By Stefanos Evripidou
LEAKED INTERNAL documents of the International Monetary Fund (IMF) reveal the executive board’s concern over “optimistic” and “ambitious” forecasts of a Cyprus recovery under the troika bailout and adjustment programme.
On May 15, the IMF board approved a €1 billion loan to Cyprus for three years as its part of a €10 billion international bailout. The approval allowed for the immediate disbursement of around €86m.
The significant remainder- €9 billion- will come from the EU, suggesting a new IMF approach to troika bailouts of eurozone countries.
In the days leading up to the decision, the 24 directors of the executive board representing IMF member countries shared their views on the Cyprus bailout in a document recently leaked by the online financial site Stockwatch.
The preliminary observations mainly respond to the projections and country-specific programme prepared by IMF staff, headed by Cyprus mission chief Delia Velculescu.
The document provides insight into the views, concerns and self-criticism of the Washington-based international lender on recent devastating developments in Cyprus.
Directors noted the inadequacy of bilateral supervision and “crisis prevention” that lead to the drastic measures initiated in March. They highlighted that the Cyprus crisis was the eurozone’s “least unexpected” since it lost market access almost two years ago, had an oversized banking sector clearly exposed to a Greek debt haircut and went through “protracted negotiations” for a bailout.
In a summary prepared by board member Menno Snel and senior adviser Ektoras Kanaris, the two note that the imbalances affecting Cyprus in mid-2011 (long-standing structural imbalances, lax fiscal policies, the banking sector’s large exposure to Greece, and lost access to long-term sovereign debt markets) were reasonably manageable at the time.
However, the situation changed dramatically after the Mari explosion and the Greek haircut on sovereign debt on October 26, 2011, which overnight cost Cyprus’ two largest banks €4.5 billion (around 25 per cent of GDP).
“Failing to request assistance at that point, when the island’s lending partners may have been more sympathetic, Cyprus’ fate had taken a path of inevitability.
“The delays in concluding an assistance package, unfavourable statements and rumours in the press regarding deposit haircuts and the consequent fall in confidence led to accelerated and substantial deposit outflows.”
While the Cypriot authorities accept some responsibility for the delays in concluding an agreement, which worsened the situation and magnified the financing needs that would eventually be met by uninsured depositors, “they would have hoped that the negotiations were dealt with (in) a more sensitive and fair manner for the benefit of Cyprus, the euro area, the EU and for the programme in general”, said the authors.
“Arguably, the most important and extraordinary element of the programme was that the recapitalisation of banks would be almost exclusively generated from the banks’ retail deposits,” said Snel and Kanaris.
The two called the ‘bail-in’ of depositors an “unconventional financing method” yet necessary alternative.
However, they note that the extensive bail-in of uninsured depositors in the two systemic banks, Laiki and Bank of Cyprus, which constitute more than 70 per cent of the domestic deposit market, “will have severe implications” and create a high degree of uncertainty in estimating the impact on real GDP.
While the restoration of a sound and well-capitalised banking system should eventually create better conditions in the economy, “the medium-term recovery of economic activity depends very heavily on the restoration of confidence, and measures and reforms to directly boost medium-term economic growth are rather sparse in the programme”.
Regarding the independent evaluation of Cyprus’ anti-money laundering (AML) measures by Deloitte and Moneyval, Snel and Kanaris said: “The results serve to further evidence that some perceptions abroad were highly exaggerated. At the same time it is acknowledged that there is room to improve and the recommendations made will be taken on board.”
The two also note the change in tack regarding the assessment of banks’ recapitalisation needs and due diligence of Cypriot financial institutions.
“…unlike previous exercises in peer countries, PIMCO has used a more conservative methodology in arriving to the final numbers, providing an implicit buffer for a worse than expected macroeconomic environment.”
Also, “very conservative assumptions” were used for estimating the recovery amounts on defaulted borrowers including, particularly, the application of a forced sale discount of 25 per cent on the projected declining market value of property collateral.
The Cypriot authorities were roundly commended for moving quickly on resolving and restructuring the island’s two largest banks and, despite accepting the programme with reluctance, being fully committed to implementing it faithfully.
“While difficult for the people of Cyprus, the degree of social cohesion in the face of the adjustment so far has been impressive and commendable,” said Snel and Kanaris.
Concluding, the authors said Cyprus faced “an extremely difficult and challenging path ahead through an extended period of consolidation and repair”.
They added: “However, after a long and tiring period of uncertainty, there is at last a paved path” which, with the financial support and expertise of Cyprus’s international partners, including commitments by the Russian government to restructure a €2.5bn loan repayment, “will see Cyprus through this difficult time”.
In their response, directors representing South American countries said the board had a difficult decision to make: “Either the Board approves a programme that has little ownership and even less chances of success, or it runs the risk of exacerbating the crisis in Cyprus which could engulf bystanders as Slovenia or Malta and aggravate the problems in Greece.”
