not be
accepted4. Cyprus had became a hot issue in the upcoming German elections, and it was
deemed politically necessary to introduce a bail-in of depositors for the deal to go through the
German (and other) parliaments.
The banks in Cyprus remained closed while a new bailout deal was being hatched and a host
of foreign media correspondents descended on the island. Cyprus’ modern economy quickly
descended into “cash-only” exchange as all bank accounts remained frozen and no one was
allowed to take more than €300 a day from the ATMs: the Eurozone had its first Corralito
moment.
On March 25th, a new deal was reached, and three days later the banks opened after a twelve
day banking holiday, a world record5. Bank runs did not occur but the banking system was
operating under strict capital controls, which has been relaxed but still in place at the time of
writing. The new deal indicated how severe was the damage caused by the bank closure and
3
“Ζητούσαν επιστροφή στο πρώτο κούρεμα” Stockwatch (2013) 30th of April
http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=173400
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One alternative that was ignored was debt restructuring that would include external debt: M. Gulati and L.
Buchheit, “Walking back from Cyprus” Vox Columns (2013) http://www.voxeu.org/article/walking-back-cyprus
However the German Minister warned that unless there was a bail-in there would be no bailout: A. Breidthardt
& J. O'Donnell “Insight - How Europe stumbled into scheme to punish Cyprus savers” Reuters (2013) 18th
March.
5
On average bank holidays occur at only 10% of the IMF database on financial crises. They last on average 5
days. L. Laeven and F. Valencia, “Systemic Banking Crises: An Update” IMF Working Papers (2012) 12/163
Electronic copy available at: http://ssrn.com/abstract=2260222
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the uncertainty; depending on who makes the calculation the bailout needs jumped to
€20.6/€23bn, an increase equal to 20.1/33.5% of Cypriot GDP6. Such an increase means that
Cyprus will miss the budgetary targets set by the troika, as in they were largely unchanged in
the second bailout agreement. The main differences in the 25th of March deal was the way
depositors in Cyprus would be bailed-in and adding the new Eurogroup demand that all the
Greek branches of Cypriot banks be sold prior to a full agreement.
The way the Eurogroup decision on the 25th of March chose to cover the bank recapitalization
needs has doomed Cyprus into a deep depression 7 . The European commission argues at
Cyprus will have a cumulative fall of nominal GDP of just 15% over three years; the IMF
suggests that the GDP will fall by more than 12% just this year. The Economics Research
Centre of the University of Cyprus suggests that a cumulative fall of real GDP of over 30% in
four years is probable8.
Tragically, the deepening recession in Cyprus that stems directly from the 25th of March
agreement is set to make a mockery of the projected debt sustainability assessment of the
European Commission. Debt sustainability was the basis of Troika’s demands for Cyprus to
avoid reaching levels of high debt that would make repayment of the official sector loan
difficult9. Yet despite predicting a recession of -12% in 2013, the budget deficit target for the
year is -2.4%10. This is impossible especially since the bailout took place prior to the end of
the tax season. Cyprus would require an impossible reduction of the government deficit by
20% in the seven remaining months of 2013 to achieve the target.
More worryingly, the key issue that made the Cypriot bailout so difficult was that the island
was facing both a banking crisis and a government debt crisis; the Eurogroup decision does
6
P. Spiegel, “Reexamining the Cypriot bailout numbers. Again” Financial Times (2013) 25th April.
Eurogroup, Eurogroup Statement on Cyprus on the 25th of March (2013)
http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/136487.pdf
Leaked IMF MoU (Final): Memorandum of Understanding on Specific Economic Policy Conditionality (2013)
http://static.cyprus.com/troika_memo_final.pdf
8
University of Cyprus, Economic Research Centre, “April 2013” Economic Outlook (2013)
http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdf
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As leaked to the financial times: European Commission, Directorate General of Economic and Financial
Affairs Assessment of the Public Debt Sustainability of Cyprus, 9th April (2013)
http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf
10
“Οι δημοσιονομικοί στόχοι του Μνημονίου” Politis (2013) http://www.politis-news.com/cgibin/hweb?A=234663&-V=articles
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not resolve the dangerous feedback loop between these two issues11. The state is not allowed
to borrow from the official sector to help the banks; yet the deepening depression will lead to
banks and cooperatives needing more support as bad loan provisions are revised upward. At
the same time the increased unemployment and a decrease in revenues will mean the state
will need to borrow more, but the local financial institutions will not be able to help12. As a
result Cyprus will need a second bailout, as the Troika is the only agent which can break the
link between weak government and weak state.
The 25th of March deal requested Cyprus to resolve the issue of the largest two banks in the
island, Laiki Bank (formerly Marfin Popular (Laiki) Bank) and at a lesser extent Bank of
Cyprus (BOC). Both banks failed their recapitalization targets and needed recapitalising
without aid from the Troika. The refusal to use bailout capital for the banking sector is new:
in all other Eurozone bailouts, a rescue fund was allocated to enable banks to recapitalise
through resources provided by the official sector. It was understood that there was a risk that
a government debt crisis could become a financial sector crisis that would undermine debt
sustainability efforts. However, German elections due in September ensured that the Cyprus
bailout would be a very different proposition.
It was decided not to close down either bank but instead to restructure them: Laiki’s insured
depositors would be transferred to Bank of Cyprus, along with all the performing assets. The
uninsured depositors of Laiki were bailed-in 100%, and they would become the shareholders
of “bad” Laiki, which would have some yet undisclosed non-performing assets. In the
process Laiki shareholders and junior bondholders were wiped out, but since the bank has not
been bankrupted there have been lawsuits against these decisions.
The BOC would also bail-in uninsured depositors, although at a yet unknown proportion, and
take the insured depositors and good assets of Laiki. The BOC board resisted and the bank
was taken over by the Central Bank of Cyprus (CBC), who sacked the board. The CBC
initially cancelled all shareholders, only to reverse the decision after the local courts put a halt
in the proceedings, questioning the legality of cancelling existing property rights. The CBC
responded to the court by creating four categories of shares, placing the new bailed-in
shareholders in the first category, with junior bondholders and existing shareholders in lower
11
SA Zenios, “The Cyprus debt: A perfect crisis and the way forward” The Wharton Financial Institutions
Center, Working Papers (2013) #13-09
12
The Economist, “Through a Glass, Darkly” (2013) 27 th of April
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categories. Hundreds of lawsuits are already in place against Laiki, BOC, the CBC and the
Cyprus government due to the way the restructuring was handled. The litigation that the
chosen method of bank restructuring has generated ensures the continued uncertainty in the
Cypriot finance industry.
