Cyprus and the Troika Trojan Horse

A creative combination of tax, bank restructuring and capital controls enabled Cyprus to secure a 10 billion euro rescue package. It’s important to note that this package is minuscule compared to Greece’s 340 billion euro bailout.

Let’s not forget Greece has given us a strong stomach. We’ve become accustomed to adrenaline filled last minute bailout deals, all served with the stark reminder that Eurozone leaders hold the key to financial stability. A small island nation dominated global headlines spreading fear throughout the financial world.

How much trouble could such a small nation cause? Even smaller than Greece which accounts for just 2.5% of the entire Eurozone?

Here are the cold facts: Cyprus is a 24 billion euro economy accounting for just 0.2% of the entire Eurozone’s GDP.

The small island nation has a population of 10 million, with 15% unemployment. It’s divided in two, sharing one half with former “enemy” Turkey; its soul is Greek and its currency European. This former British state prided itself on its strong banking system.

Who’s really to blame for Cyprus’s downfall?

A potential target is Greece. Part of its bailout deal was a 70% ‘haircut’ on holders of Greek debt. This caused a massive hole in Cyprus' budget and extended its deficit to 7.3% of Gross Domestic Product in 2011. The budget deficit then recovered dropping to 4.2% of GDP in 2012, above the Eurozone’s 3% target. This may well be among the biggest contributors to its downfall.

Given that the Eurozone’s leaders manufactured this haircut, it is curious that this highly educated group failed to anticipate the effect it would have on the Cyprus economy, or on any other bond holder for that matter. Now the blame could shift to the Troika for not considering the true effects of ‘haircuts’.

It is clear that the European Central Bank did not measure the contagion effect of Greek haircuts on a systemic basis. Instead what they came up with appears to have been a quick fix solution to console irate German tax payers and the International Monetary Fund.

Then there’s the Cypriot government.  If you know you have a hole in your budget surely you should make provisions by raising taxes and spending less?  So is the country or its banking system to blame for its downfall?

Cyprus’ banking system is 7 times larger than its economy and is the largest contributor to the country’s growth. In fact the banks have been the main source of revenue for the country since 1974, crowding out other “productive industries”.  Agriculture accounts for a mere 2.4% of Cyprus’ GDP.  Industry makes up 17%, while services contribute 81% to the economy.

Meanwhile, there is also a somewhat shady side to the island: Cyprus has been known to attract “dirty” money, offering a tax haven for the rich – a fact that many of Russia’s wealthiest have used to their advantage. Given that this was an easy way to collect taxes, why didn’t the Cypriot government heed calls by Germany to sort out its banking system?

Did the banks need a bailout, or was it the government? Cypriot debt totals 15 billion euro of which Banks’ and Central Bank debt only amounts to 1.9 billion euro. Bank deposits are 68 billion euro which means that the banking system in theory should be relatively stable. Also Cyprus had a loan-to-deposit ratio of almost 100% - this means that for every euro lent out there is a euro deposited.

But Cyprus’s two banks were weakened by Greek bonds and non-performing real estate loans.

European regulators say that by the end 2010, the Bank of Cyprus and Laiki Bank had a combined 5.8 billion euros of Greek government bonds, which equates to one third of Cyprus’s GDP. A knock of around 2.6 billion euro was taken during the Greek haircut.
Many are now asking why the Cypriot government increased their exposure to risky Greek government debt when other big global banks, were doing the exact opposite? Were they taking unnecessary risk or did they feel overly confident that Greece would not default. While Greece did not default in the traditional sense, the ‘haircuts’ are actually known as a selective default, with only parts of the debt being written off.

The property prices have plummeted between 25-45% after prices were artificially pushed higher over a period of several years. Bankers are denying they were involved in the property market scandal despite not accounting for bad loans since the financial crisis and keeping the “bad” loans on their books as assets. The massive decline in property prices not only means bad news for banks and home owners but also for property developers.

It’s estimated that the property market write-off will be between 3-6 billion euro.

The Rescue

Cyprus’ package arrived just in time to avert catastrophe and a collapse banking system. But like all last minute bailout packages the money comes at a great cost.

It all started on Saturday 16 March 2013, an ideal day to announce drastic measures to unsuspecting citizens. Cyprus became the fifth Eurozone nation to secure a bailout package, and in return would have to contend with draconian measures to scrape together 6 billion euros.

Total  bank deposits in Cyprus total 68.7 billion euros (20 billion of which are Russian deposits).

Initially the bailout conditions were aimed at hitting ALL savers. It was proposed that a 6.75% tax be levied on all bank deposits below 100 000 euros and 9.9% tax on all deposits above 100 000 euros.

President Nicos Anastasiadis announced banks would only reopen on Wednesday the 19th of March. Monday was a public holiday, which would help buy time needed to continue crucial negotiations.

