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Cyprus: The Agony to Come

By Andrew Novo and Scott B. MacDonald

A deal has finally been reached between Cyprus, the European Union, the European Central Bank, and the International Monetary Fund to secure a bailout for Cyprus’s distressed banking sector. The deal with the Troika provides some €10 billion of badly needed liquidity at the cost of haircuts, or a loss that will be repaid to creditors, for depositors with the Cyprus Popular Bank (Laiki) and the Bank of Cyprus. Part of Laiki will be subsumed by BoC and wound down, the rest has been purchased by the Greek Piraeus Bank.

Although depositors in other institutions have been spared haircuts, the damage to the Cypriot financial sector and the broader Cypriot economy is profound. As the final terms are hammered out, the Cyprus crisis may be fading from market headlines, but for Cyprus, the worst is yet to come. The harsh reality is that Europe’s solution to Cyprus’s problem, imposed by European policymakers for European policy imperatives is likely to cripple the island’s economy for years to come. The knock on effects of the blow to the financial sector undermines confidence in the island’s economy, limits its future prospects for growth and will likely push it into a period of rising unemployment and economic contraction, credit will be hard to come by, and banks will begin to pressure debtors for payments, putting tension on a previously relaxed lending market.

Cyprus’s economic burden can be understood in both regional and local terms. On the regional level, the precedent for European rescues for Eurozone crises is hardly encouraging. Greece’s financial crisis has been practically endemic since 2009. Two major bailouts were needed and there may yet be a third. The country’s economy has continued to contract as austerity has failed to correct the fundamental lack of competitiveness in the Greek economy and has contributed to record unemployment of more than 26 percent. Greece’s continued rocky path is a harsh warning to Cyprus.

In Cyprus itself, there were warning signs of impeding economic doom before March of this year. With its tourist industry hurting from the broader European downturn and its businesses hamstrung by the continual Greek crisis, the Cypriot economy began to slide in 2011. By mid-2012, it became the fourth European country to apply to the European Union and IMF for rescue funds. At that time, the number €17.5 billion was mentioned—roughly the same as the country’s GDP. In Cyprus 2012 was a difficult year, particularly for Cypriot banks which were hard-hit by the 53.5 percent haircut imposed on holders of Greek sovereign debt.

But there were broader problems. These were epitomized by Cyprus’s largest supermarket chain—Orphanides—which took losses of more than €17.7 million for the first three quarters of 2012. The now bankrupt company owes €10 million to creditors, €85 million to suppliers, and a shocking €140 million to banks—mostly to the now defunct Laiki. The Orphanides bankruptcy directly affects more than 1,250 employees, 2,000 suppliers and is an estimated €400 million loss for the Cyprus economy as a whole.

For businessmen like Orphanides, the cozy and personal nature of Cypriot banking allowed them a great deal of leeway in managing their debts. Suppliers continued to bring goods to the stores even though they had not been paid and banks continued to forward cash in spite of late or little repayment for their efforts. Such behavior was not restricted to supermarkets. Cyprus’s real estate market has also been living on borrowed time and is now a major cause for concern. At the close of 2011, home prices were down more than 14.5 percent from their 2008 highs—when buying an apartment in some areas of the capital Nicosia was as expensive as buying one in Kensington or the swanker parts of New York City. With deposit money locked in and banks calling in their loans and becoming less flexible creditors, prices will face downward pressure. Developers and homeowners may have to dump property to come up with badly needed cash, while foreign investment in Cypriot vacation and retirement homes is likely to fall given the unstable nature of the island’s financial system at present. The shrinking financial sector—which employs nearly 80,000 Cypriots (in a workforce of 425,000)—will also contribute to substantial new unemployment, while Troika-enforced austerity will reduce the numbers and the salaries of government employees. Laiki bank alone employs more than eight and a half thousand workers. As the bank is wound down, most are likely to lose their jobs.

Cyprus has had to deal with unfavorable bank balance sheets largely because of the Greek haircut, but non-performing loans such as those given to supermarket giant Orphanides and the declining housing market have not helped. On a household level, Cypriots are the third most-highly leveraged people in Europe, falling into the high-household indebtedness category with countries like Ireland, Portugal, and Spain.

With Cyprus’s corporate tax rate set to rise, its credibility in tatters, its position as a financial hub crippled, and its development of natural gas a decade away, the short-term outlook is bleak. Significant economic adjustments in the standard of living can be expected as Cyprus will join Iceland, Ireland, Spain, Portugal, and Greece as countries that have faced their day of reckoning for their participation in the culture of overleverage. For the rest of Europe, there is fear that the island’s painful medicine will become a blueprint for other countries confronting similar financial problems. Indeed, the Cypriot plan was held up as a blueprint for future bailouts by the Dutch finance minister, raising serious questions about how much confidence ordinary Europeans should have in the safety and soundness of their deposits at banks – a stunning reversal in the policies of advanced economies since the 1930s. For Cypriots, the policy is hardly a comfort. They will bear its costs, and those costs are just beginning.

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Dr. Andrew Novo is a Professor of Strategic Studies at the National Defense University. Dr. Scott B. MacDonald is the Head of Research and Senior Managing Director at MC Asset Management Holdings, LLC.  They have co-authored When Small Countries Crash

[Photo courtesy of @Popicinio]

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