The bank branches of all Cypriot banks, irrespective of whether they were in trouble, were to
be sold to Piraeus bank in Greece by the order of the CBC at the request of the Troika. The
deal was awful for the Cyprus government, but the Troika insisted that Cyprus should be
isolated, cutting off the only channel of contagion to the rest of the Eurozone13. Yet this
decision ensured that depositors in Greece avoided the bail-in of Laiki and BOC, while
Cyprus depositors would have to pay more, increasing the amount that was converted to
shares in the bail-in.
How bad was the deal for Cyprus? The CBC received €525 million from Piraeus bank
(effectively given by the Greek Bank Rescue Fund, set up by the Troika). For that amount,
Cyprus sold €16bn of assets and gave away 15bn of deposits 14 . It was stuck with
recapitalizing the Greek branches losses prior to the sale: just for Laiki in Greece that was
estimated at €2.8bn. In addition up to €5.5bn in liquidity assistance given to fund withdrawals
of Greek depositors from Greek branches became liabilities of the Cypriot branches, despite
being guaranteed on Greek assets. Thus, Cyprus was forced to cover the Greek liquidity gap
of Cypriot banks while losing the assets that were pledged to the assistance. The deal was so
poor that Laiki refused to sign and the CBC governor ignored them and just signed on their
behalf15. Lawsuits relating to the sale of the Greek branches are expected.
Perhaps the most controversial decision in regards to the banking central was the handling of
the liquidity assistance provided by the ECB through the CBC. Through the Emergency
Liquidity Assistance (ELA) procedure the ECB, through its local subsidiary (in this case the
CBC) injected up to €9.9bn of liquidity in Laiki, as the bank was facing substantial
13
H. Dixon, “Cyprus bank ‘resolution’ a bad joke” Reuters (2013) 2nd of April http://blogs.reuters.com/hugodixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/
14
Piraeus Bank, Press announcement (in Greek); Piraeus Bank has taken the Greek banking business of Bank of
Cyprus, Cyprus Popular (Laiki) Bank and Hellenic Bank (2013) 26th March
http://www.piraeusbankgroup.com/el/~/media/0B74D7B60CF54BE7A57C8AB42720866D.ashx
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H. Dixon, “Cyprus bank ‘resolution’ a bad joke” Reuters (2013) 2nd of April http://blogs.reuters.com/hugodixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/
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withdrawals 16 . Laiki provided discounted assets as guarantees for the ELA: this liquidity
assistance remained a liability with priority of repayment for Laiki and an asset for the CBC
balance sheet; the ECB is not technically part of the process, although it is the provider of the
given liquidity. Yet the CBC, with the blessing of the ECB, kept providing liquidity to Laiki,
even though it became clear in 2012 that the bank was becoming insolvent. Laiki received
€9.8bn of ELA by June 201217, and the current central bank governor (Panikos Demetriades)
seems to have refused to shut down the bank for political reasons, meekly stating that he
warned the departing Christophias government.
Why did the CBC governor not press the issue? There is the suggestion that his appointment
by the previous Christophias government (on the 3rd of May, 2012) was conditional to Laiki
remaining open until after the elections, scheduled in February 2013. The fact that Laiki
became insolvent but was still provided liquidity became an issue in the Eurogoup negations
of the 15th of March; the Eurogroup warned President Anstasiades that failure to agree on a
bail-in of depositors would mean the stopping of liquidity of the ECB/CBC to Laiki. This has
led to public conflict between the new government of President Anastasiades and the acting
CBC governor.
The ELA given to Laiki has complicated attempts to restart the Cypriot financial sector.
Some argue that ECBhas placed its own interest above the local legal framework, damaging
the Cypriot economy further, through the actions of its local subsidiary, the CBC 18. This is
because the CBC accepted discounted assets of Laiki and provided over 9.9bn of ELA to
Laiki, even though it was clear by the level of withdrawals that the bank was by then
insolvent. But, when Laiki was restructured the CBC did not claim the assets that were
pledged to the liquidity provided, but liability of the ELA was transferred (with dubious
legality) to the new Bank of Cyprus19. A question of conflict of interest clearly arises here:
the CBC (and by proxy the ECB) did not want to become owner of the assets that guaranteed
the ELA, but by transferring the liability to Bank of Cyprus, it has effectively reduced the
recovery value of the bailed-in depositors. There have been calls for the investigation of the
16
The ELA directive: European Union, “Directive 2009/44/EC of the European parliament and of the council of
6th of May” Official Journal of the European Union (2009) L146/37
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:146:0037:0043:EN:PDF
17
Α. Αντωνίου, “Λαϊκή: Καταστροφή εξ Ελλάδος” Inbusiness (2013) 15th April
18
J. Ewing, “Blaming Europe’s Central Bank” The New York Times (2013) 29th April
19
C. Xiouros, “Χειρισμός του Emergency Liquidity Assistance της Λαϊκής Τράπεζας στο πακέτο διάσωσης της
Κύπρου” Stockwatch http://blog.stockwatch.com.cy/?p=1754
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CBC’s role in providing liquidity to Laiki and to legal avenues being explored to force the
CBC to liquidate the ELA by taking the pledged assets20.
By placing the ELA burden onto the newly restructured Bank of Cyprus the CBC ensured
that both capital controls needed to be introduced, as that the new bank would be capitalised
not very liquid. It was feared that as over half of the deposits of the new BOC are foreign and
are expected to flee in the first opportunity, capital controls for the whole economy had to be
imposed to prevent further liquidity shortages for the new BOC, as it would reach the limit
allowed under ECB rules. The new Bank of Cyprus will be capitalised fully as it received
good assets from the insured deposits of Laiki, and the bail-in of its uninsured depositors. Yet
this bank might not be able to lend as some argue the ELA has priority in repayment21.
The author has never seen a messier or more confusing bailout. It is clear that the deal on the
25th of March might be a better deal for the Eurogroup as it avoided spooking European
insured depositors, but it was a catastrophe for the financial sector of Cyprus. It is one thing
to bail-in the depositors of a small bank; it is quite another to do it simultaneously to the two
largest banks of a country that held 37.9% of all Cypriot deposits in February 2013 22. In
Cyprus, you simply cannot avoid doing business with Laiki and/or Bank of Cyprus: they are
by far the largest banks on the island by any measurement and were the most accommodating
in terms of international business due to their global presence. The Cypriot banking system
was mostly funded by depositors being €66.7bn or 71% of liabilities in June 2012. Out of
those just 40% were by Cypriot residents, with 34% being non-residents using Cyprus as a
business centre, 19% from Greece and 7% from all other countries (Russian citizens directly
provided 2% of deposits)23.
