Why Cyprus Is Big Enough To Cause Trouble

Tyler Durden's picture

Authored by Martin Lueck of UBS,

Cyprus is the euro area’s third-smallest economy in GDP terms (larger only than Malta and Estonia, but likely to be outgrown by the latter this year), accounting for less than 0.2% of the region’s output. Yet, we believe it is big enough to cause trouble. The country urgently needs external funding and applied for an EU/IMF/ECB (in short: troika) programme last summer. In the meantime, the amount in question has risen to EUR17.5bn (c100% of GDP).

However, the conditionality that comes with this programme does not go down well with the current Cypriot government, whereas politicians in core eurozone countries have started to point fingers at the small economy’s low-tax, soft banking regulation business model. What emerges is the threat of another deadlock, in which a small country pulls the eurozone’s consistency per se into question, while politicians in creditor countries place their hopes on a new, more forthcoming government. As it stands, until that happens financial markets will have sufficient time to turn nervous again.

Analogies to other emergency cases...

The Greek economy collapsed partly as a consequence of excessive leverage and a dysfunctional public sector. Ireland suffered from its bursting real estate bubble and implosion of its oversized banking system. Cyprus, in turn, presents itself as a combination of similar legacies. Strong trade links to the Greek mainland led to collapsing business when demand from Greece capsized. Tax revenues dried up in the wake. At the same time, shrinking house prices and massive write-downs on bank assets (in the first place, loans to Greek borrowers and Greek sovereign paper) led to increasing external funding needs in Cyprus’ financial sector, one of the largest in the euro area relative to GDP, close to that of Ireland (Chart 1).

Evaporating bank profits further eroded tax revenues, eventually causing a massive deterioration of Cyprus’ fiscal position.

...plus a good dose of home-made problems

By mid-2012, larger banks like Bank of Cyprus or Cyprus Popular Bank alone reported loans to Greek borrowers that exceeded Cyprus’ GDP. In addition, these institutions suffered from the Greek PSI, i.e. the haircut on Greek sovereign bonds carried out in connection to Greece’s debt restructuring on 21 March 2012. Yet bailing out the country’s banking sector has become difficult for the government since Cyprus lost access to market funding in April 2011.

Current ratings are CCC+ by S&P, B3 by Moody’s and BB- by Fitch. Despite the 2011 deficit and debt exceeding the Maastricht thresholds by quite some margin (deficit/GDP was 6.5% in 2011, debt/GDP rose by 10 percentage points to 71.5% in the same year), there has hardly been consistent effort on the part of President Dimitris Christofias’ administration to reign in excessive debt. As a result, without a EUR2.5bn loan granted by the Russian government at an interest rate of 4.5% in December 2011, the Cypriot government would have been forced to resort to a troika programme a lot earlier.

Although the Russian government asked for no conditionality, it is exactly the strong links (some would say dependence) between Moscow-educated Mr Christofias, Cyprus’ c15,000 Russian immigrants (c2% of the south’s mainly Greek-orthodox population) and Russia’s potential geo-strategic interest that raise concerns in EU capitals. From an EU perspective, being too harsh on Cyprus in terms of conditionality would increase the risk of even more Russian influence. But, being too soft could risk allegations of sacrificing core EU taxpayers’ money to bail out deposits of ‘Russian oligarchs’ in Cypriot banks.

What is arguably needed, therefore, is another exercise of political brinkmanship, by which the public opinion in creditor countries is massaged towards more willingness to accept a bailout, whereas creditors pressure Cyprus to enhance transparency in the financial system and convince the troika that allegations of Cyprus facilitating money-laundering and tax evasion are unfounded. As the outgoing Cypriot government run by Mr Christofias, who will not run again, has so far refused to implement even the conditionality agreed in the memorandum of understanding (MoU), creditors will likely prefer to wait until the new government takes office. We therefore expect no decision on Cyprus from the Eurogroup meeting on 21 January. Any solution before the election (first round scheduled for 17 February) looks unlikely.

Until then, there will be plenty of time for investors to turn nervous. The Cypriot case has all the ingredients to raise questions about the consistency of the euro project again, comparable to – albeit possibly less dangerous than – the ‘Grexit’ hysteria less than a year ago. Until a bailout is granted, the Central Bank of Cyprus will probably continue to fund the economy. At the peak in September 2012, its balance sheet had expanded by 64% from January 2011 (Chart 2).


The central bank’s emergency liquidity assistance (ELA) to the banking system skyrocketed from EUR150m in March 2012 to EUR9.9bn (c55% of GDP) in September.

Even despite the small size of the economy, Cyprus therefore has the potential, in our view, to become a catalyst that may eventually end the complacency brought about by the ‘Draghi plan’ in H2 last year. If this proves correct, it would likely mean that peripheral spreads widen and risk assets could turn more volatile, especially in view of Italy’s election and Spain’s funding needs.

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kliguy38's picture

Merkel has no plans....she only takes orders like a good soldier for the boyz

AlaricBalth's picture

Cyprus banks are a haven for Russian oligarch's money laundering activities. Merkel knows that by bailing out Cyprus, she is aiding the recovery of billions in "black dollars" which would otherwise be lost in bankruptcy. You can bet Putin is pulling Merkels strings on this one.


