6 Αυγούστου 2013

Greek Myths: "Cyprus Pays for Its Own Failures"

On August 6th the Brookings Institution circulated a collection of papers titled "Greek Myths and Reality." The publication was timed to coincide with Greek Prime Minister Samaras' visit to the US and its purpose was to discuss - and possibly debunk - several myths about Greece and its current crisis. My contribution to this collection discusses whether it is fair to say that "Cyprus Pays for Its Own Failures." Read on.

An untimely experiment
In March 2013 Cyprus became the fourth Eurozone country to receive a rescue package from the troika of international lenders. It was perhaps the most controversial of the four agreements because of the “bail-in” element: for the first time, depositor money was to be used to recapitalize banks in trouble. The idea had been quietly discussed in policy circles for many months but its actual implementation in Cyprus came as a surprise to most and caused a stir. The inclusion of secured depositors in the original haircut decision was indeed a stunning outcome that has been subject to serious criticism.

The economic principle behind the bail-in is sound. Rather than being bailed out with state (taxpayer) support, ailing banks must self-finance their capital shortfalls by bailing in bondholders and – if necessary – depositors. This is a move in the right direction, yet there are several reasons why March 15, 2013 was not the right time to begin implementing it:
  1. A formal framework for bail-ins did not exist at the time and the decision was applied in Cyprus in a haphazard and improvised manner. For example, there was no distinction between long-term deposits earning high returns and short-term deposits in current accounts. As a result, many companies lost large chunks of their working capital, leading to severe liquidity problems in the daily functioning of the economy. At least, we seem to have learned our lesson: the draft EU directive agreed upon in June has explicit provisions to protect small businesses.
  2. Rules must be clear ahead of time. People who deposited their money at the banks were not aware that a bail-in was a policy option.
  3. The bail-in was applied to Cyprus’ two systemic banks and effectively decimated the country’s banking sector.
  4. Cypriot banks are deposit-based and had very few outstanding bonds. As a result, the burden fell almost exclusively on unsuspecting depositors. 
  5. There was no prior assessment of the impact of the bail-in on the Cyprus economy.

The economic consequences of the bail-in are nothing short of catastrophic. Total depositor losses have been estimated at around €8.3 billion, or 46% of GDP (€17.9 billion in 2012). The financial and business services sector that had been the most important growth engine for the Cypriot economy for the last several years has been crippled and there is nothing on the horizon to pick up the slack. It may take years to rebuild the image and credibility of Cyprus and develop new export sectors. The decision to shrink the banking sector to half its size overnight has resulted in a liquidity crunch that will stifle growth prospects for the short to medium term. Most analysts expect a contraction of 20-25% over the next three years. Unemployment was already at 15% prior to the haircut and is bound to rise well above 20%.

Did Cyprus really deserve this? Why was such a blunt and untested instrument used with little apparent regard for its tremendous social cost? Was there no alternative path that would provide Cyprus with the necessary support in a manner consistent with EU principles but without causing so much social disruption?

Ring-fencing Greece
Europe should have shown more solidarity towards Cyprus. It could have recognized the fact that the economic woes of Cyprus were to a large extent due to Europe’s poor handling of the Greek crisis, including the mistimed haircut of Greek government bonds that cost Cypriot banks €4.5 billion (25% of GDP). The prolonged recession in Greece hurt Cypriot banks even more as they had extensive operations in Greece. Cypriot banks in Greece were in effect Greek banks, one of them being actually managed by a Greek group. It would have been justified to make provisions for capitalizing the Greek operations of Cypriot banks the same way that Greek banks were capitalized after the losses they took as a result of the Greek haircut.

On the contrary, Cyprus was doubly penalized. When the depositor bail-in was put on the table, the troika insisted that deposits in Cypriot banks in Greece should be exempt. The intent was clear. After a long and painful slog, the Greek economy was finally beginning to turn around. The last thing the troika wanted was to see the Greek banking system implode as a result of the bail-in of Cypriot banks. Thus, the solution adopted was to exempt Greek deposits from the haircut. It may have protected Greece but at the expense of depositors in Cyprus. Furthermore, the troika insisted that Greek operations of Cypriot banks be sold off to Greek banks, thus leading to an indirect transfer on top of the big losses already incurred because of the crisis in Greece. Thus in trying to save Greece and also cut off any transmission mechanism to the rest of the Eurozone, Europe decided to offload the cost to Cyprus – and many people think it is rather unfair.

