The possibility of Cyprus becoming the Achilles Heel of the eurozone and causing its eventual downfall has been heightened by the botched resolution to its payments crisis. This comes at a time of increased regional risk aversion as the eurozone’s plight has re-emerged on investors’ radars with Germany (and other, strong countries) seemingly more reluctant to offer blank checks.
Few had envisaged that the problems in Cyprus might prove the catalyst for a eurozone break-up, which although still an extreme-risk event could erupt unpredictably if the financial markets react negatively, punishing other debt-ridden sovereigns across the periphery at a time of increased political uncertainty (in Italy especially) and worries over Spain. Cyprus itself could still become the first country to leave the euro, an event that would test firewalls in the event of a bank run, but the situation had been anticipated.
Our firm, via the International Country Risk Guide, alerted clients to Cypriot expropriation risk back in January 2011, through a downgraded score for contract viability. A short-term, high-risk, worst-case scenario alert was also adopted in October of that year.
Mired in recession, having taken a hit on Greek exposures and blindly allowing an ‘Iceland-esque’ banking sector bubble to develop, the tiny eurozone state, amounting to just 0.2 percent of its total GDP, has now been forced to seek a €10 billion ($13 billion) bail-out from the European Commission, the European Central Bank and the IMF – the troika – as part of a €17 billion ($22 billion) part “bail-in” package to prevent insolvency. With a large budget deficit, a legacy of accumulated indebtedness and banking sector capitalizations to factor in, the country’s general government gross debt is on an unsustainable upward trajectory toward 150 percent of GDP in 2015 without remedial action to bring it back onto a manageable path.
The terms of the agreed Troika plan are clear, but the government is struggling to devise a suitable tax contribution palatable to bank depositors. In its infinite wisdom it had sought to impose a one-off tax on all savers in Cypriot banks at a rate of 9.9 percent on deposits of more than €100,000 and at 6.75 percent on all deposits below that amount. Talk of it being equivalent to a negative interest rate and the least worse of two options — the other being the collapse of the banking system and sovereign default — has fallen on deaf ears. Indeed, faced with angry reactions of “theft” from residents and uninsured British and Russian Cypriot bank account holders alike, the authorities are now scrambling to amend their hastily-conceived plans, with talk of reducing the lower tax rate to 3 percent and replacing the revenue loss with two higher rates — one of 10 percent on deposits between €100,000 ($130,000) and €500,000 ($650,000), and another of 15 percent on deposits above that amount. There is also mention of sparing small savers with deposits of less than €20,000 ($26,000), but handing out bank shares in compensation to the others has worthless value in the short term.
As plans are being finalized, with events remaining fluid, electronic transfers are in lockdown, the banks are shut until March 21st at the earliest — extending the normal bank holiday in Cyprus by two more days — and cash is now king in shops and restaurants, for those who can obtain it.
The crisis has highlighted the poor communication and coordination skills of Europe’s leaders in resolving the on-going eurozone crisis.
The government is still aiming to fund more than half of the bank recapitalization via the depositor “bail-in” to limit any additional borrowings. But it will still be beholden to the harsh troika loan-terms attached to the remainder it seeks — the types of swingeing fiscal austerity measures and structural reforms deemed an appropriate long-term life-support mechanism for distressed sovereigns (as in Greece). Other features of the program involve pushing up the Cypriot corporate tax rate from 10 percent to a still-competitive 12.5 percent and raising €1.4 billion ($1.8 billion) in privatization revenue should investors be tempted in. Other conditions involve raising the tax on investment income, bailing-in bondholders, too, and reducing the size of the banking system to the EU average by 2018.
Cyprus has an extremely large bank sector relative to its size, estimated at around eight times its €17 billion ($22 billion) GDP. The problem has been exaggerated by money laundering, which requires better surveillance. Russia, criticized for being at the center of such flows — making Cyprus a tax-efficient conduit for mafia and other illicit money flows — has reacted negatively to the tax proposals that could impose a €2 billion ($2.6 billion) bill on its fellow countrymen, and which is complicating a restructuring of Russia’s €2.5 billion ($3.25 billion) loan extended to Cyprus in 2011. Speculation that the giant Russian hydrocarbons producer, Gazprom, is willing to provide all the support Cyprus needs in return for exclusive licenses to explore for its gas have been officially denied.