Wednesday became Thursday, and Thursday, Friday.

The world watched as the Cyprus government (by order of Eurozone Finance Ministers) switched off all electronic transfers, limited withdrawals and froze the tax on each deposit.

Even the most austere of investors screamed sacrilege. The Holy Grail of banking had been desecrated.

Could consumers and business ever trust the banking system in Cyprus again?

Perhaps unsurprisingly, the Cypriot parliament voted against the “confiscation” levy and Germany expressed its disappointment.

The market started to speculate that Russian millionaires were the target.  It’s said that real reason for the deposit tax was because Eurozone leaders wanted to sever Russian-Cypriot ties.

While rumours ran amok, Cypriot leaders went on a controversial visit to meet with the Russians in hope of economic assistance.

They returned empty handed.

By then the Eurozone, IMF and EU also known as the Troika -a Russian word for “group of three”- signalled that they would withdraw the bailout offer if the terms were not met.

Social media participants predicted a massive outflow of money as soon as banks opened. Ironically, given the apparent way the concerns of smaller investors had hitherto been ignored in negotiations, if the bailout terms weren’t going to make the banks fall then a massive exodus of depositors would.

As the pressure mounted the Cypriot parliament had very little negotiating power left.

Cypriot authorities agreed that all bondholders, investors and savers with over 100,000 euros tied up in the country's two biggest banks - Bank of Cyprus and Laiki - would take massive losses as part of bailout terms.

A monstrous tax of between 40-80% would be levied on all unsecured deposits above 100 000 euro – including unsecured pension funds. Deposits below 100 000 euro would not be affected.

Bank of Cyprus (BoC) shares were rendered effectively worthless, wiping out their value in a complex recapitalization scheme.

Laiki has shut its doors, with all deposits - or at least what’s left over -moved to BoC.

To save the country from any further pain politicians installed Capital Controls, forcing depositors to stay put for at least six months.

After being closed for 8 days, banks opened their doors on Thursday 28 March.

Last minute deals

Of perhaps most concern here is the fact that Cyprus rang the alarm bells back in 2011, when the country’s borrowing costs rose to double digits making international capital markets inaccessible.

The country engaged in dialogue with the powers that be, hoping to find a solution before it was too late.

In mid-2012 the country officially requested assistance, asking the Eurozone for access to cheap money so that it could fund its growing deficit.

As recent history tells us, access to cheap money in the most desperate of times does not come easily or cheaply.

Staying with the trend of self-destruction, a change in leadership on the cusp of a bailout package was also fitting for an indebted Eurozone nation, as Nicos Anastasiadis was elected president in December 2012.

After the bailout, criticism started flooding in.  Economists pored over tax rates, tax compliance, manufacturing, productivity, bank capital adequacy ratios, government spending and all types of other economic indicators fitting to a troubled Eurozone nation.

The island has implemented a range of austerity measures to rake in more cash –the ultra-low corporate tax rate has increased from 10% to 13%, while property taxes have also been hiked.

And after a 2.3% drop in growth in 2012, Eurozone leaders are now expecting Cyprus to contract by 8.7% in 2013, followed by a 13.9% drop in 2014.

ECB President Mario Draghi has promised the world that this economic experiment is not ‘a template’. He said Cyprus is not a ‘model’ for all ailing countries. This declaration means Cyprus’ bailout package was carefully crafted in the most unorthodox manner for a very good reason.

Cyprus’ bailout package, which we could argue has become a Trojan Horse, has caused much pain to not only Russian Oligarchs but also to pensioners with savings above R1.2 million.

Now bailout package costs have escalated to almost 100% of GDP up from 17.5 billion to 23 billion euro.

More pain lies ahead…some economist are expecting further cuts on Greek debt, which
will further plunge Cyprus into economic disarray.

As the famous Edmund Burke quote goes: “all that is necessary for the triumph of evil is that good men do nothing”. 
The evil in this case is not only the failure to find a quick solution as the crisis broke out but also the deep rooted
weakness in the drivers of the Cypriot economy. If  Cyprus had not relied so heavily on its banks and property
market perhaps the hit wouldn’t have been as devastating.

Increasing holdings in Greek government debt when other big banks was also a big mistake, adding to its economic woes. Whether it was just a catalyst for the
inevitable or the reason for its downfall, Cyprus now needs to hone other sectors of its economy.

Burke also wrote, “better be despised for too anxious apprehensions, than ruined by too confident security”. 
Whether the weak banking system was the real reason for Cyprus’ demise or a combination of factors, it is worrying that leaders were so late to act.
It’s said that Slovenia could be the next Eurozone country to fall, let’s hope swift action is taken ahead of time.
 

- eNCA

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