By Jim Leontiades
There were many influences leading to the Cyprus financial crisis. Many of these were due to local persons and organisations but there were also strong foreign influences making their contribution. The following is my version of the key events, with particular emphasis on the role of the eurozone.
- Before the Euro: Prior to joining the eurozone, borrowing was difficult for a number of countries, particularly those in Southern Europe. In those days the Greek drachma routinely depreciated some 10-15 per cent annually, inflation was high at 8-10 per cent. Credit was tight. The Greek government had to pay lenders interest rates on the order of 20-30 per cent. Borrowing was difficult.
- Greece Joins: Once Greece joined the euro the drachma was replaced. Depreciation of the currency was no longer a problem, inflation moderated and interest rates fell drastically to 3-5 per cent. In Greece, a populist government which had previously had difficulty in accessing financial markets suddenly found it could borrow almost without limit and without the damaging inflation, depreciation and sky high interest rates that such borrowing would have occasioned before joining the euro. This enabled Greece to engage in high cost public projects like the Athens Olympics and to fund an enlarged public sector.
- Easy Credit: There was also excessive borrowing in other countries, though for somewhat different reasons. Spain and Ireland also borrowed heavily, much of the new money going to private borrowers and fuelling a housing boom. Credit was freely available. Being a member of the common currency also tended to disguise national risks. There was a tendency for lenders to treat all member countries of the common currency as quite similar in terms of financial risk. This was not to last.
- Lehman Bros. bankruptcy: The 2007 Lehman Brothers bankruptcy in New York changed the economic climate. Banks became reluctant to lend. They took also took a closer look at the eurozone countries and saw that each country had different levels of debt, revenue, and a different risk profile. Interest rates rose again, particularly to highly borrowed countries with limited repayment capability. New financing from international capital markets became more difficult and for some countries, such as Greece, eventually impossible.
- The Default on Greek Bonds: In 2011 an over-borrowed Greece found that it was not able to pay its creditors. The country reached an agreement with the eurozone and declared a default on its bonds. Holders of Greek bonds, including Cypriot banks, would lose a major part of their investment (75 per cent).
- Cyprus: Cyprus was initially exempt from the debt problems plaguing Greece and some other European countries. The year 2008 found the country with a low national debt of 8.3 billion euros (49 per cent of GDP). This changed during the presidency of Demetris Christofias. On taking office, the new government increased spending almost immediately. Government advisors drew the government’s attention to the dangers of the government’s increased spending as early as 2008.
Evidence was presented before the Pikis Commission of Inquiry by a host of senior civil servants, ministers and advisors, all of whom had communicated warnings to the government of the deteriorating financial situation.
By 2012 the national debt had almost doubled to 15.4 billion euros (86 per cent of GDP,17,603 euros per person). The problem was not the level of the national debt so much as its rate of growth and a recurring annual deficit of 5-6 per cent.
- The international rating agencies: In June 2012 the ECB refused to accept Cyprus bonds as collateral for loans. Prior to that, the rating agencies having become alerted to the dangers of excessive borrowing within the eurozone and the problems of the Cypriot banks, had downgraded Cyprus bonds to the point where Cyprus was cut out of the international financial markets.
- The Banks: The Greek bond default added enormously to the country’s difficulties. Cypriot banks lost an estimated 4.5 billion euros. This was less than some other countries losses but represented an astonishing 25 per cent of this country’s GDP, greater proportionally than any other eurozone country and guaranteed to cripple Cypriot banks. The Cyprus government agreed to this “haircut”, not raising any objection or suggesting alternatives
Investing so much of the banks’ assets in Greece (too many eggs in one basket) was a huge mistake. It should be noted that all sovereign debt in the eurozone at that time was rated as zero risk by the European Central Bank and that this was the first bond default in Europe since 1933
An important contribution to the magnitude of the loss was the merger of Marfin in Greece and Laiki. As indicated before the Pikis Commission of Inquiry, some of the manoeuvres associated with this merger were of doubtful legitimacy.
9. ELA and Laiki: Rapidly rising domestic debt, losses of the main banks in the Greek bond default and the eventual shutting out of the country from international financial markets meant that Cyprus was desperately in need of cash.
The Laiki Bank needed billions of euros just to remain viable. The European Central Bank provided additional financial assistance in the form of ELA (Emergency Liquidity Assistance). The Cyprus government supplied an additional 1.8 billion euros to Laiki from a loan obtained from the Russian government. Eventually, even more money was needed, both for Laiki and the BoC as well as well as to finance the governments own spending.
10. ELA and the European Central Bank: The Emergency Liquidity Assistance supplied by the European Central Bank (ECB) is perhaps the single most important event contributing to the current economic crisis. The ECB had been supplying ELA to the troubled Laiki Bank since 2011. It continued supplying such emergency liquidity right up to the March 2013 negotiations. From a level of 3.8 billion Euros in May of 2012, ELA to Laiki rapidly grew to over 9 bill euros in the space of the next 9 months. This figure amounts to over 50 per cent of national GDP, a proportion greater than any ECB loan to any other country and possibly, in GDP terms, a world record for a single bank.
If Laiki had been declared bankrupt earlier, Cyprus would have had to call for European financial assistance, but the amounts required would have been significantly less and the resulting crisis much more manageable. Of course, only Eurogroup financial assistance could have made the resulting crisis manageable. That would have required the Christofias government to sign an MoU with the Eurogroup. Why did this not happen?
The Financial Times quotes the governor of the Cyprus Central Bank as stating that Laiki had to be kept afloat for political reasons, “until the next election” (FT 16 April 2012).
The government had in fact asked the Eurogroup for help in June 2012 but did not follow through. In short, the decision not to sign an MoU required the continuation of ELA. But who decides whether to continue or cut off ELA? The ECB position is that ELA was the responsibility of the Cyprus Central Bank.
This is counter to the statute governing the establishment and operation of the European Central Bank. The official Journal of the European Union states: “The national central banks….shall act in accordance with the guidelines and instructions of the ECB” (Protocol no. 4, article 14.3, Official Journal of the European Union)
The decision-making power of the ECB was evidenced during the March 2013 negotiations. President Nicos Anastasiades was informed by the Eurogroup at that time that he had only a few days to agree to their conditions or the ECB would cut off ELA to the Cyprus banks. The threat to cut off ELA provided the “gun” that President Anastasiades stated was held to his head during this time, bringing down the entire banking system and probably forcing Cyprus out of the euro.
It seems both the Cyprus government and the ECB were complicit in favouring delay and a continuation of ELA. But the ECB was the supplier and had decision power over ELA as well as responsibility for the prudent management of the eurozone system of banks.
11.The March 2013 losses: The March 2013 agreements between Cyprus and the Eurogroup included for the first time in the eurozone a “bail in” on deposits over 100,000 euros. Also agreed in the negotiations was the forced sale of the facilities of the three major Cyprus banks in Greece within the space of few days. Financial experts have estimated that the sale of these assets was adverse to the best interests of the Cypriot banks, costing them3.4 billion euros. Additionally, the Bank of Cyprus was required to acquire Laiki and its massive ELA debt. These arrangements essentially crippled both banks and the Cypriot financial industry.
Even before the March negotiations, there was the view expressed most forcibly by the German representatives that the Cyprus banking industry was too large in relation to the economic size of the country. The main banks were too big and too international, particularly with reference to Russian investors. This no doubt accounts for some of the drastic measures taken to reduce its size. But the decisions taken regarding the Cypriot banks not only reduced their size but threatened their very viability, not only internationally but domestically as well.
Dr Jim Leontiades teaches at Cyprus International Institute of Management