Thursday, 20 December 2012

The Cypriot Patient

Good news for the Greeks yesterday, as the S&P ratings agency has upgraded the nation by six notches, from "Selective Default" to a "B-", with a stable outlook. Hopefully, the agency can understand the situation better than everyone else, and the Greeks will be able to say that they have put the worst behind them as 2013 leaves. Yet, their neighbouring Cyprus now appears to have taken a harder hit than first expected: the approximate bail-out package just for bank recapitalization is expected to be about €10 billion, the second largest in history, measured as a percentage to GDP.

Newspaper cover from Cyprus. Source:
Data for the second quarter of 2012 have shown that so far the island has a 74.6% debt-to-GDP ratio, or approximately €13.2 billion (simple calculations can show that Cyprus's GDP is about €17.7 billion). If we just add the €10 billion to receive the amount would reach a staggering 130% debt-to-GDP ratio, or €23.2 billion. Although I cannot find the article now, I remember a Cypriot authority stating that the debt burden would not exceed 120% (or at least that's what he hoped for), a threshold over which debt is not considered viable any more. It would appear that this was just wishful thinking.

The interest rate for the €10 billion bailout is expected to be around 2.5%, as Finance Minister Vassos Shiarly expects. Although I would like to know where he got those expectations from, even if he is right, an island whose budget is around €9.5 billion, would have to pay about €250 million per year just on interest payments.

Is this sustainable then? The answer is it will depend on how the Cypriot economy will react to the fiscal adjustments (aka austerity measures) the government in association with the Troika has pushed through. The expected adjustment will reach 7.25% of GDP. Assuming that GDP only declines by 3.5% as expected, it would mean that the debt-to-GDP ratio will increase by more than 5%. Oh, and the careful reader will also note that in the above calculations the amount paid for debt refinancing and other government needs has not been added. Guess how the calculation for sustainability goes when another €6 billion is added on the tap. Yes, exactly like Greece's.

What many have not yet realized is that although bad spending policies by the government and bad decisions from the banks have worsened the problem in Cyprus, another culprit has to be the Eurogroup itself. Had the infamous decision for cutting Greek debt by 70% not been taken, the Cypriot banks would not have lost around €4 billion of hard-earned money. Instead, they are now eager to receive government support or they will have to be liquidated. (for more details on who to blame for the crisis read this).

Obviously, one would be insane not to assign blame to the politicians or the bankers, who have tolerated and promoted a policy of over-spending and over-lending for years. An asset bubble had been raging for years in the island, assisted by the bankers, land developers and foreign demand. Now that the time for things to go back to normal has finally come, people naturally hate it. Living in fantasy for too long will cause you to forget what reality really is. It appears that everyone seems to forget that a correction was bound to happen some time. For Cyprus, this time is now. Nevertheless, consequences would have been much easier had the Eurogroup not taken that decision. Not just for Cyprus but for the rest of Europe as well.

Nevertheless, Cyprus can feel that it has been treated unfair for two reasons:
1. The aforementioned Eurogroup decision has brought the crisis much faster than the economy expected it.
2. The Cypriot banks are not getting funded by the ESFM/ESM funds like Spain's but are forcing the government to assume responsibility for them.

Even if we accept that Cyprus had opted for a bail-out before Spain did, it would still appear that the EU has a strange way of operating the ESM: not depending on the bank or its significance in the local economy, but on a sovereign level. If a nation is more important than another, economic-wise, then it would appear that they will support it and let the other fall. Yet, this is not the solidarity the EU officials have been proclaiming and surely not the preservation of peace and equality, values for which it received the Nobel price earlier this month.

This sort of injustice sets a paradigm for the EU authorities: they operate exactly like national governments do: assist people in power, those who are economically strong or have good connections and do not pay much attention to "ordinary" people. They just do it on a wider scale. Is this the kind of governance that we should be happy about, or is this how the first visionaries saw the EU becoming? I would certainly hope not.

As for the sustainability of the Cypriot debt, it looks that history will be repeating itself: Greece and now Cyprus. A €16 billion package will not be enough if the banks are not directly funded by the ESM/EFSF. New memorandum will have to be signed soon, and debt reliefs will be implemented.

That is, unless they bring their minds about and decide to do what would really make the island's transition from recession to recovery easier. Otherwise, it would be recession to depression.

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