The IMF is currently praising Cyprus for its efficiency in pursuing the Troika’s stabilisation programme, at least with respect to public finance. It appears that the Cypriot government will deliver on the target of 7% fiscal adjustment over 2013-14. It has even been announced that the primary deficit for 2014 will be 3% of GDP instead of the IMF projected 4.25%.
A successful programme then? Not according to research currently undertaken by Research on Money and Finance (RMF) in London in conjunction with Prometheus Research Institute in Nicosia. Leave aside the implications of such ferocious austerity for output and employment – GDP will fall by at least 8% in 2013 and probably 4% in 2014, while unemployment is already at 18%. The real problem with the Cypriot economy has always been its banking system rather than public finance. Indeed, fiscal imbalances have been caused by the financial crisis generated by a hugely expanded banking system. What, then, has the Troika brought to Cypriot banks?
The Troika programme has entailed the resolution and merger of the two largest commercial banks, i.e., Bank of Cyprus and Laiki Bank. In effect, Bank of Cyprus has taken over the weaker Laiki, the new bank has been recapitalized and the funds have been obtained through a haircut on deposits, mostly for Laiki but also for Bank of Cyprus. The third significant commercial bank, Hellenic, was also recapitalized but without a haircut on deposits. Furthermore, the significant Cooperative Bank sector has been effectively nationalized, restructured, and brought under a single authority. The aim of these measures were to restore health to the banking sector and to support recovery of the economy as a whole. Bear in mind that the measures have occurred in an economy that is absolutely dominated by the service sector, and which has attempted to become an offshore banking centre during the last three decades. The primary and secondary sectors of the Cypriot economy are minor.
There are three distinct periods:
First, a boom that run to 2008 and which exhibits steady expansion of banks domestically, both within and outside the EMU. It was, effectively, a banking bubble financed by domestic and foreign flows (the notorious ‘Russian money’) and aimed primarily at the real estate market in Cyprus.
Second, a further boom that commenced with the accession of the country to the EMU in 2008 and lasted to 2010. It was a banking explosion funded by the conversion of domestic deposits into euro that afforded to banks tremendous new liquidity – ‘Russian money’ had little to do with this period. The super-bubble pivoted primarily on Greece, where Cypriot banks acquired large assets in the form of public bonds and commercial loans. This was arguably one of the worst banking decisions made anywhere in the world in recent years.
Third, a bust commencing in 2010 caused overwhelmingly by the loss of EMU-related assets. The Cypriot banking system was finally destroyed by its overextension to Greece, whether that was public bonds or private loans. Domestic and non-EMU assets continued to rise steadily until the second half of 2012. The sharp turn-around in these categories occurred only when the Troika arrived and the ‘rescue’ was applied. Similar behaviour was also observed for deposits, which are the main source of funding for Cypriot banks. Nonetheless, by 2011, as Cyprus was cut off from the international markets, public borrowing to fund banks, much of it in the form of ELA (Emergency-Liquidity-Assistance by the Cypriot Central Bank, authorized by the ECB), also ballooned.
In short, the Troika arrived as the Cypriot banking system was contracting after wild overexpansion following the country’s entry into the EMU. It was not ‘Russian money’ that brought the acute phase of the crisis but the haircut of Greek public bonds in 2011-12 and the accumulation of bad debts in Greece as the Greek economy went into deep recession – both caused by another Troika programme. Once the Troika applied its programme to Cyprus – with a severe haircut for deposits – the banking system went into rapid contraction domestically and outside the EMU.
At present the aggregate assets of Cypriot banks stand at 90bn euro, roughly five times GDP, down from about nine times GDP in 2011. The contraction is thus extremely severe, but will not stop at this level. Assets are heavily funded by about 33bn of deposits held by domestic households and firms, roughly another 10bn held by non-financial agents outside the EMU, and about 4.5bn by non-financial agents within the EMU. However, the main reason why banks have been able to hold on even to this reduced liquidity is the battery of banking and capital controls, imposed by the Troika in contravention of EU regulations and practice. The controls have prevented deposit holders from withdrawing their wealth en masse following the haircut imposed by the Troika. When they are lifted, much of the remaining liquidity is likely to disappear. Furthermore, Cypriot banks currently hold about 45bn worth of loans made to domestic households and businesses. Much of this lending is attached to real estate either directly or indirectly, since Cypriot banks typically take real estate as collateral. With the collapse in real estate values and the deep recession now spreading across the Cypriot economy, perhaps 40% of these loans will prove to be bad. The possibility of further haircuts on deposits remains substantial.
In short, Cypriot banking is irretrievably bust, partly as a result of the foolishness of Cypriot banks and partly due to Troika policies. Under the current programme the system will get steadily smaller, it will be plagued by liquidity problems and it will face mounting bad asset problems. At the same time it will become heavily concentrated as the (fundamentally insolvent) Bank of Cyprus will come to dominate it. If this is programme success, what exactly is programme failure, one wonders.
Cyprus needs a radically different policy with regard to its banks. The Troika programme is the road to shrinkage and irrelevance. The implications for the rest of the economy can easily be surmised.