A faulty model?
Many people have criticized the existence within Europe of low-tax jurisdictions, such as Cyprus, that serve as financial and business centers. Germany in particular has long been in favor of tax harmonization across Europe. The German finance minister, Wolfgang Schäuble, stated on several occasions that Cyprus model had failed and the country needed to chart a new course, while French finance minister, Pierre Moscovici, went so far as to call Cyprus “a casino economy”. 

What exactly was the Cypriot business model? In the aftermath of the Turkish invasion that devastated the island’s economy, Cyprus decided to fashion itself as a financial and business center. The main attraction was a low corporate tax rate for international businesses, complemented by a good location and climate, a common law-based legal framework and the high quality services provided by UK-educated accountants and lawyers. This was highly successful and the sector became the most important growth engine, especially after Cyprus joined the EU in 2004. This growth was accompanied by a large expansion of the banking sector to nine times GDP in 2009. The rapid expansion of the banking sector caused problems. Armed with plentiful liquidity, the banks financed business and consumer loans, a construction boom in Cyprus and rapid expansion abroad, especially in Greece, where they created extensive branch networks and invested in government bonds. Ex-ante, the expansion abroad could have been part of a well-designed diversification strategy. Ex-post, it turned into a disaster as exposure to the Greek economy brought the banks to their knees.

Given the outcome, it is easy to concur with the conclusion that the model has failed (though it is still difficult to come to terms with the “casino economy” reference). But it is important to understand exactly where the failure lies. Cyprus failed in letting its banking sector get too large and expand too quickly and recklessly. This does not render the strategy of a country specializing in the provision of business services as a failure. For the last twenty years Cyprus has invested in building an infrastructure that is designed to serve the needs of the international business community. It has established itself as a place where one can receive high quality accounting, legal and other business services at competitive rates. Many other countries, including several European ones, have followed similar strategies. There is nothing legally or morally wrong with being a business center, as long as the rules are followed and the banks are kept under tight control.

Did Cyprus follow the rules? In the months leading up to the March 2013 decision, the German press painted a picture of Cyprus as a laundering center for the ill-gotten gains of Russian oligarchs. This created a negative political climate and provided the moral justification for the country’s harsh treatment. Is there any truth to these allegations? Cyprus had in fact acquired a bad reputation for money-laundering in the 1990s. But in preparing for EU accession, it completely revamped its regulatory framework to meet European standards. International organizations like Moneyval rated Cyprus equally high with many other European countries for its anti-money laundering (AML) procedures. A more in-depth investigation specially commissioned by the troika pointed out weaknesses in the implementation of AML procedures in Cyprus but did not uncover anything that would justify shutting down the country’s international business sector.

Cyprus is perhaps paying for old sins and for electoral brinksmanship in other countries. The irony is that by recapitalizing the Bank of Cyprus using depositor money, the Eurogroup has handed ownership of the bank to its big depositors - purportedly those same Russian oligarchs! In reality, the vast majority of Russians with money in Cyprus are said to be owners of small and medium sized businesses rather than oligarchs (should we call them polyarchs?), while big depositors include many Cypriot pension funds, provident funds, and 401k-type investment plans who saw their savings wiped out.

Too high a price
Cyprus has made many mistakes. It allowed its banking sector to get too large and to expand quickly and recklessly abroad. It indulged in a decade of over-borrowing and over-consumption. When the international crisis first hit in 2008, it failed to appreciate the extent of the possible repercussions. Even after the Greek debt restructuring, the Cypriot government seemed oblivious to the blatantly obvious and failed to take any meaningful corrective action.

It is now time to pay the bill for these mistakes. This is perfectly acceptable, except that the bill is unjustifiably high. Cyprus is not paying just for its own mistakes. It is paying for a series of policy mistakes committed by the EU over the handling of the debt crisis. It is paying for the fact that it is small and thus can serve both as a testing ground and as an example to other profligate countries. This may be an instructive tool and an effective disciplining approach, but it hardly abides by the principles of fairness and solidarity espoused by the European Union. As it watches yet another European country sink into depression, the EU needs to take a long, hard look in the mirror.