By Athanasios Orphanides
WHEN Cyprus joined the euro the economy was in good condition. Successive governments had worked hard to create a growth model that could employ our highly educated workforce in offering financial services. Cyprus had developed into a regional financial centre.
Fiscal finances were in good order. The country had a solid banking system. Funding was stable and deposits exceeded loans. Despite a real estate overheating, similar to the UK, Ireland and Spain, risks were contained by tight loan-to-value ratios.
Cyprus had already in place liquidity regulations and macro-prudential measures whose significance has only recently been recognised by the international central banking community.
Cyprus and its banking system enjoyed international respect.
Five years later, the economy is in shambles. For two whole years, Cyprus has had a government with no access to markets. Euro deposits in Cyprus are unequal to euro deposits elsewhere. How could this happen?
Could anyone have seen this coming? A look at the credit default swaps for the five euro area member states that have requested support so far offers an explanation. This figure confirms that Cyprus has been in a crisis. But this figure obscures a crucial element that made Cyprus unique.
This uniqueness is shown by the date when the eurogroup received a request for help by the Cyprus government in relation to its exclusion from the markets. Greece, for example, sought assistance on April 23, 2010 and its Memorandum of Understanding was finalised on May 2, 2010. In all cases, except Cyprus, when a government run into difficulties, with the CDS spreads reaching or exceeding about 600 basis points, it asked for help. And in each case within three weeks or so, a programme (MoU) was agreed, and the government started its implementation.
The Cypriot government run into problems in May 2011, two years ago. But unlike everyone else, the Cypriot government refused to follow the rules. More than a full year passed before the Cypriot government was forced to ask for help, on the same day in fact that Spain asked for assistance.
But Cyprus was also unique in that the government refused to finalise an MoU. In contrast, Spain completed its agreement on July 20, 2012, three weeks after it had asked for help.
The inaction by the government had severe economic consequences, with unemployment reaching historic highs.
This was the first time in the history of the republic that unemployment had reached double-digit levels during peace time. Worse still, by February 2013, one out of every three young adults was unemployed. The government had set in motion all the ingredients needed for creating a lost generation.
What happened? What made Cyprus so unique? In February 2008, just two months after Cyprus joined the euro area, there were presidential elections and the public voted in the leader of the communist party.
The public did not foresee the catastrophe this could bring. At that time, the economy was doing so well that voters focused on the political problem of the island.
The government started overspending as soon as it took power. In an environment of stagnating growth it created doubts about the sustainability of its fiscal affairs. When financial markets raised red flags, the government had a choice: Fix the problem, regain credibility, restore sustainability; or make the problem worse.
Faced with this choice, the government assaulted the banking sector that was already weakened by the global crisis. By the time the five-year term of this government had ended, it had also succeeded in destroying the economic model of the country.
The spending spree started the imbalance. Growth averaged around 4 per cent before the crisis. Starting in 2007, there was a 4 per cent growth path, but over the next five years the graph line showing growth of real GDP remained about flat.
By contrast, real government expenditures accelerated after 2007. This only stopped when the government run out of money and could no longer keep up. Couldn’t someone explain to the government why this was a problem? There were many attempts. Concerns were raised as early as 2009.
However, the government refused to either acknowledge or correct the evident imbalances. The argument was used that debt to GDP was below the average of the euro area so there was plenty of room for more spending and bigger deficits.
Concerns intensified during 2010 with the further deterioration of fiscal finances in the context of the sovereign crisis in the euro area that year. The large size of the banking system and its connectedness to Greece implied greater vulnerability to fiscal missteps.
A letter from the Central Bank to the government, dated 18 May 2010, warned “… that unless there is a change in direction with meaningful fiscal consolidation, primarily on the expenditure side, the consequences for the Cypriot economy will be catastrophic”.
Before the end of the year, on December 15, 2010, the presidential palace would receive another warning, this time from the European Central Bank. The letter, co-signed by the then ECB President Jean-Claude Trichet and the governor of the Cyprus Central Bank was emphatic.
