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Country Report Cyprus

Country Report

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Thanks to the EUR 10bn bailout program presented in late March Cyprus will, at least for the near future, remain in the eurozone. While the level of social protest has remained relatively low, a blame game has started between the Cypriot Central Bank and the government. Meanwhile, several capital controls remain in place at the time of writing. Cyprus will face a difficult and uncertain future. The downsizing of its financial sector forces the country to reinvent its business model. Meanwhile, the government has to implement severe budget cuts. We therefore expect the economy will contract strongly. As a result, another bailout or a restructuring of government debt may be needed in the near future.

National facts of Cyprus
National facts of CyprusSource: EIU, CIA World Factbook, UN, Heritage Foundation, Transparency International, Reporters Without Borders, World Bank.

The bailout

In late March 2013, the eurozone countries, the ECB and the IMF agreed on a EUR 10bn bailout package for Cyprus. The Executive Board of the IMF is expected to approve the agreement in May. Thanks to the program, Cyprus will remain in the eurozone, at least for the near future. As part of the deal Cyprus will have to downsize its oversized financial sector to the EU average (currently 346% of GDP). The two largest banks - Bank of Cyprus and Laiki (also known as Cyprus Popular Bank) - will be restructured, whereby creditors and shareholders will have to cover all the losses, but deposits up to EUR 100,000 will be exempted. As a result, uninsured depositors, bond holders and shareholders will take heavy losses of up to 100%. Furthermore, Cyprus is forced to raise its corporate tax and to implement a number of privatizations. Besides, the country will have to reduce government spending by 5% of GDP by 2015 and by an additional 4.5% of GDP by 2018. The pension system will be reformed, which will result in a higher retirement age, and healthcare spending cuts will have to be implemented.

In the weeks before the final bailout program was released, Cypriote bank accounts were frozen. After the presentation of the bailout program, some restrictions were eased, but there are still capital controls in place. There are, for example, still restrictions on the amount that can be withdrawn or transferred from accounts. However, the partial reopening of bank accounts in late March was much less chaotic than had been feared and did not result in large scale riots and panic. Nonetheless, there has been a lot of criticism in the Cypriot press about the deal and there have also been calls in the media to leave the eurozone. AKEL, the main opposition party, does not rule out euro exit. Furthermore, the bailout has resulted in a political blame game between the Cypriot government and the Cypriot central bank. The parliamentary ethics committee has announced on 10 April that it was investigating the role of Panicos Demetriades, who is the governor of the central bank and whom was nominated by the previous communist government, in the bailout deal. Demetriades has reacted by stating that "the independence of the central bank of Cyprus is being attacked". Afterwards three board members of the central bank resigned. Earlier the finance minister who had helped to conclude the rescue program resigned as well. 

The outlook

Cyprus will not only have to thoroughly restructure its two largest banks, but also the overall economy. The future of Cyprus as an offshore financial center was already uncertain before the details of the bail out plans became clear, as the Cypriote financial sector was highly leveraged and partially depended on black and grey money. In the longer run, a restructuring of the Cypriot economy therefore seemed unavoidable anyway. However, the adjustment now has to take place very abruptly and in a time of crisis, which will increase the resulting economic hardship. A comparison can be made with Iceland. Relatively, Iceland’s pre-crisis financial sector was bigger (10 times GDP) than that of Cyprus (7 times GDP). Where Iceland had some other export sectors (fish and metals), Cyprus has some important export sectors as well. Transportation (primarily the maritime sector) and travel services (tourism) accounted for almost half of all service exports in 2009. Iceland’s GDP fell by 12% from its 2008 peak to its 2010 trough. The economy recovered afterwards, but GDP is still 5% below its pre-crisis peak. Unemployment increased from 1% to 9%, and has fallen to 5.3% afterwards. Economic hardship for Cyprus is likely to be harsher, as unemployment is already 14.7% in Cyprus. Furthermore, in contrast to Cyprus, Iceland was able to smoothen the adjustment of its economy through its exchange rate and monetary policy. Cyprus will not have this option, as it is part of the eurozone. Besides, Cyprus will also have to reduce its government spending strongly. Furthermore, while Iceland protected its domestic deposit holders, in the case of Cyprus, domestic parties with deposits of more than EUR 100,000 will also be hit. As both companies and individuals may thus lose wealth, this is likely to depress domestic demand and increase the number of bankruptcies in Cyprus. The overall fall of GDP is therefore likely to be bigger than in Iceland. In an interview with the Wall Street Journal, European Commissioner for Economic and Monetary Affairs Olli Rehn has indicated that a 12.6% contraction through 2014 would be the best (i.e. accurate) estimate, although he added that the uncertainty is very high.

The extent to which GDP will fall will depend on how successful the Cypriots will be in finding a new business model. Due to the losses for depositors and other bank creditors and the imposition of capital controls, Cyprus does not seem to have much of a future as a banking hub. Related business services are also likely to face difficult times. The tourism sector is sizeable, but faces competition from Greece and Turkey. The country does have some gas reserves, but the exploitation of gas fields is difficult as Turkey, has also laid a claim to these fields. Even in a best case scenario, it will take a few years before exploitation of these fields can start. As the downsizing of the financial sector is an important condition tied to the rescue package, one should expect the negative economic consequences of this downsizing to be incorporated in the rescue package. However, the economic assumptions of previous programs tended to be overly optimistic. Therefore, we think there is a high probability that another bailout package will be needed. This leads to uncertainty, which in turn is likely to depress investment and overall economic growth in the near future. The economic outlook for Cyprus is thus very bleak. 

Economic indicators of Cyprus
Economic indicators of CyprusSource: EIU; the Economist Intelligence Unit estimates and forecasts for 2013 and 2014 do not necessarily represent Rabobank views and hence may deviate from the text.
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