The same directors had some choice words for the Eurogroup’s controversial decision on March 16 to impose a levy on insured and uninsured depositors in both solvent and insolvent banks, berating IMF staff for its part in the troika’s “unacceptable” decision, that was “fortunately shot-down” by the Cypriot parliament on March 19.
“It should have never been endorsed by Management, especially before consulting with the Board,” they said.
Another director said the Cypriot crisis will always be associated with “the unsuccessful attempt to involve in bank resolution and for the first time holders of insured deposits, even in solvent banks”.
If the scheme had gone through, the IMF could have been subject to serious reputational risks, he said, adding: “We should keep in mind that the insurance of bank deposits has been the cornerstone of financial stability and trust in banking since the Great Depression.”
The second package, involving the resolution and restructuring of the two banks, was a better option as it doesn’t hit insured depositors or solvent banks and reduces the burden on tax-payers.
“However, direct recapitalisation of insolvent banks by the European Stability Mechanism would have been a far better option, with much higher chances of success. It would have not deprived Cypriot businesses from their working capital and medium-income households from their life-savings.
Alas, this option was, as staff puts it, ‘not available’ (i.e. not acceptable for Cyprus’ euro-area partners).”
The board also noted that the Cypriot authorities’ measures to resolve the two banks without using taxpayers’ money came before the EU has even agreed on its own EU-level resolution mechanism, proposed in 2012 and still under consideration.
Directors said it was still unknown how the Cypriot restructuring process will differ from a possible EU resolution mechanism, and voiced concern at Europe’s slow pace of reform in terms of greater fiscal integration and setting up a single supervisory mechanism.
A number of directors voiced concern about the exemptions in the haircut on the two banks, warning of the “legal consequences of giving unequal treatment to uninsured depositors”.
They also raised the discrepancy between using depositors’ money for Laiki and Bank of Cyprus, and, in the future, public money for recapitalising other “solvent but under-capitalised” institutions like the cooperative banks.
They further questioned the solvency of the cooperative sector, given that its non-performing loans (NPL) averaged 38 per cent of total loans at the end of 2012, with NPLs in some cooperatives reaching as high as 80 per cent.
The Russian board representative questioned why Cyprus’ business model with its over-extended financial sector was deemed “unsustainable and doomed to fail” since other small economies, including in Europe, have comparably sized banking sectors and still operate.
Cyprus’ downfall was its large exposure to Greece despite the latter being in acute crisis for the last three years, he argued.
“Questions about the effectiveness of Fund surveillance in this case could be raised. Also, we wonder to what extent the obvious complacency of the Cypriot bankers stemmed from the fact that in 2010-2011 the Fund had been actively supporting an illusion that Greek public debt was sustainable.”
Regarding the restructuring of the Russian loan, he said the details outlined are “nothing more than preliminary assumptions at this stage” since the bilateral negotiations have yet to commence.
A majority of directors seriously questioned the IMF’s medium-term growth forecasts for Cyprus, given the extent of the fiscal and financial adjustment and lack of clarity as to what Cyprus’ new business model would be.
Some directors charged IMF staff with an “over-dose of optimism”, given its projected cumulative drop in output of 13 per cent for 2013-14, a return to growth in 2015, and a primary fiscal surplus of 4 per cent of GDP by 2018.
“This huge fiscal effort would be quite difficult to materialise in any country, but even more in Cyprus that needs to find a new business model in the midst of the deepest crisis it has ever had, in an unfavourable international environment and while its eurozone partners are themselves striving for more fiscal adjustment.
“Every programme needs a pinch of optimism but in this one the required dose of good-will – or suspension of disbelief, if you will –goes way beyond the average,” they said.
Another director said: “Even with consistent programme implementation, Cyprus faces a difficult economic path. In particular, the drivers of growth on the island will need to shift dramatically.”
A number of board members questioned what Cyprus’ future growth model will be exactly, and which sectors will lead the recovery, given the beating taken by the financial sector and burst property bubble.
One director said the potential offshore gas exploitation, which IMF staff did not include in its forecasts, was the only source of growth he could see Cyprus relying on.
Board members agreed with staff that, down the line, the Cypriot government will have to focus on public expenditure rather than revenue, with further cuts in the public sector payroll and social benefits expected.
The British representative said the projected fiscal adjustment was “ambitious” and highlighted the need for structural reforms to underpin the consolidation effort in the medium-term.
“Nonetheless, given the uncertainty surrounding the programme, we note the possibility that headline fiscal targets might prove difficult to achieve for reasons beyond the control of the (Cypriot) authorities,” he added.
The board welcomed the inclusion of a significant 10 per cent buffer in staff’s debt sustainability analysis “to provide financial flexibility in the event the recession is deeper than anticipated”.
By Stefanos Evripidou