Cyprus: Now the real work begins

Cyprus: Now the real work begins

 “Last month Cyprus agreed to a € 10bn bailout from the IMF and ECM, which has relieved considerable short-term stress on the national banking system, as well as calming investor fears about the wider European community.”

Good news, one would think. However, don’t let this opening paragraph from a newspaper fool you, Cyprus is far from safe. What makes Cyprus an interesting story is that it was actually in excellent economic shape, not only before the recession (as every country was, it seems), but remained so during it. The Cypriot 2009 downturn was arguably the mildest in Europe, weathering the storm through strong growth, low unemployment and solid public finances. In comparison, Greece, to which Cyprus made the mistake of lending the equivalent of 160% of its GDP, made the wrong choices on multiple levels, from fixing the consumer price index basket over failure to meet inflation targets to bribing tax collectors on a national scale. In Cyprus, on the other hand, the infrastructure and key economic indicators were sound, but the combination of a banking credit glut and a property boom were always going to be a highly unsustainable form of growth.

It would be foolish to think that the confirmation of the bailout will automatically result in stabilisation and a return to long-term prosperity. The successful implementation of austerity measures over a prolonged period of time will be met with considerable opposition from the vast majority of the public. The government caused genuine outrage when proposing that the smallest savers pay more to reduce the size of the bailout, a plan that defied all logic. The excuse that Cyprus has less private bondholders than Greece and therefore needs to target a different group shows a lack of imagination. Under the new deal, deposits over € 100,000 will be taxed most heavily while deposits of less than € 10,000 will be exempt. Tax increases and privatisations will also help pay for the bailout. Furthermore, as Greece has so ably demonstrated, austerity measures require a substantial change in culture. A country’s ‘way of doing things’ for decades or even centuries cannot be transformed overnight.

As for the here and now, the high level of uncertainty is best portrayed by the strict capital constraints designed to prevent bank runs and the panic that ensues. These constraints may be defined as temporary, but the temporary capital controls enforced in Iceland in 2008 are still in force today. Cyprus will also continue to find it incredibly tough to borrow money as the government could not even afford to bailout Cyprus’ leading banks (or recapitalise, where the banks are given money in exchange for ownership via shares). That level of failure is a serious cause for concern, and while the banks in Cyprus have not collapsed, they almost certainly would have without the bailout.

Taking vast deposit sums from Russia in the first place, as well as not involving them in bailout negotiations was a poor move, both politically and economically. Russia could have been, and still could be, a huge source of support for Cyprus, through either direct investment in the banking and natural gas sectors, or by extending the € 2.5bn loan it has already made to them. These options have the potential to negate the investment risk in Cyprus. Another significant political factor is Germany’s discontent at the thought of European taxpayers saving Cyprus. This is understandable, although a German pattern toward European countries in need, as they have the best growth prospects in Europe at the moment. The concern for money laundering from the sizeable inflow of Russian money has not served Cyprus well either. Potential exposure to the UK is basically a non-issue, as the Bank of Cyprus UK is already covered by the Financial Services Compensation Scheme, while George Osborne is negotiating with Laiki Bank for greater transparency.

Authorities should have seen this coming. The lesson of Iceland has not been learnt – growth in developed countries that beats even emerging market rates is always a sign of trouble. It is a shame that once again, an otherwise stable country has almost been brought to its knees by a poorly regulated, risk-seeking banking system. Indeed, the risks can be overcome, but the situation could have been easily avoided in the first place, a notion that will remain in investors’ minds for a while.

Categories: Economics, Europe

About Author

Matthias Vermeulen

Matthias has extensive experience in equity & financial research and has worked in brokerage houses in London and Brussels. His specializes in the political risks, macro-economy & financial systems of both the UK and Europe. Matthias graduated with Upper Second Class Honours in BSc Accounting, Business Finance & Management at the University of York. He also graduated with a MSc Behavioural & Economic Science from the University of Warwick.