Among other things, it warned, that in light of the large size of the Cypriot banking system, the country could experience negative feedback loops between the financial sector and public debt that could be disastrous for the country. The letter stressed that the challenges faced by the Cypriot economy required prompt corrective action.
Unfortunately for the Cypriot public, the government dismissed all these warnings. Not heeding the ECB warnings was particularly costly. Through its actions, the ECB had demonstrated its willingness to provide support and diffuse stress situations. It had been purchasing Greek, Irish and Portuguese bonds. A few months later, it started purchasing Italian and Spanish debt.
Cyprus had a government that chose to dismiss all warnings. Unsurprisingly, the ECB made no purchases of Cypriot bonds.
The failure of the government to correct its widening fiscal problems and the deterioration in Greece attracted attention to Cyprus in 2011.
The sovereign was downgraded. But instead of taking consolidation measures the government imposed a levy on banks to raise more revenue and continue spending.
This was the opening salvo in what was to follow. The global banking crisis was already pressuring banks. Banks were raising additional capital to defend against rising risks. And the government chose to add to these pressures.
By May, the situation had deteriorated but the ministry of finance denied it. There was a reason for the denials. The ministry of finance was trying to avoid disclosing the deterioration of the country’s finances prior to the parliamentary elections in late May 2011.
For many months, the ministry had been postponing needed long-term bond issuance. The maturity of the debt was significantly and dangerously shifted from long-term financing to short-term financing to facilitate the election plan.
It was later disclosed that the ministry of finance had even asked a rating agency to postpone downgrading the sovereign until after the election.
The government’s plan was successful. The communist party gained one seat on the 22 May 2011 parliamentary elections. However, the country was to pay a huge cost. The government had lost control of its financing.
Anyone with access to market data could see the tsunami coming. The central bank had been providing information to stakeholders. Markets had treated Cyprus similarly to Italy and Spain until the end of 2010. The government’s refusal to take action with the budget for 2011, put Cyprus in a worse condition. Portugal was the only country giving cover to Cyprus.
By the beginning of 2011, it was clear that if Portugal was forced to seek help, Cyprus could be next. The loss of market access was immediately evident. By mid-June, yields were as high as the levels for Greece, Ireland and Portugal when they were contacting the EU and IMF to ask for financial assistance.
A chart showing these high yields was attached to yet another warning letter sent by the central bank to the president on June 17.
The summer of 2011 presented an explosive mix for Cyprus. The government had lost access to markets in May. There was a very unfortunate Iran-Syrian arms related incident in early July. And the euro area crisis intensified. The Mari explosion on July 11, 2011 was very damaging.
The event paralysed the government and resulted in political instability. The explosion also had a tremendous economic cost. Over half of the island’s electricity supply was lost. The island had to endure rolling power outages. The economy was thrown into a death spiral.
In yet another warning, the central bank noted that following the explosion, and in light of having already lost market access, the economy was in a critical condition comparable to that in 1974. Action was imperative to avoid the worst.
Once again, action was not forthcoming. Instead advisers, including academics based abroad were drafted in to criticise those calling for action and argue that what was needed was more spending.
The country was falling apart. But what about its banking system? Certainly, the banking system of any country driven to the ground by its government sooner or later faces severe difficulties and a crisis. But what was the state of the Cypriot banking System in July 2011?
The answer can be obtained by looking at the results of an European Banking Authority stress test that by coincidence was published that month, on July 15.
The two largest Cypriot banks participated and both passed. The system was under pressure, but banks had been raising capital to defend against risks and could weather even possible haircuts to Greek debt that were then under discussion.
On July 21, the EU Council decided to implement a private sector involvement (PSI) on Greek debt. The decision, following negotiations with bank groups, called for a voluntary haircut of up to 21 per cent. The two large Cypriot banks, with major operations in Greece, held a lot of Greek debt, as all banks operating in Greece were expected to. This was a painful loss to shareholders. However, the banks had accumulated more than enough capital and they weathered this decision with existing buffers.
Unfortunately, on October 26, the EU Council decided to abandon the 21 July 2011 agreement. The governments backtracked on their decision and forced a bigger haircut that eventually translated into about 80 per cent in market value.