Sudden Debt's picture

I wonder if there will also come out a Youtube vid of Merkel dancing bunga bunga in Cyprus...


From Germany With Love's picture

In an interconnected world, a snowball can cause an avalanche. Does this really need to be pointed out? Spreading risk decreases the likelihood of failure becoming a bigger problem - but when it does so, it becomes systemic failure immediately.

Consider it this way: it took only one floor of the WTC to cave in to take the whole building with it.

From Germany With Love's picture

I take it you didnt fully listen to the Stieglitz lecture posted here a few days ago.

Also it is the logical systemic consequence inherent to the term counter-party risk.

They Tried to Steal My Gold's picture

Ridiculous,,,,the Soviets will provide the cash in return for offshore oil & gas rights.. This is a yawner....

ThirdWorldDude's picture

Lol, Soviets is a term I haven't heard in quite some time.
The perspective problem is that the only Soviets nowadays sit in offices in DC, Brussels and Paris...

LeisureSmith's picture

Cyprus could indicate that it intends to let Russia build a naval base on their territory......and then watch as the EU showers them in cash.

pasmurf's picture

I like Der Spiegel's take as well the Guardian's "Debt Crisis blog" reporting on this.

Der Spiegel's take was that there will be no bailout of Cyprus and that could destroy her coalition.  

IMF wants a debt haircut for the Cypriots, but the Greeks were to be the last to default in Europe according to Frau Merkel.  

The Guardian was saying that Merkel would bailout Cyprus after the current president had left, voted out?, in February so the funds wouldn't arrive until March.  In essence a rebate of the Greek PSI.  So wouldn't the other bond holders who participated in the Greek PSI request their own rebate?

Greek PSI rebates?  Sounds like the Europeans were drinking too much when they were discussing these options.

Bicycle Repairman's picture

Cyprus is much smaller than Greece, Portugal or Spain, and they have been handled.

Let's move on.

q99x2's picture

If Cyprus takes 3.5 years to not default and not exit the EU and I have to hear about it like Greece it's gonna ruin me.

AssFire's picture

So sick and tired about all the haters..

Miley, We Love You!

what this is my ZH profile???

holdbuysell's picture

Article summary:

ANYTHING connected to the banking system via derivatives is a problem that could cause a systemic failure.


AgAu_man's picture

Why don't we just storm the Central Banks already? Like the French stormed the Bastille?

Rhetorical question, as 90% of the ppl would not know 'why', and 99% would not dare, unless the MSM assured them that this was 'ok'. 

Ned Zeppelin's picture

As near as I can tell, this guy actually thinks the chance of this turning into something is virually nil. If Greece, Spain and Italy are AOK, why on earth would this country pose an issue - set up an alphabetized facility and start printing.  Isn't that what the ECB is doing no matter what?

jonjon831983's picture

Dunno, his last paragraph hints at the domino effect on the rest of EU if something does happen to Cyprus:


"Even despite the small size of the economy, Cyprus therefore has the potential, in our view, to become a catalyst that may eventually end the complacency brought about by the ‘Draghi plan’ in H2 last year. If this proves correct, it would likely mean that peripheral spreads widen and risk assets could turn more volatile, especially in view of Italy’s election and Spain’s funding needs."

ShortTheUS's picture

Those charts for Cypress are Insane in the Membrane....

Lord Of Finance's picture

   'Do my shit under cover, now it's time for da blubba

    Blabber, to watch the belly get fatter

    Fat boy on a diet, don't try it

    I'll jack yo ass, like a looter in a riot'



  Dang. I thought dat was some for real poetry fo' shizzle. Down votin' me all up in a hizzy.

americanspirit's picture

Cyprus is 50% Greek and 50% Turkish. Which Cyprus is the problem here? Oh, and since when do we start calling mobsters "oligarchs"?

You want yer oligarchs? We got yer oligarchs right here - starting with Jon boy. And his BFF Barack.

bugs_'s picture

the Templars should never have sold Cyprus

electricgorilla's picture

Good post. Cyprus wasn't on my radar but they surely do matter in the grand scheme of the Euro project. Why is Pimco and Blackrock in Cyprus right now negotiating with banks. Angela Merkel is is rather hostile in her dealings with Cyprus. Could this be like Lehman. The one they decide to let fail that turns out to get out of hand. Who knows.





Lord Of Finance's picture

B-Real, D.J. Muggs and Sen Dog are on their way over there too. After their reunion tour was a huge flop, they heard all the buzz about Cyprus and had no idea the place existed. It must be fate they thought. Goona do some whack-ass benefit for the ailing nation in another useless attempt to try and resurrect their "music" careers yet again.


  Off course they could always go back to "writing" intro-theme "songs" for the WWE wrestlers as they did about 10 years ago, but that was an embarrasment too painful to revisit.

Notarocketscientist's picture

This is pointless article.  As if the EU is going to be allowed to collapse because of this minnow.  They have done far less palatable bail outs in the past....

Lord Of Finance's picture

Toally poits. Ay comm


A ats o wite "sotin for te sohing houl beusly.

Colonel Klink's picture

Economic slavery like Greece bitchez!!

Throw off the shackles of debt and tell the international bankers to go fuck themselves.

And since it hasn't been said in the thread yet....