So why was the bail-in of depositors as a method of financing bank recapitalisation chosen?
The bail-in was considered as ideal by some in the Troika as Cypriot banks were
overwhelmingly dependent on deposits (there was very limited unsecured debt)
20
24
. The
C. Xiouros, Handling of the Emergency Liquidity Assistance of Laiki Bank in the Bailout Package of Cyprus
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2254499
21
SA Zenios C. Xiouros, “Μπορεί να διασωθεί η Τράπεζα Κύπρου από τα λάθη του Διοικητή;” Stockwatch
http://blog.stockwatch.com.cy/?p=1734
22
Source: Central Bank of Cyprus, “Market Shares of Banks, February” (2013)
http://www.centralbank.gov.cy/nqcontent.cfm?a_id=11912
23
Ibid p.9
24
J. Cotterill, “A stupid idea whose time had come” Financial Times Alphaville (2013) 16th March
http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/
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German press and government also backed it, arguing that if Troika funds were used to help
out the banking sector, it would effectively help rich Russians who deposited their money in
Cyprus due to the high interest rate25. The claim of Russian presence / high interest rates is
essentially misleading as to who suffered the real damage of the bail-in.
The outflow Russian depositors prior to March 15th was significant as the German and other
northern European statesmen made no secret of the fact that a bail-in of uninsured depositors
would be part of the Cyprus bailout deal26. Although the interest rates for saving accounts in
Cyprus were higher than in Germany, inflation was also higher, averaging at 2.7% in the last
three years, meaning that some of the interest rate differential could be explained away. In
any case, the bail-in was on all uninsured accounts, even non-interest bearing business
accounts27. As a result the bail-in affected business accounts of Cypriot companies taking
away all working capital of most large Cypriot businesses.
The decision to bail-in the uninsured depositors of these two banks has wiped out the
liquidity from the Cypriot economy. Firms which followed sound financial planning during a
recession (cut costs and accumulate a cash reserve) suddenly found their whole reserve
amount over €100,000 turned into illiquid shares with no market value. While this was
perhaps expected for Laiki, it was largely unexpected for the case of BOC, which had only
missed its recapitalisation needs in May 2013 by just €200/€300 million28. Thus most large
firms and pension funds in Cyprus were caught out; the resulting liquidity tightening means
that the local market has crashed. The business confidence index has reached a historical low,
with consumers stopping all but non-essential consumption29.
25
P. Schuseil, “The Cyprus Bailout Controversy in German Media and Politics” Bruegel (2013) 22nd of March
http://www.bruegel.org/nc/blog/detail/article/1049-the-cyprus-bailout-controversy-in-german-media-andpolitics/ and “German views on Aid for Cyprus” Bruegel (2013)
http://www.bruegel.org/nc/blog/detail/article/985-german-views-on-aid-for-cyprus/ 16th of January
26
L Jr Thomas, “In Cyprus Bailout, Questions in Whether Depositors Should Shoulder the Bill” New York
Times (2013) 10th of January; T. Barber “Cyprus must pay the price for joining the Euro” Financial Times,
Global Insight (2012) 9th of October and M. Walker “Inside Merkel’s Bet on the Euro’s future” Wall Street
Journal (2013) 23rd of April
27
Statistical Service of the Republic of Cyprus, “Inflation, 1960-2012, 8th of January update” (2013)
http://www.mof.gov.cy/mof/cystat/statistics.nsf/economy_finance_14main_en/economy_finance_14main_en?O
penForm&sub=4&sel=2
28
A. Hliades, “Truth and Lies (in Greek)” Politis (2013)) 3rd April p.9
29
University of Cyprus, Economic Research Centre, “April 2013” Research in the Economic Attitudes (In
Greek) (2013)
http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdfhttp://www.ucy.ac.cy/data/ecorece/erevnes%20
oikonomikis%20sigkirias_04_2013.pdf
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It is my opinion, proponents of the bail-in did not understand how complicated it is in
practice and how difficult it was for Cyprus to resolve the banking sector problems quickly
and effectively. The CBC needs to take over and administer two banks that are far larger than
itself: this created manpower shortages and delays. It has also proven difficult to distinguish
who is uninsured: for example, is the joint bank account of a family of three to count as
insured for €300,000 or for €100,000?
In addition both the Eurozone and the Cyprus government have demanded exemptions to the
bail-ins, creating further delays. The Eurozone has demanded that all inter-bank loans should
be exempt, while the government, fearing that the bail-in will also cause a pension crisis, has
asked for exceptions for the affected pension funds. The list of exemptions has now widened
to include charities, educational institutions and local government, but at the time of writing
the list has been removed from the central bank website and there is still uncertainty if any
exemptions will be granted. The size of the exemptions will determine the amount the
depositors are bailed-in30.
The resulting confusion has created delays and increased local and international litigation
claims creating ever greater uncertainty. The letter by the Governor of the Central bank to the
Acting Executive Officer of Laiki, dated 11th of February 2013, clearly states that the
Governor considered that bailing-in depositors is illegal under the constitution of Cyprus and
the European Convention of Human Rights, calling it “legally unfounded”; the same
governor would now have to defend such bail-ins in local and foreign courts.
The delay in the resolution of the bail-ins and the existence of capital controls is destroying
any chance of effective resolution of the banking crisis. As there are strict limits to what one
can do with their deposits in Cyprus, the Cyprus banking sector loses its credibility and utility,
damaging even healthy institutions. This creates a “catch-22”: the longer capital controls are
in place the more depositors become flighty and consumption plummets; the resulting
deterioration on the Cypriot economy delays the final resolution of BOC and Laiki, as more
provisions against bad loans need to be undertaken. At the time of writing just 10% of the
uninsured Bank of Cyprus deposits has been released to the clients; a 37.5% has been
converted to shares, and the remaining 52.5% is held frozen by the Central Bank until
30
“’Μακρύς κατάλογος’ εξαιρέσεων από κούρεμα” Stockwatch (2013) 10th April
http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=171716
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September, when hopefully the final bail-in percentage will be announced. Yet as it seems
likely that capital controls will remain in place at least until then, the situation of the financial
industry will deteriorate further, leading to much more severe bail-ins for the uninsured
depositors. Controls have begun to have very negative effect in the remaining competitive
industry of Cyprus, that of business services.
