Cyprus Mail
CM Regular ColumnistOpinion

A tale of two economies in Cyprus

By Erol Riza

The recent upgrades in Cyprus’ growth outlook and the boom in ephemeral factors that have benefitted the economy in the last three years should not make the new government after January’s election complacent.

By all accounts, if the numbers published by the EU were true about the whole real economy of Cyprus there would be grounds for praise. However, the problems of the real economy have been swept under the carpet, very smartly, by growth performance and fiscal improvements.

The fundamentals though, excluding the fiscal improvements, are not such that should allow the new government to relax efforts to improve structural inefficiencies and work to improve productivity.  The government should be judged by its actions on reform, the improvement in productivity and inclusive and sustainable growth prospect.

In fact, given that some of the ephemeral factors may not be present in the same numbers (tourists and passports) in the coming years, and with problems such as high private indebtedness and the highest non-performing loans (NPLs) in the EU, it is easy to see that a new financial crisis may be looming. If this happens it will be very difficult for Cyprus to manage since the banking system will be hurt further by increasing NPLs.

In 2013, like other bankers and economists, I saw the Troika as the best thing to happen, especially in terms of dealing with the bloated, very costly public sector. I thought that the politicians would have learnt the lesson from the crisis and adjusted. Alas, I was wrong. To change the economic model one needs to plan ahead, seek to change the culture and attitudes and persevere with reforms. That sadly has not happened. Cypriots seek short-term solutions with no pain hence the holy grail of real estate and passports.

While there was much talk about putting the economy on an improved course and creating a sustainable model we are witnessing the complete opposite. The economy is back to being dependent on selling real estate and on capitalising on the business services which thrive due to the favourable tax jurisdiction of Cyprus.

Some might question what is wrong with this business model and why should it change. As one of the major developers in Cyprus asked me when I served on the interim board of Bank of Cyprus: “What else do we have other than real estate and sun to sell?” But the real question to ask is what have the government and the private sector done to change the direction of the economy?

The government has dutifully helped developers to sell real estate and has abolished taxes to help them to develop more real estate in support of a sector which has huge non-performing loans. Even where these are possibly being repaid it is because they have had debt written off and some do not pay their property taxes.

Why should this matter if the government’s coffers are doing well? It does matter when the rest of the private sector and households do not enjoy such forbearance from the government and little from the banks; no surprise that there are billions of returning NPLs since the early restructuring was not sustainable and household debt remains stubbornly high. There are €11bn of terminated loans and €4bn returning NPLs.

The real worry for the banks, however, will be the future provisioning of NPLs which are unsecured and to a lesser degree the secured ones. The ECB current proposal to have future unsecured NPLs fully provisioned within two years and the unsecured within seven years will add further problems to the banking system, especially if future NPLs includes returning loans which have been restructured already.

Some of the fundamentals of Cyprus have not changed and those who invested thinking they had found great value in Cyprus have been disappointed, to say the least. While property prices and rents may have gone up along the coast due to overseas buying and setting up of offices by financial firms, this investment is limited to certain areas and has not filtered down to the rest of the economy.

It is not hard to argue that the cheap all-inclusive packages that hotels offer to some tourists do not do much good for the rest of the economy. Is this the quality of tourism that will provide permanent jobs and growth? If the reported restriction of capital exports by China means that fewer flats will be sold this inward investment, benefitting developers will be lost with all the repercussions this will have on their ability to service their debt.

Unless Cyprus introduces the necessary reforms and reduces its reliance on real estate, business services and tax incentives it will be vulnerable to a new crisis as the problems of the banks and the economy need certainty and decisive action by the government to resolve the NPL burden.

Unless the state gets involved to resolve this burden there is hardly a ready market solution to deliver the desired results. There is little market appetite to buy the terminated loans of €11bn nor the €4bn returning NPLs. At best some of the prime land may find overseas buyers but that is not enough. The rest of the collateral in Cyprus is not along the coast and the banks have had to increase provisions on the insistence of the Single Supervisory Mechanism to meet challenges of a dysfunctional real estate market.

The European Central Bank (ECB) wants NPLs to be reduced and quickly, hence the urgency which the Central Bank of Cyprus attaches to this in recent remarks by the governor. Since primary residences are difficult NPLs to manage only government intervention makes sense.

Whilst the rating agencies see improvements in some areas of the banks the fundamental problem of high private sector indebtedness – an issue which has been repeatedly, and quite rightly, highlighted by other economists in Cyprus – cannot be wished away.

The problem is still with our three systemic banks and no well-informed banker will tell you that the legal framework in Cyprus lends itself to developing a secondary market for NPLs or for securitising primary residences. For the latter, one is well advised to read the Moody’s report on NPL securitisation.

In summary, the economy is not out of the woods and the banking system needs the state to get involved. The ministry of finance has to revisit some of the ideas which have been put to it and not rely on those who argue that the taxpayer should not help the banks resolve NPLs. If this were not the right course, why would the ECB propose that the governments should guarantee the riskiest tranche of a bond issue in order to support an NPL securitisation transaction? Only a government entity can take a 20-year view on the problems of households and SMEs which have their primary residence as collateral.

In addition to the domestic factors that entail risks, one cannot ignore the perils from the next potential financial crisis that may occur in the global economy.

While the central banks have succeeded in saving the banks there are severe problems which are likely to surprise when the next crisis develops. As one famous economist has said the huge global debt has moved to the central banks’ balance sheets and they have to start reducing their balance sheet size. Some central banks have announced such measures and the impact could be very sudden when the markets wake up to reality.

The world economy has been kept afloat in the last decade with historically low official interest rates which may start going up. We need to ask whether we live in a politically and economically predictable world or a risky one?  Reputable economists such as Niall Ferguson say it’s the latter and he sees financial red lights flashing again.

If nothing changes after the elections then the major developer will be right: Cyprus has only real estate and sun to sell.

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