Cyprus: Can the banking crisis be tamed?

Cyprus: Can the banking crisis be tamed?

Wednesday, April 10 2013

 
B K Mukhopadhyay

Cyprus is going to receive €1 billion from the International Monetary Fund (IMF) as part of the €10 billion rescue package it agreed late in March, 2013 with euro zone finance ministers that prevented the meltdown of the island's banking sector and its exit from the euro.

The fund would support Cyprus through a three-year loan that aims to help Nicosia consolidate its finances and restructure its trouble-ridden banking sector. This combined financing package of €10 billion is designed to help Cyprus cover its financing needs, including servicing of debt obligations, while it implements the policies needed to restore the health of the economy and regain access to capital market financing.

The EU-ECB-IMF (European Union, the European Central Bank and the International Monetary Fund) troika clearly wants Cyprus to downsize its banking sector, continue fiscal consolidation efforts through spending cuts, while at the same time implement deep structural changes to improve competitiveness.

Accordingly, "A combined financing package of €10bn is designed to help Cyprus cover its financing needs, including to service debt obligations, while it implements the policies needed to restore the health of the economy and regain access to capital market financing." The International Monetary Fund has demanded that Cyprus cut state pension costs and reform its welfare system as the price of a €1bn (£854m) loan to help bail out the stricken island. The IMF said the poorest Cypriots would be protected from the worst of the cuts, but Cyprus must press ahead with measures to bring its annual state budget into surplus by 2018.

As the things stand now: Cyprus needs the money to refinance its stricken banking sector and reduce government debts (almost touching 180 per cent of GDP). The crisis brought Cyprus to the brink of collapse after it was in effect locked out of private markets and forced to seek funds from the EU and IMF. The economy struggled to bring the situation under control after a series of mishaps (inclusive of imposing a tax on bank deposits of less than €100,000 - protected under EU guarantees, which was later reversed).

Cyprus crisis intensified, adding problems to the euro zone - already being blitzed by gloomy economic data as manufacturing and services output in the 17-country currency club fell by more than expected in March, 2013, showing and indicating that the euro zone suffered a sixth successive quarter of GDP (gross domestic product) contraction in the first quarter of 2013.

Since the announcement of the bailout, Cyprus has become the first euro zone member to apply capital controls, with limits on credit card transactions, withdrawals, money transfers abroad and cashing cheques. Though this move aims to block outflow from the country, yet steady flight of deposits have been noticed when talks were on to tax depositors' savings.

Depositors with more than €100,000 in the Bank of Cyprus could lose up to 60 per cent of their funds. The shakiest of the Cypriot banks - Laiki, the island's second largest - will be closed. Smaller deposit holders at Laiki will be transferred to the Bank of Cyprus, which will need serious recapitalisation, not least because it inherits Laiki's €9bn debt to the ECB. Deposits of more than €100,000 - amounting to €4.2bn in all - will be placed in a "bad bank". That means savers will only get a fraction of their savings back and the deposits could, in theory, be lost entirely. Money for that will come from Bank of Cyprus's own wealthy deposit holders. Bank of Cyprus, the biggest lender, will be restructured.

These changes, it is hoped, will avoid a run on the banks. The threat that the ECB would stop providing day-to-day support for the Cypriot banking system has been lifted. The new proposal removes the most objectionable aspect of the first package - the levy on all depositors - making it less politically toxic. By raising money from the better off - many of them Russian - Cyprus will get €10bn from the troika (the European Union, the European Central Bank and the International Monetary Fund).

This market economy, incidentally it may be mentioned here, remains dominated by the service sector, accounting for four-fifths of GDP -tourism, financial services, and real estate being the most important sectors. Erratic growth rates over the past decade reflect the economy's reliance on tourism, the profitability of which can fluctuate with political instability in the region and economic conditions in Western Europe. The economy, which tipped into recession in 2009 (contracting by 1.7 per cent), has been slow to bounce back since, posting anaemic growth in 2010-11 before contracting again by 2.3 per cent in 2012. Serious problems also surfaced in the Cypriot financial sector in early 2011 as the Greek fiscal crisis and euro zone debt crisis deepened. Not surprisingly, Cyprus experienced numerous downgrades of its credit rating in 2012 and has been cut off from international money markets.

Cyprus's banking sector - eight times bigger than the country's gross domestic product - was already severely damaged by its high exposure to bad Greek debt. As the sovereign debt crisis in Greece worsened, Cypriot banks were forced to take huge losses that penalised its finance-driven economy. The island also suffered predominantly from exposure to the domestic property market which was hit by a sharp fall in demand.

Can it then be reasonably forecast that Cyprus would face a bleak economic future in which the need for a second bailout looks a probability? It is not just that the country's economic model has been destroyed. Nor is it simply that a brutal austerity programme is the condition for the €10bn loan.

Nicosia implemented measures to cut the cost of the state payroll, curb tax evasion, and revamp social benefits, as well as trimmed the deficit to 4.2 per cent of GDP in 2012, but in July, 2012, it became the fifth euro zone government to request an economic bailout programme from the European Commission, the European Central Bank, and the International Monetary Fund.

The question that looms large at this stage is: can the risk of a full-scale economic collapse that may result in Cyprus having a debt problem worse than that in Greece be wiped out?

Though these international lenders said they were targeting a reduction in banking so as to achieve an average euro zone size of 300 per cent of GDP by 2018, yet there are reasons to believe that what has happened in Cyprus will have ramifications for the rest of the single currency. Added to this, Russian fallout is a distinct possibility. ECB President is not thus wrong, when he opines that the plan to tax savers in Cyprus was "not smart to say the least".

The rescue package would definitely call for tough efforts from the Cypriot population, as the government will be forced to push through painful changes to meet the loan's conditionality. Cyprus bailout, though deeply flawed, yet can be described as one of the efforts launched in the time of real need as the same at least removes immediate risks of a banking collapse.

It is has been observed in the recent times that the problems which are allowed to persist in comparatively small and weak economies spread wings and eventually land on the stronger economies. Should we then wait for the second bail out?

Dr B K Mukhopadhyay, a Management Economist, writes from Guwahati, India. m.bibhas@gmail.com

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Wednesday, April 10 2013