The banking sector’s problems therefore are still unresolved; the resulting uncertainty this
generates has led to a “sudden stop” of lending and borrowing. Unless that link between a
weak financial sector and a weak government is broken, depositors worry that a second bailin might take place as the economic outlook deteriorates, prompting them to make the
rational decision of taking their money out of the country. This fact, combined by the lack of
an explicit unlimited liquidity commitment by the ECB, requires the existence of capital
controls, which further damage the economy. In addition the Cypriot capital controls,
although granted an exemption by the ECB and the IMF, may still be in breach of Bilateral
Investment Treaties entered into by Cyprus, providing further litigation against the republic
and the restructured banks.
The final bailout amount and its breakdown is still fuzzy and confusing, indicating how
messy the Cyprus bailout is in practice. The European Commission suggests a breakdown of
what the government of Cyprus needs to provide for itself as €10.6bn; €600m from increases
in taxation; €400m from the sale of all the gold of the CBC, €1.5bn from privatisations, €1bn
on local debt rollover and €100m from lower interest through debt restructuring of the direct
loan by the Russian Federation, the remainder through depositor bail-in31. The numbers and
their estimations vary depending on different versions of the document, with other recent
documents suggesting a smaller depositor bail-in might be necessary 32 . The Troika will
provide Cyprus €10bn, out of which €2.5 will go to support the cooperative sector and other
banks, €3.4bn is given for the fiscal needs of the state over the period 2013-2016, and €4.1bn
will go to pay in full maturing foreign loans of the Republic of Cyprus.
The most surprising issue in this whole mess is the decisions relating to the country’s
sovereign debt. All private sector participants, even bank depositors, will be affected, but the
31
European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt
sustainability of Cyprus, 9th April (2013) http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9April2013.pdf p.10
32
P Spiegel, “Reexamining the Cypriot bailout numbers. Again.” Financial Times (2013) 25th March
http://blogs.ft.com/brusselsblog/2013/04/reexamining-the-cypriot-bailout-numbers-again/
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foreign law sovereign bondholders are to be paid on time and in full. The IMF had instructed
the previous government to pass legal instruments allowing the arbitrary restructuring of
locally issued debt. The new government will now use that privilege to roll over €1bn of debt,
and will reduce the debt it has with the CBC by swapping it with land worth of €1bn33. The
direct loan with the Russian Federation, whose terms have never been made public and
whose maturity is due in 2016 will also be restructured, becoming a five year loan with
repayment starting in 2018, and providing a lower interest rate.
The irony is that although Greece PSI was meant to be an exemption, both Private Sector
Involvement and Official Sector Involvement aspects exist in the Cyprus bailout; it is just not
affecting the foreign bondholders or European Union governments. It is incredible that
foreign debt holders are to be immune from pressures to restructure their bonds, despite the
Cyprus bailout requesting such a restructuring from local lenders and a foreign government34.
What makes it even more astounding is that the timing of payouts to bondholders seriously
restricts the viability of the Cypriot bailout plan. At a time when Cyprus is already failing to
meet its deficit targets, the first tranche of €2bn of Troika financing will be received in May.
Yet €1.4bn will go towards paying in full Euro Medium Term Notes expiring in the 3rd of
June, leaving only €600 million for financial and banking needs until the first half of the year.
Because of this there are growing calls for foreign law bondholders to be pushed into the
same restructuring that is being offered to the local institutions and the Russian government35.
Questions of fairness of paying in full strategic investors who knew the risks of Cypriot
Government bonds while bailing-in Cypriot grandmothers are being asked, while the amount
of litigation the Cypriot bail-in and capital controls have created make the threat of further
litigation on foreign debt not so prohibitive36.
33
European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt
sustainability of Cyprus, 9th April (2013)
http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf p.12
34
J. Cotterill, “The Buchheit bat-signal, a few days on” Financial Times Alphaville (2013) 21st of March
http://ftalphaville.ft.com/2013/03/21/1430252/the-buchheit-bat-signal-a-few-days-on/ ; J. Cotterill “A stupid
idea whose time had come” Financial Times Alphaville (2013) 16th March
http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/
35
Public Debt Office, Cyprus, “Outstanding Securities in the Foreign Market as of 31st of December (2012)
http://www.mof.gov.cy/mof/pdmo/pdmo.nsf/All/0F88002C3BEA16C1C225784800373547/$file/Outstanding%
20securities%20in%20the%20foreign%20market%2012_12_31.pdf
36
M Zachariades, Fairness and Sustainability for Cyprus" Econbrowser (2013)
http://www.econbrowser.com/archives/2013/04/guest_contribut_36.html Cyprus Academics Initiative, “The
Cyprus debt crisis: Capital Flows and Debt Restructuring” Stockwatch (2013)
12
The above was an attempt to explain the complicated situation that arose during the last two
months in Cyprus. Yet we need to understand how Cyprus ended up in this mess and what are
the challenges moving forward?
2. How did Cyprus end up here? Entry in the Eurozone
The Republic of Cyprus joined the European Union in 2004 and like all member states (with
the exception of the UK and Demark) it committed to join the Eurozone once the necessary
macroeconomic conditions were met37. Joining the European Union was considered a great
strategic success for a republic which has multi-communal rights enshrined in the constitution,
but is effectively without Turkish-Cypriot representation since 1963 and under partial
occupation since 1974. The Republic in the EU represents the whole island de jure, but in
reality more than 42.8% of the area is under Turkish military occupation, United Nations
Buffer Zone control, or British Sovereign Base Area command.
Cyprus was by far the most prosperous nation in terms of income of the ten new entrants in
the EU, having the best macroeconomic indicators relative to other fellow entrants. In fact
unlike other new entrants, Cyprus was and still is a (marginally) net contributor to the EU
budget. Between EU entry and the entry into the Eurozone 2008, Cyprus had fulfilled the
Maastricht criteria for entry, had an average yearly inflation of 2%, maintained a GDP growth
rate of 4.1% and had one of the lowest European unemployment rates at 4% 38.
The Eurobarometer survey of opinions on the Euro in 2007 indicated that Cypriots were most
suspicious of the Eurozone and only reluctantly left the Cypriot pound: only 40% of
respondents thought the Euro would have a positive impact for Cyprus, and just 33% of
Cypriots thought the adoption of the Euro was a positive experience for other countries39.
This was due to the relative success of the Cyprus Pound in being a stable currency. However
a rapid entry in the Eurozone was considered vital for Cyprus for two reasons:
37

to reduce the interest rate premium on government and private borrowing.

