Important steps but major challenges still ahead

[Accountancy Cyprus, No. 116, September 2014.]

Two important financial milestones marked the summer of 2014. In June, Cyprus tapped international capital markets for the first time since January 2010, raising €750 million of fresh funds. The return to the markets after a 4.5 year absence was certainly a significant and gratifying event, not because it took place just 15 months after the big shock of March 2013.

One of the reasons for this success is that the Cypriot economy is faring much better than almost anyone expected; the fiscal situation has improved substantially and the recession is not as deep as feared. The strict implementation of the Memorandum of Understanding (MoU) has proven successful in bringing stability to the country and has contributed to the improvement in the international image and credibility of Cyprus.  

The return of investor confidence in international markets was another important contributing factor. The markets are flush with liquidity, bond yields are very low and international investors are looking for investments that will deliver some return without undue risk. The timing was very good for Cyprus and the government wisely seized the opportunity. The success improved the image of Cyprus abroad and at the same time provided a psychological boost at home.

But perhaps the most important consequence of the bond issue is that it paved the way for Cypriot banks – particularly the Bank of Cyprus – to tap international markets themselves. The Finance Minister made this point emphatically at the time, which suggests that pushing the banks in this direction might have been one of the government’s prime motivations all along.

Intentional or not, the Bank of Cyprus got the message and quickly moved to issue new capital. This process was concluded at the end of August, when the bank’s shareholders approved the injection of €1 billion in additional share capital. The successful conclusion of the capital increase was the second major event of the summer. It puts the bank in a very strong position with a core Tier 1 capital in excess of 15% that will allow it to absorb any losses due to declines in the value of its assets, particularly the loan portfolio. 

These developments are certainly positive, but the road ahead is still long and full of challenges. In a sense, fixing our fiscal house was the easy part. Raising tax rates and cutting expenditures are relatively straightforward things to do. Implementing structural reforms is much more difficult, both for practical and for political reasons.

The practical aspect is that structural reforms (such as privatizations, implementation of the national health system, public sector reform, etc.) are complex endeavors that require resources and commitment from the government. Politically, these issues are also much more sensitive because they impact powerful entrenched interests that will not go down without a fight. We have already seen this in the vocal protests against privatizations; but opposition to reform is working in more subtle ways in other areas also.

The difficulty of reform is exacerbated by the fact that the government does not have a majority in parliament. This has been made painfully obvious in the endless wrangling about the foreclosure law. In any other country, the government would only have to convince its coalition partners. In Cyprus the government has to struggle to convince one or more of the opposition parties to support its bills. This state of affairs has been an almost permanent feature of our political system and is probably the main reason why practically no major reforms have ever been implemented in Cyprus in the absence of outside pressure. Political uncertainly could be a major obstacle as we try to implement the most difficult aspects of the MoU.

The improvement in public finances and the successful return to the markets have led to suggestions that Cyprus may be able to exit the program ahead of time, in 2015 instead of 2016. It is true that a key objective of the MoU is to support Cyprus until it can finance itself. But an equally important objective is to reform the economy and to build the foundations that will put Cyprus on a path of sustainable growth. Major challenges still lie ahead: privatizations; public sector reform; implementation of the national health system; further stabilization of the financial sector; and thorny negotiations over COLA and civil service pay and benefits.

We must not get ahead of ourselves. The measure of our success should not be the time that we will exit the program but the extent to which we will improve the institutions and strengthen the foundations of the Cypriot economy. 

A time for reform

[Accountancy Cyprus No. 114, March 2014.]

In March 2013 Cyprus experienced the shock of the depositor bail-in. Bad banking practices, excessive construction activity and a general culture of over-consumption had created huge imbalances during the boom years of 2004-2008. The global financial crisis burst the bubble and a painful adjustment was inevitable. The pain was made much greater by a string of policy failures that culminated in the bail-in, causing in a tremendous loss of wealth, the destruction of the banking sector, a loss of trust and credibility, and significant economic hardship. The economic outlook in March 2013 was extremely bleak.

One year later, things are not as bad as many feared. The contraction in 2013 was about 6%, much smaller than anyone expected. Unemployment has risen but seems to have leveled off and currently stands at 16.8%, not that much higher than the 14.8% it had hit in March 2013. Fiscal targets are being met, with room to spare. The banking sector is moving in the right direction, although the process will be long. The sector’s return to normalcy remains the biggest single challenge Cyprus faces as it strives to emerge from the recession.

With the fiscal situation in check and the banking sector’s reorganization nearly complete, the focus must now shift to structural reform. Cyprus’ track record in this respect is miserable. The political system has an extremely difficult time designing, agreeing to and implementing important reforms. It is not an exaggeration to say that the only major reforms implemented in Cyprus over the last twenty years were those associated with EU accession. It is difficult to think of a single major reform that came from within the system.

The Memorandum of Understanding requires Cyprus to implement a number of major reforms.  Many of those are much-needed, by Cyprus’ own admission; they have been considered and debated by the Cypriot political system, but never carried through to fruition. Examples include the national health system, social security, tax collection, local government, property titles, semi-governmental organizations, and public administration. The MoU provides an opportunity and the seemingly necessary outside pressure to push ahead with reforms that will modernize the economy, increase efficiency and improve competitiveness.

Public sector reform is particularly important. In the World Bank’s 2014 Doing Business report, Cyprus ranks 39th in the world overall but scores much lower in several aspects of public service provision: 86th in dealing with construction permits, 108th in getting electricity, 103rd in registering property, and 110th in enforcing contracts. These are unacceptable outcomes for a country that markets itself as a business center.

Beyond the MoU, Cyprus needs to refocus its economy and correct the economic distortions that built up over many decades and culminated in the boom and bust of the 2000s. The image of Cyprus as a business and financial center took a big hit in March 2013. But the sector has held up very well and there was no mass exodus of international businesses. This remarkable resilience pays tribute to the quality of services provided by Cyprus’ accountants, lawyers and financial advisors and gives hope that Cyprus can maintain and build on its status as a business center. In order to do so, Cyprus must do three things:

• First, it should focus on the provision of business services and play down the financial dimension (which was probably exaggerated anyway). As a business center Cyprus can continue to provide good quality and cost-effective legal, accounting and other services without requiring a large domestic banking sector and the associated risks. 
• Second, it should play down its low tax regime and focus on the quality of its services and the other benefits that are truly unique to it. Cyprus has well-trained and highly experienced professionals and a good legal framework (and its location is still great). It would also do well to specialize in particular niches – the success of shipping provides a good model. 
• Third, it needs to become a model in implementing regulations on financial transparency, money laundering and tax evasion. The laxity of the 1990s still haunts Cyprus; a clean image can attract reputable businesses and bring many benefits to the country. 

It is often said that every crisis is an opportunity. It is a cliche, but it is a good one. Cyprus must use this opportunity to push through reforms that will correct the mistakes and excesses of the past and put the economy on a path of steady and sustainable growth.