At the same time, they demanded a new recapitalisation exercise with elevated core-tier 1 capital requirements (nine per cent) without an agreement on how capital would be provided. This was a huge blow to the banking system in Europe. ECB President Mario Draghi later characterised this sequence of decisions as a “Lehman” event for Europe.
The October 26, 2011 decision cost about 25 per cent of Cypriot GDP to Cypriot banks. Remarkably, the government agreed to this decision while the exposure of Cypriot banks and associated cost to them were public information.
The two banks had extra capital to cover about 15 per cent of GDP. The largest bank could complete covering all additional required capital once it had completed the sale of some insurance assets. But the second largest bank needed temporary support of about 10 per cent of GDP to reach the 9 core-tier one threshold. However, as the sovereign had lost market access it faced a difficulty.
With the economy tanking and no access to markets the sovereign faced default. Once again, the government avoided seeking assistance from EU/IMF. Instead, the government sought a bilateral loan from the Russian Federation, of about 15 per cent of Cypriot GDP. Once again, the government chose to delay taking corrective measures and make the problem worse.
The government tried to delay everything beyond the February 2013 elections. It might have worked. If banks could be assured that government debt would remain ECB eligible, then the government could raise the funds through issuance of debt that banks could finance with liquidity provided by the ECB using the bonds as collateral.
But there was a catch. ECB eligibility requires at least one investment-grade rating of sovereign paper. The Cyprus government had suffered such a loss of credibility that it could no longer safeguard its rating. But this rule had been waived for programme countries. Could Cyprus secure similar support?
A last chance presented itself in April 2012. A new minister of finance had assumed office in March. He suggested that the government adopt and implement voluntarily measures similar to what a MoU would have demanded and in this manner avoid a formal support mechanism.
At a meeting with the executive board of the ECB on 17 April, he committed to adopt and implement specific measures before the end of May. Unfortunately, his plan was deemed too politically costly for the communist party and resoundingly rejected. The president’s public dismissal on June 1, 2012 pushed Cyprus over the cliff. Shortly after, government bonds no longer met the ECB eligibility criteria.
The ECB did not waive the rules for Cyprus. Cyprus became the first country in history whose central bank refused to accept its bonds for monetary policy purposes for many months. Unfortunately, although the government asked for help on June 25, 2012, it chose not to complete the MoU.
The government desperately tried to push adjustments beyond the February 2013 elections. Simultaneously, it intensified its assault on the banking system as a platform for the election.
After the communist party effectively secured the control of the central bank, on May 3, 2012, the government and central bank could engage in a coordinated campaign against the banks as part of the February 2013 presidential election campaign.
The central bank contributed in a number of ways. It removed the chairmen and CEOs from the two largest banks. It started a number of investigations against the banks, with selective defamatory leaks to press. More damaging for the international image of the sector, the central bank characterised banking in Cyprus as “casino banking”. And, as was reported widely, it took steps to exaggerate the capital needs of the banking system.
The goal was to create a negative image that could be used to claim that the only reason the government had to seek EU/IMF assistance was problems with the banks.
The coordinated campaign succeeded in creating the image that the banking system was so severely undercapitalised that if the government provided the capital, as was done in previous cases, then, according to standard IMF analysis, government debt could be deemed unsustainable.
The bail-in of depositors became the only option the Eurogroup was willing to discuss.
The economic consequences of these five years were severe. By 2012, real GDP per person fell cumulatively by more than 10 per cent relative to 2007. Worse, as a consequence of the damage to the economic model of the island, the decline was projected to continue.
In five short years, Cyprus had become a case study on how destructive economic populism can be. I recall a lesson I learned long ago from the famous economist Rudi Dornbusch while studying about other crises that could have been avoided. As Rudi used to say: “Populism always ends in tears”.
Athanasios Orphanides was governor of the Central Bank, May 2007 – May 2012. This article is taken from a presentation he gave on May 17 at the conference ‘Cyprus: five years in the Eurozone’, organised by the Tassos Papadopoulos Studies Centre