to enhance its competitive advantage in business services
European Commission, Adopting the Euro http://ec.europa.eu/economy_finance/euro/adoption/
Source: IMF World Economic Outlook Database, October edition (2012)
http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx
39
European Commission, Flash Eurobarometer Introduction of the Euro in the New Member States: Analytical
Report (2007) http://ec.europa.eu/public_opinion/flash/fl_214_en.pdf
38
13
Cyprus wanted to enter the Eurozone as soon as possible in order to reduce the interest rate of
its lending. The republic had to endure high interest rates due to the risk posed by the
presence of Turkish Troops on the island and the non-resolution of the communal problem.
This high government rate created a high base rate for the economy: private borrowing was
also at high interest levels. The gradual abolition of capital controls prior to accession to the
EU, combined with preparations for Eurozone entry led to a reduction of borrowing costs,
creating a windfall gain for the government and for Cypriots. From 2008 onwards, both the
government and Cypriots used that windfall to increase their debt to worryingly high levels
Why Cyprus’ entry in the Euro was considered crucial in order to develop the emerging
business service sector? Even before EU entry, the Cypriot government had promoted the
island as an offshore international banking and business services centre and considered that
Eurozone entry would increase the island’s attractiveness. One can argue that before the
decision to enter the EU, anti-money laundering controls were below standard. Yet, as part of
the negations for entry, successive Cypriot governments ensured compliance with
increasingly more stringent directives on issues of corruption and illegality: it was a price
worth paying in order to gain the advantages of EU entry.
Some suggested that Cyprus did improve its regulatory framework while at the same time
relaxing the supervision of money-laundering, which might be fair. It is worth noting
however that in terms of compliance Cyprus currently ranks as 7th out of the 17 Eurozone
countries according to Financial Action Task Force (FATF) of the Organisation for Economic
Cooperation and Development (OECD), with Germany being 14th. The issue of moneylaundering and tax avoidance became a contentious issue during the negations of the Cypriot
bailout, with the German press arguing that none of their contribution to the bailout should go
to support tax dodging depositors of Cypriot banks. Thus, as part of the Memorandum of
Understanding, a commitment was made for two anti money-laundering investigations: a
“customer due diligence” report by the European Commission’s MONEYVAL40, which has
up to now given Cyprus a clean bill of health, and a separate report from a private firm. At
the time of writing the MONEYVAL investigation has been concluded, but not released, and
a contract has been signed with Deloitte to undertake the private investigation.
40
MONEYVAL: acronym of Committee of Experts on the Evaluation of Anti-Money Laundering Measures and
the Financing of Terrorism
14
Meanwhile the effort to clean up its act in terms of money laundering had an effect: by 2000
Cyprus was removed from the “blacklist” of annual reviews by the FATF; this resulted to
some loss of attractiveness for offshoring in Cyprus41. In an effort to maintain the island’s
attractiveness as an offshore centre, Cyprus lowered its local corporate tax rate in 2003 to the
same level as the offshore rate (10%), enabling foreign firms to register as Cypriot. At that
moment Cyprus gave a great advantage for offshore business to the transferred into domestic
companies, creating the initial conditions that would lead to the crisis. It allowed essentially
offshore firms to become European firms with all the advantages that entailed, and enabled
them to continue to use Cyprus as a conduit of their tax efficiency, while being domiciled
inside the Eurozone from 2008 onwards.
The combination of the above policies led to unintended consequences: Cyprus in the
Eurozone did expand as a financial centre, but not in the way the policy makers envisaged.
The favourable double taxation treaty of Cyprus and Russia and other countries42, combined
with the low corporate tax rate for Cypriot firms led to the island becoming a conduit for
deposits to and from Europe. European, Russian and Ukrainian firms registered as domestic
companies in Cyprus and used it for tax efficiency purposes. Sometimes Cyprus companies
would funnel capital back from other offshore centres into Russia and other countries and
gain tax exemptions by registering it as foreign investment.
These practices were encouraged by Cypriot banking, accounting and law services, and over
time they managed to attract an ever greater number of European and non-European firms.
Firms would be domiciled on the island and open accounts in Cypriot banks; at the same time
they would lend the money back to their international operations, making Cyprus more of a
centre for capital flows (in and out) to capitalise of tax efficiency and investment schemes.
This “roundtripping” of deposits explains in part how Cyprus is considered one of the largest
investors in Russia. But it must also be understood that Cyprus is neither the main centre of
Russian deposits within Europe (Luxembourg and Switzerland hold far higher absolute
numbers of Russian deposits), and nor were such practices isolated to Russian firms and
Cypriot banks, but also involved other EU and non-EU companies and financial institutions.
41
F Mullen, “Economic Impact of Membership”, in J Ker-Lindsay, H Faustmann, F Mullen (eds.) An Island in
Europe: The EU and the Transformation of Cyprus (2011) p.72
42
The double taxation treaty has been updated in 2009 with an additional protocol. Cyprus ratified the Protocol
in September 2011 whilst Russia ratified it on February 15, 2012. The Protocol came into force on April 02,
2012. Source: Inland Revenue, Republic of Cyprus, Double Taxation Agreements (2012)
http://www.mof.gov.cy/mof/ird/ird.nsf/dmldtc_en/dmldtc_en
15
The CBC governor at the time of Euro entry, Athanasios Orphanides (2007-2012) attempted
to isolate the domestic market from these volatile, essentially foreign deposits that were used
for “roundtipping”. The CBC asked for MONEYVAL data of country of residency and
enforced stricter reserve ratios on such loans; as a result banks gave lower interest in such
“roundtipping” deposits, as they incurred a greater cost to banks. Hence the foreign press was
wrong to justify the bail-in of Cypriot depositors as one of higher interest rates on savings, as
at least “roundtipping” deposits did not receive necessarily higher rates than what they would
have received in other Eurozone countries; with their Cyprus presence they gained from low
corporate tax rate, tax efficiency and other business services.
The PIMCO report commissioned by the CBC clearly indicates that by 2012 this went out of
hand: by 31st of March 2012 Cypriot banks had over €143bn worth of assets43, when the GDP
of Cyprus was just €17.8bn. The banking system became far greater than the nation’s ability
to monitor and support it in times of crises. This would be less of a problem if the banking
sector was under majority foreign ownership, as in the case of Luxembourg, and hence under
the supervision of a regulatory authority which has the capability and the backing of a much
larger and solvent state.
