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.