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: cyprusgasnews.com

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.

An Alternative to the Greek Bailout

Don't know if you heard it but EU officials state that they plan to do another, smaller haircut to Greek bonds to make the debt level fall to about 100% of GDP thus theoretically making it more viable. This makes us understand the reasoning behind EU policymakers decisions: If one mistake doesn't fix things why not try two? Well gee guys did you have to do a PhD to learn that?

Without a doubt the Greek haircut was a mistake. All it did was make the banking system more fragile than it already was (let us not forget that it had already faced a sub-prime lending crisis which had barely finished when this started) and countries who thought had no financial problems turn to the ECB and the IMF for funding to rescue their banks. Another stupid idea is as I have mentioned in a previous article using the IMF to fund European countries. If the ECB will not act as a normal central bank then why bother with the Union and the common currency? Just make trade agreements and return to national currencies. Either we become the United States of Europe or we shut this thing up before it blows in our faces. But I am getting out of subject.

As usual, my friend Wolfgang (whom you have met here) will ask what alternative I would propose for the Greek Debt. Which is simple. Make a separate entity, like for example the EFSF, and let it buy all Greek debt. Since the entity will be funded by the ECB it will have no liquidity problems as the Greeks will slowly (as if now they are really fast in repaying it right Wolfgang?) repay their debt. The entity would control the old bonds and slowly repay the banks as the flow of cash increases with a flat interest rate for all bonds. The banks' Greek bonds would have been held in the entity without them being able to sell or otherwise use them; however this would be much better than taking losses of tens of billions of euros over a year. Ask any bank in Spain. Italy, Cyprus or Greece if you don't believe me!

What about refinancing then? Well here the idea would have remained the same. The country would have to go through severe structural changes, cuts in government spending, etc etc and the refinancing would be made by the ECB. This way the only country that would have been "punished" would have been the one which made the mistakes who led it there.

Had this occurred we wouldn't be talking about banking problems in almost any country. The only countries which might have faced that would have been Greece and Cyprus. If the banking sector problems had not occurred then the rating agencies would not have degraded most of the countries they had. Thus, with only some budget cuts the Eurozone would have been a happier place.

P.S. OK Wolfgang I admit it. The above plan has a caveat: It would essentially mean that Silvio Berlusconi (you remember him right? The bunga bunga guy!) would have remained in power. Oh well, I guess we would have to live with it. (Sorry Angela!)

Impressions from a Southern European Country

After watching that Cyprus has also applied for a bailout from the EFSF/ESM fund (following Greece, Ireland, Spain and Italy) I decided to to watch a bit more carefully on how the situation will be handled this time. From what I can see in the news, the group of experts (or technocrats if you prefer) of the International Monetary Fund, the European Commission and the European Central Bank (the so-called troika) have reached the same conclusions as they had done before for the case of Greece, Ireland, Spain and Italy: Austerity Measures. Surprise, Surprise! As if any European citizen was expecting anything else.

News stories of what they intend to propose specify things like large cuts on government expenses, decreases in civil servant wages and benefits and increases in direct and indirect taxes. Although I am positive that the Cypriot state needs to perform some sort of rationalization over its expenses (the Southern European states have a much deserved reputation of not being very logical when it comes to government spending. An excellent example of such irrationalities is Greek government's allowance to the civil workers who arrived at work on time) this sort of thinking and acting will not ease the burden of a sovereign debt crisis. Judging however of the ease at which the troikans believe that austerity measures are a panacea I would propose that the next country that will need a bailout ship its accounting books to them and spare the EU some money on traveling!

As one may observe, austerity measures have not so far helped in easing the effects of the near-bankruptcy of Greece. In Spain, unemployment has reached 25% amongst the population and about one out of two youths under 25 is jobless. And yet, Mariano Rajoy's government announced huge cuts in the nation's budget which will only worsen the situation. Mario Monti's government of technocrats in Italy (in my opinion the best leader in the EU at the moment) has only taken 30bn euros worth of measures, and those in December 2011. In comparing the two states it would now seem that prospects seem slightly brighter for the Italians as per the spring 2012 European Commission forecasts. (for more details read the European Commission Economic Forecast. Be warned it is 190 pages long!)

As one may observe the Commission states that after 2012, a bright future awaits the Union.However I do not believe that such a comeback will be feasible so easily. In an already depressed economy the cost of slashing government spending is going to be more than the amount of money not spend.

As one may see from Google's public data Spain had negative growth only twice in the last 50 years while the more politically unstable Greece and Italy have had more ups and downs. On the other hand Cyprus's only year of negative growth since 1961 was 2009 (wouldn't it be nice if they could just keep it up? Damned bank exposure to Greece!). However, if you exclude the 1974 change in Greek authorities after the 1967 coup d'état, a year which was marked by a 6,44% Greece had not faced major economic downturns. The same holds for the Italians whose worst year was 1975 with a 2,09% drop.

According to the Debt-Deflation Theory of the Great Depression by Irving Fisher and the academics who have studied and written about it over the years (one of which in the Governor of the Bank of England Mervyn King) a large government sector has stabilizing consequences to an economy. In Hyman Minsky's Stabilizing an Unstable Economy (you can find it here) this idea is revisited and it is once again shown that a large government (up to a point obviously) is beneficial for the financial stability of a nation. (I am under the impression that the troika will not especially enjoy this paragraph) Thus the danger that may arise from an excess of austerity measures is to make the already fragile system more prone to future crises.

Following this ideas it is more essential to provide incentives for growth and then impose austerity measures. The logic behind the EFSF so far has been: we give you money if you promise to be frugal with them. Well gee EFSF thanks a lot! What would actually make sense would a be a policy of ''we give you money, spend them to boost the economy, and then impose some austerity measures". (If you are one of those who like to derive examples from economic history you may use the one of Theodore Roosevelt and the Great Depression) I once again state that I am not against the rationalization of government expenses. However, this should be done after the economy stabilizes and not before! If the economy does not grow how is the nation going to pay back it's lenders?

I guess that following the traditional German logic of keeping inflation low and finances tight at all costs led us to where we are now (a note on the solution of the Greek debt haircut on posts to come) and will keep us there until the Germans realize that the hyperinflation of the 1920's will not occur if the let the ECB act as regular central bank and print money. It would even make the value of the dollar fall which would help German exports! 

(Mrs Merkel please listen to reason! Most Europeans are bored of the same meetings with the same conclusions!)