Some did warn about big, domestically owned banking institutions and the inability of the
government to support them in times of crisis, but most ignored the advice44. In fact, when
the second biggest bank, then called Marfin Popular Bank (now Laiki) announced in May
2009 that it would merge its Greek and Cypriot operations and move its headquarters to
Greece, (thus regulated by the Central Bank of Greece) due to claimed obstruction to its work
by Orphanides, most financial commentators in Cyprus breathed a sigh of relief. Yet the
decision was reversed in September 2009 through direct political intervention by the then
President of the Republic of Cyprus, Demetris Christofias; as a result the bank merged its
Greek branches with the Cypriot operations while maintaining its headquarters in Cyprus thus
increasing rather than reducing the systemic risk to the Cypriot economy45.
43
PIMCO, Independent Due Diligence of the Banking System of Cyprus (2013) p.8
C Stephanou, “The Banking System in Cyprus: Time to Rethink the Business Model?” Cyprus Economic
Policy Review, (2011) Vol. 5, No. 2, pp. 123-130
45
Alvarez and Marshall, Investigation Report, Bank of Cyprus – Marfin Popular Bank Group Review of Cross
Border Merger 26th March (2013) p.5 http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriotbanks-sought-state-help/20130404
44
16
The stage was set for a serious banking crisis: it took the actions of the communist led
government during the period 2008-2013, the actions of the two largest banks of Cyprus,
Marfin (Laiki) bank and BOC and the decisions of the Eurogroup to make Cyprus the most
intractable bailout case within the Eurozone.
3. Marfin Laiki Bank; Cypriot Bank Expansion in Greece
When Cyprus became independent in 1960, it already had a competitive domestic banking
infrastructure. Bank of Cyprus (BOC) was based in Nicosia (the capital) but was already a
national bank and the biggest bank on the island. Limassol’s Cyprus Popular Bank (in Greek:
Laiki) was much smaller in second place. Other financial institutions (most notably the
cooperative sector) and foreign banks existed, but the aforementioned banks dominated the
domestic financial landscape.
Competition was mainly based on expansion in larger foreign markets. Both banks had
established branches in Greece prior to the entry into the European Union due to the strong
cultural links of Cyprus with Greece. The rapid inflow of deposits explained above led to a
rapid expansion of their operations in Greece, as well as in new ventures in Serbia, Romania,
Russia and Ukraine. In an attempt to outgrow its far larger competitor (the BOC), Laiki
decided in 2006 to merge with two smaller Greek banks. Greek lawyer Andreas Vgenopoulos
was placed in effective control, despite not having significant ownership. In doing so the
Cyprus Popular bank undertook a Faustian contract, which doomed itself and the small
Cypriot economy.
Cyprus Popular (Laiki) Bank, was merged with smaller Marfin Bank and Egnatia Bank to
form Marfin Popular Bank (MPB). The Greek branches of these banks were merged as
Marfin Egnatia Bank (MEB) a subsidiary which with 95% ownership by MPB. The merger
was a disaster for Laiki. MEB was one of the worst performing Greek banks, running into
trouble very early in the Greek financial crisis: by 2012 over 40.1% of its Greek loanbook
was non-performing46. Up to €800 million was given in loans to third parties to buy shares in
Marfin Investment Group, a company also controlled by Andreas Vgenopoulos; many of
these loans were structured as bullet loans, with the principal and sometimes the interest all
46
A. Antoniou, “Λαϊκή: Καταστροφή εξ Ελλάδος” Inbusiness (2013) 15th of April
http://www.sigmalive.com/inbusiness/news/business/40289
17
paid in the end of the loan period47. The decision to turn MEB into a branch of MPB in 2009,
while keeping the main company under the regulatory supervision of Cyprus ensured a direct
transfer of exporting the poor performance of MEB in Greece to the Cypriot state, who would
have to act as the lender of last resort. What is shocking is that the merger and the
convergence of MEB into a branch was not finalized until the 31st of March, 2011. By that
date it must have been clear that MEB was moribund, and that the Private Sector Involvement
(PSI) of Greek Government Debt was on the cards, as the Merkel/Sarkozy “Dauville moment”
suggested it as far back as Octomber 2010.
It is not clear why the conversion of MEB to an MPB branch was not stopped by Orphanides.
When the merger and branching was finally approved in 2011, the MPB was holding 3bn of
Greek Sovereign debt, for which the CBC requested an increase of capital of 1.5bn. Yet
despite increasing evidence that there would be a mandatory private sector involvement of
the Greek Government Bondholders, the MPB maintained the high levels in Greek
government bonds it had purchased. By July 2011 the Cyprus Government was also aware of
the “voluntary” private sector involvement as agreed by the EU’s Consilium, and yet no
efforts were made to force MPB to realise the losses of Greek Government Bonds48. The
eventual losses of Laiki and Bank of Cyprus to the Greek PSI were €3.5bn, putting the death
knell on any possibility of the Cypriot Banking Sector being able to fully initiate a selfrecovery without government support.
The MPB was not the only Cypriot bank which acted recklessly in hoarding Greek
Government Bonds as the Greek PSI was crystallizing. Alvarez and Marshall indicate that the
then CFO and future CEO of Bank of Cyprus, Giannis Kypri, informed the market that the
bank sold €1.8bn Greek Government Bonds, with only €0.1bn left in the bank portfolio 49. Yet
on the same day the BOC began repurchasing Greek Government bonds reaching close to
€2.4bn by June 2010. The report highlights that in BOC (and it is assumed that similar
actions were taking place in Laiki) kept trying to hide the emerging losses in Greece through
speculation in Greek Government Bonds. Up to 30% of pre tax profits were coming from
47
Alvarez and Marshall, Investigation Report, Bank of Cyprus – Margin Popular Bank Group Review of Cross
Border Merger 26th March (2013) http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriot-bankssought-state-help/20130404
48
Council of the European Union, Statement by the Heads of State of the Euro Area and Euro Institutions, (2011)
21 July http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/123978.pdf
49
Alvarez and Marshall, Investigation Report, Bank of Cyprus – Holdings of Greek Government Bonds, 26th
March (2013)
18
Greek government bond related activity in the BOC prior to the Greek PSI. The risks were
there, but it seems banks preferred not to divest Greek Government Bonds, as that would
mean they could “avoid the crystallisation of losses”50.
This is a case of clear moral hazard. By 2010 the combined investments of MPB and BOC in
Greek Government Bonds were higher than the ability of the increasingly cash strapped
Cyprus government to absorb them. Thus banks in Cyprus knew that if Greek bond PSI did
take place, their losses would be severe enough to force the Republic of Cyprus to seek a
bailout. Thus any Greek PSI would either be vetoed by Cyprus, or Cyprus would hold out
until support for the Cypriot banks or for the Cypriot government was guaranteed. This
spurious strategy allowed them to invest in increasingly high risk Greek government bonds.