The crisis has of course highlighted the poor communication and coordination skills of Europe’s leaders in resolving the on-going eurozone crisis, and of the lack of progress to date in establishing a banking union to remove the threat of contagion and bank-runs from one euro jurisdiction to another. Whether European policymakers intended it to be a dry-run for finally getting to grips with the problems in Greece, Spain and other peripheral countries (which could still lead to a singular default) is unclear, but it has invariably created more uncertainty at a time of increased anxiety over Italy’s political deadlock. Risks heightened following the Italian election, but not unduly so as the financial markets kept matters in perspective given the security of the European Central Bank’s Outright Monetary Transactions (bond-purchase) program unveiled last year.
The unfolding problems in Cyprus have also led to a moderate response, thus far, pushing up bond yields and widening spreads slightly, but not causing major panic. Yet the Cyprus predicament adds a new dimension to the euro crisis — the prospect of removing depositor protection, which despite guarantees that Cyprus is a special case has merely created confusion and uncertainty, undermining the euro, affecting equities, boosting gold prices (while other commodities are falling on weaker demand fears), and ensuring that investors seek safety in the haven of other assets, such as German and U.S. bonds, at the expense of higher-risk eurozone debt absorption. The risks of a gradual run on banks in the more indebted eurozone countries, such as Portugal, Ireland, Italy, Spain and Slovenia, have also increased, if for now a major destabilization scenario caused by a sudden loss of confidence in euro assets, generally, seems excessive.
The delicate political backdrop to the crisis is hardly helping matters. Domestically, the landslide victory for the pro-bailout conservative Democratic Rally (Disy) party candidate Nicos Anastasiades at the presidential election in February had been interpreted as ‘resolution-friendly.’ Anastasiades is more amenable to the types of structural reforms required to steer the country out of its present mess than his Communist predecessor, who rejected privatization of state-owned enterprises. The new cabinet contains many respected economists and business-minded figures to instill confidence in the international community. But with control of only 28 of 56 parliamentary seats, the government, comprising Disy and the Democratic party (Diko), does not have a majority to legislate, while the junior partner is in any event threatening to vote against the plan. European policymakers are of course admonishing talk of a Cypriot euro exit, but it is not out of the question — the Cypriot bail-in seems a convenient test-case and Cypriot politicians are not ruling out such a prospect, even the pro-euro ones, according to their media interviews.
On balance, though, PRS believes that policymakers may still reach a solution convenient to all parties to ensure that Cyprus becomes just another bump on a rocky road to resolution. If so, the euro will stabilize long-term and confidence will be slowly restored. But while eurozone contagion risk may be effectively controlled, Cyprus’ problems may only just have begun.
Indeed, the prospect of any growth in Cyprus this year has now evaporated. After contracting for the seventh consecutive quarter, by 3.1 percent year on year, during the fourth quarter of 2012, PRS predicts another year of contraction in 2013, with further declines in GDP likely in 2014-15. Apart from a booming tourism sector largely untouched, until now, by the country’s problems, most other areas of economic activity, including construction, manufacturing and most other types of services activities, are struggling with poor export markets, fiscal consolidation and tightened credit availability as banks deleverage. This is weighing heavily on confidence and crimping private consumption and investment. The unemployment rate, which moved into double digits last year, and which reached 14.7 percent in January, according to Eurostat, is on course to average 16 percent or more by 2014 according to current projections, further fuelling social tensions and emigration.
A large structural current account deficit, amounting to more than 6.5 percent of GDP in 2012, is symptomatic of the country’s problems, reflecting as it does Cyprus’ import-dependency, its narrow export base beyond tourism, and worsening income flows in connection with financial exposures to Greece. Goods and services trade, bolstered by solid tourism inflows, will nonetheless provide a net contribution to economic growth in 2013, assisted by depressed imports. The current account will only slowly improve, however, given adverse income flows.
Consumer price inflation remained quite high at an average of 3.1 percent in 2012, down only a touch from the 3.6 percent average for 2011. However, PRS foresees a sharper fall in 2013 to around 2 percent as weaker demand, and lower producer input costs, including wages, take effect. But all that assumes that Cyprus avoids a euro-exit scenario, which would have catastrophic short-term implications. The reintroduction of a Cypriot pound at a devalued rate would lead to a spike in import prices, causing a short sharp shock to disposable incomes and an even larger drop in GDP before recovery sets in as the terms of trade adjustment takes effect.
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