But why did the Cyprus Government not request a bailout when the Eurogroup decision for
the Greek PSI was confirmed in EU consilium meetings in July/October 2011 and finalized in
February 2012?
4. The Disastrous Government of President Christofias
There is no doubt that an emerging crisis was brewing over the island of Cyprus since 2008.
Yet the above issues were then still manageable with correct leadership: At best Cyprus could
have introduced measures to combat the emerging banking crisis right away and avoid a
bailout; at worst the Cyprus government could have just borrowed for its stricken financial
sector at the same time as Spain.
Sadly the Cyprus elected a president in February 2008 with no real understanding of the
issues who was also ideologically averse to the idea of the European Union. President
Demetris Christofias (2008 to 28th February 2013) was the general secretary of the AKEL
party. The party, which used to be aligned with hard line communist values, still has antiEurope, anti-NATO, and anti-IMF views, which President Christofias has expressed
frequently during his time in office.
If the banks are to blame for questionable morality, the government of Demetris Christofias is
to blame for stubbornly refusing to accept the limitations of government in a weakening
economy. The Christofias government can be summarised as one of unrestrained largesse:
50
Alvarez and Marshall, Investigation Report, Bank of Cyprus – Holdings of Greek Government Bonds, 26th
March (2013)
19
too much government spending, too much short term borrowing, too much solidarity to
Greece, and too much delay in seeking a bailout.
Christofias received an economy which was still unaffected by the Lehman crisis but it was
beginning to have collateral damage from the emerging Greek debt crisis. The initial
conditions were ideal: low debt to GDP (48.9%) ratio and small government surplus for two
years (cumulative +4.4% of GDP) 51 meant that the government could have supported the
banking sector initially through borrowing in external markets. However, in 2009 the
economy went into a recession (-1.8% of GDP), while the Christofias government went on a
reckless spending spree. Despite government revenues falling by -8.5%, the Christofias
government increased expenditure by 7.8%, mainly in untargeted and ineffective social
benefits and in exercising the patronage that previous Presidents had also exercised by
bulking out the government employment. This yawning gap between revenue and
expenditure kept getting larger despite the weak recovery of the economy, as the government
kept increasing expenditure faster than revenue throughout its five years in office; by 2011
the debt to GDP of Cyprus rose to 71% of GDP. Even in July 2011 when the need for
reigning in government revenue was understood by the then minister of Finance, Charilaos
Stavrakis, President Christofias delayed and then cancelled the implementation of mild
austerity measures 52. This eliminated the ability of the government to borrow to help the
banks, leading to a series of credit rating downgrades: these were largely ignored by the then
minister of Finance, Charilaos Stavrakis who complained of unfair treatment by credit rating
agencies.
There was resistance to this untargeted expansionary fiscal policy by the then CBC governor
Orphanides, which led to public spats. The government in turn sought to reduce the
governor’s power by placing pro-government members in the CBC board and removing the
management of public debt from the CBC, establishing a public debt office in the Ministry of
finance in August 2010. This enabled the Christofias government to continue borrowing
increasingly short term foreign and local loans and bonds, while ignoring the slide in credit
rating of Cypriot Debt by rating agencies: S & P downgraded Cyprus from ‘A’ in March
2011 to ‘CCC’ in 2013. The increase in cost of borrowing due to being downgraded led to
51
Source: IMF World Economic Outlook Database, October edition (2012)
http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx However that surplus was related to the
construction boom.
52
“Political row puts Cyprus austerity plans in doubt” Financial Mirror (2011) 25th of July
20
ever more short term borrowing. This dangerously skewed debt repayment of the Cyprus debt
in an unsustainable way: over 71% of the total public debt needed to be repaid in the period
2013-2016 with median expiration dates of Cypriot debt calculated in September 2011 as 2/3
years, the shortest in the Eurozone53.
This short term borrowing was both domestic but most worryingly foreign, through the use of
Euro Medium Term Notes (EMTN); over €3.5bn mainly short term EMTN were issued. The
role of the EMTN in the Cypriot debt is important as it placed a hard deadline for which
further delays would lead to default. By borrowing short the Cyprus government ensured that
Cyprus could not delay the inevitable forever as there was a €1.4bn repayment scheduled on
the 3rd of June, 2013. This hard deadline meant the the new government of President
Anastasiades had no time to negotiate away the insistence for a bank depositor bail-in. He
had to accept what he was offered or face default within the first 100 days of his presidency.
In 2011 several incidences occurred that should have convinced the government to enter into
a bailout; instead the Christofias government kept delaying what was becoming increasingly
inevitable, with disastrous results for Cyprus: problems were compounded but not resolved.
May 2011 saw further downgrading Cyprus by credit rating agencies and bank, raising
borrowing costs and reducing the available liquidity. Then on the 11th of July, confiscated
explosives that had been heading for Syria were negligently left in the sun for two years, and
as a result they exploded, taking thirteen lives and destroying the main power station of the
island. The Vassiliko power station was supplying 53% of the island’s electricity capacity; an
independent commission found the President and his office at fault. The destruction of
Vassiliko station led to higher than expected government expenditures, as well as very high
electricity prices, causing first a stagnation in GDP in 2011 and then a “double dip” recession
in 2012. Meanwhile Greece applied for support from the European Commission, which was
an opportunity to tie the Cyprus issue with one of a much greater sovereign state, especially
since the Greek PSI caused high losses to Cypriot banks; yet Cyprus did not ask for a bailout
in 2011. In August 2011 the finance minister resigned over the obstruction by the President
in his plans to introduce austerity. Finance ministers came and went, but no one could change
the mind of the President. By December 2011 the government announced it had secured a
direct loan by the Russian Federation to the tune of €2.5bn; the terms of the loan were kept
53
C. Votsis, “Κολυμπώντας με τους καρχαρίες” Σχόλιο Στρατηγικής, Cyprus Cooperative Central Bank (2011)
5th September
21
secret. Rather than using the amount to recapitalize the banks and introduce fiscal
retrenchment, the Russian federation loan was spent for general government expenditure.
Meanwhile Troika and Eurogroup meetings were confirming that the owners of Greek
Government Bonds would take increasingly ever larger losses through the implemented PSI;
yet the Cypriot government did not attempt to ensure that the losses of the Cypriot banks
would be accommodated. It is of great mystery why did the Cypriot government not speak
out or ensure aid to Cypriot banks while the PSI negotiations were taking place, as the
resulting deal led to a €3.5bn loss for the Cypriot banking system. The acceptance of the
Eurogroup decision over the Greek PSI by President Christofias without securing support for
Cypriot banks ensured that Cyprus would face in 2013 not just a public deficit crisis which he
created, but also a banking crisis that he failed to contain.
Time essentially run out and the Christofias government asked for a bailout officially on the
25th of June 2012. Negotiations dragged on however until the 4th of December, despite all
opposition parties requesting greater fiscal restraint and swift negotiation with the Troika
representatives. Despite President Christofias first accepting the bailout, he once again had a
change of heart; by borrowing from provident funds and pension funds of government and
semi-government organisations, by providing €1.8bn of share capital to Laiki and accepting
ELA for the Cypriot banking system, he managed to finish his term of office without signing
or implementing the Cyprus bailout programme.
As a result of President Christofias recalcitrance, the next president faced a “perfect storm” of
problems. State coffers are empty while short term loans are due; reforms that were due to be
implemented over a five year period need to take place within the first 100 days; any room
for negotiation was removed, and the ability to secure the banking system, as well as
negotiate away from a depositor bail-in, has evaporated. He and his government are the
principal reason the Cyprus issue has been so complicated, and why the Troika could use
Cyprus a a guinea pig of future “templates” of bailouts in the Eurozone.
5. Conclusion: Where does Cyprus stand- more out that in?
The Cyprus bailout programme was passed by a very slim majority by the Cyprus parliament
on the 30th of April, 2013. And yet we haven’t seen the end nor the final resolution of the
22
Cypriot crisis. Capital controls are in place, effectively discriminating between Euros in
Cyprus vis-a-vis the rest of the Eurozone, leading to increased desire for capital flight.
Cyprus is in effect more out of the Eurozone than in. Although such capital restrictions have
been relaxed it is hard to see when they can be lifted since the majority of Cypriot deposits
are foreign owned and they will not be willing to stay in the Cypriot banking system for long.
Meanwhile the banking crisis that the bail-in of depositors sought to resolve has remained an
open wound. What is preventing its closure is the precedent of the bail-in, the delayed
restructuring of the Bank of Cyprus, the insistence of the ECB/CBC in offloading the ELA
liability to Bank of Cyprus and the lack of direct support by the Troika to the banking sector.
Unless the vicious cycle between a weak government that is unable to borrow, and the weak
financial sector that needs capital, is addressed, Cyprus will not be able to enter a roadmap
for recovery.
And yet the whole operation can be seen as a success by the EU: the embarrassment of
bailing-in insured depositors was prevented, German sensitivities prior to elections were
addressed, and contagion effects were limited through the sale of the Cypriot branches in
Greece. Cyprus can now stay in the Eurozone and suffer an economic calamity comparable to
the war and occupation of 1974, or it can exit the Eurozone with even worse outcome but
with limited impact to the rest of the Euroarea, bar the realisation of small losses for the
official sector.
The damage for Cyprus meanwhile has been huge. The elimination of most working capital
from business through the bail-in is closing even healthy industries that had their working
capital turned into illiquid shares. There is an intense lack of liquidity as banks and
cooperatives reign in on all lending and accumulate resources as the bad loan provision rates
rise. Meanwhile the closure of banks for a record period and the lack of liquidity led to the
Cypriot economy reverting to a partial cash-only basis, slowing down the velocity of money
and hence placing a further drag on GDP. As a result of the above the real economy has
crashed: unemployment figures, already at prior to the bailout 12.7%, are expected to rise to
over 20%. The capital controls are threatening the future of the already wounded business
services sector, while tourism lacks the ability to borrow in order to invest in further capacity.
23
Whose fault is it? It is clear that the previous government of President Christofias must take a
large part of the blame: the combination of excessive spending and the failure to receive
support for the Cypriot banking sector during Greek PSI negotiations doomed Cyprus into a
double calamity. The Cypriot banking sector and its regulatory authorities must be blamed for
letting the banking sector to get so out of hand, and for mistakes in regulation and the
subsequent restructuring processes. The new government of President Anastasiades also
made mistakes, although its share of the blame is limited, considering it was only in power
for 15 days prior to the first Eurogroup meeting. Yet a great part of the blame must be handed
to the Troika and the Eurgroup as well. The demands of each member of the troika to
safeguard their own interests (IMF – debt sustainability; ECB – ELA, European
Commission – containing contagion) has led to several demands being made on Cyprus
which are collectively disastrous. The insistence of the Eurogroup in placing politics, such as
the German election needs, above practical issues led to a badly botched bail-in of depositors
and a world record closure of the Cypriot Banking System. As Morski states for the
Eurogroup “No human agency has achieved so much economic destruction in such a short
time without the use of weapons”54.
What next for Cyprus? The Cyprus crisis was a banking crisis that also because a government
debt crisis due to the mismanagement of President Christofias. Capital controls are in place
and the bailout was only passed by one vote, with voices clamouring for exit from the euro
and default becoming increasingly louder. The bailing-in of pension funds in Laiki and Bank
of Cyprus might just turn the crisis into a pension crisis as well.
What Cyprus needs is understanding and solidarity from the rest of the Eurogroup. In order
for Cyprus to find its feet, Europe must appreciate that direct support of the banking sector
will be needed. Also since Cyprus is small, the amounts Cyprus needs to find its feet are
minor relative to the EU whole: Cyprus should be allowed to become from a net contributor
to a net recipient of EU funds as the per capita GDP of Cypriots will fall dramatically.
Both European Commission President Barroso and Oli Rehn have issued statements
confirming additional funds to stimulate economic growth in Cyprus, but the amounts are far
54
P. Morski Cyprus: The Operation Was a Success. Shame the Patient Died. (2013) 25th of March
http://pawelmorski.com/2013/03/23/cyprus-the-operation-succeeded-shame-the-patient-died/
24
less than the current needs of Cyprus55. Cyprus should also be allowed to restructure Cypriot
foreign debt, something the government of Cyprus requested, and was denied on the 25 th of
March. Restructuring existing foreign debt is one of the few ways Cyprus can gain some
breathing space. Cypriot EMTN bonds should be restructured on a longer time horizon; while
loans by the EFSF, the European Investment Bank, the Council of Europe development Bank
and the French Treasury should be restructured on similar terms as those of the Russian
Federation loan.
55
JM Barroso, Letter from Commission President Barroso to President Anastasiades of Cyprus (2013)
MEMO/13/339 on the 16th of April. Rehn, Statement on Cyprus in the European Parliament (2013)
SPEECH/13/325 on the 17th of April