IIF RESEARCH NOTE

Cyprus: Just The Facts

March 19, 2013

Lubomir Mitov
CHIEF ECONOMIST European Department 1-202-857-3653 lmitov@iif.com

A credit-driven boom concealed large macroeconomic imbalances pre-2008 Cyprus was hit twiceby the global crisis and the Greek PSI Economy in deep recession, market access lost Government debt structure leaves little scope for PSI Deposits were stable until recently, withdrawals have picked up this year Domestic banks remain heavily vulnerable to deposit runs Large NPLs to boost banks capital needs

Jared Bebee
ASSOCIATE ECONOMIST European Department 1-202-857-3639 jbebee@iif.com

The purpose of this note is to shed light on the circumstances that have led to the current crisis in Cyprus and the vulnerabilities related to public finances and domestic banks. The note does not address the implications of the recent Eurogroup decisions and the associated political tensions in Cyprus. Instead, it provides background information for further analysis. The note is organized as follows: Section 1 (p. 2-3) looks into the buildup of macroeconomic imbalances during the boom years; section 2 (p. 4-5) discusses the impact of the crisis; sections 3 and 4 (p.6-9) summarizes the state of public finances, and section 5 (p.9-13) examines the state of the banking system. Strong output expansion in the years following EU accession helped boost income and living standards in Cyprus, but also masked growing macroeconomic imbalances that were uncovered by the 2008 financial crisis. Instead of addressing the underlying problems, the previous government attempted to mitigate the recession with a large fiscal stimulus. This helped initially to contain the drop in output albeit at the expense of sharply wider fiscal deficits.
Domestic banks were hit hard by the Greek PSI The 2008 financial crisis uncovered large macroeconomic imbalances

Chart 1 General Government Debt % GDP 90

Chart 2 CDS Spreads basis points 2000 Portugal 1500

80

Cyprus

70
1000

60
500 Ireland

50

40 2000 2002 2004 2006 2008 2010 2012

0 Jan 11

Jul 11

Jan 12

Jul 12

Jan 13
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However, a second shock following a power plant accident in 2011 and the restructuring of Greek government debt (to which domestic banks were heavily exposed) has plunged the economy back into recession. Access to markets has been lost, the fiscal deficit and government debt has risen and domestic banks have become all but insolvent (Charts 1 and 2, previous page). Attempts to secure foreign funding and recapitalize the banks were only partially successful, prompting the authorities to ask for EU and IMF assistance. However, reluctance by the previous government to accept key demands by the Troika has delayed approval of the program until now. In the meantime, the fiscal deficit remains large, government debt has approached 90% of GDP and domestic banks remain operational only thanks to a large infusion of liquidity through the Emergency Liquidity Assistance facility (ELA) of the ECB. Cyprus circumstances leave little room for maneuver. With most government debt held by domestic banks, a Greek-style PSI looks impractical. On the other hand, the heavy dependence of domestic banks on nonresident deposits and the large size of the system relative to GDP leaves banks extremely vulnerable to deposit runs. Stemming bank runs is especially important given the large amount of insured deposits (180% of GDP).

A CREDIT-DRIVEN BOOM MASKED GROWING IMBALANCES During most of the preceding decade, Cyprus experienced an extended period of robust growth, low unemployment and strong public finances. Real GDP rose 3.6% a year on average during 2000-2008, led by strong expansion in services (mainly business services and shipping), construction and real estate. Growth was particularly impressive after EU entry in 2004 and ahead of euro adoption in 2007 (Chart 3), when stepped-up capital inflows and falling risk premia facilitated a surge in bank lending that fueled a real estate boom. The unemployment rate fell from 4.8% in 2000 to as low as 3.7% in 2008 despite the influx of a large number of foreign workers.
Cyprus experienced an extended period of robust growth through most of last decade

Chart 3 Real GDP Growth, 2000-07 12-month change in % GDP 12 10 8 6 4 2 0 -2 -4 -6 2000 2001 2002 2003 2004 2005 2006 2007 Net Exports Public Cons Fixed Invest. Private Cons

Chart 4 General Government Revenue and Expenditure % GDP 50

45
GDP

Expenditure 40 Revenue 35

30 2000 2002 2004 2006 2008

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The rapid growth in business services reflected a favorable business environment and the availability of an educated, English-speaking labor force.

Foreign capital was attracted by one of the lowest income tax rates in the EU (10%, zero for dividends) and the existence of double taxation treaties with many countries.

Construction grew 6.7% a year on average during 2000-2008, and the number of newly built houses tripled between 2000 and 2008. Housing prices rose 50% during 2006-2008.

Growth since EU entry was driven by domestic demand, with private consumption rising 6.5% a year from 2005 on average through 2008 and fixed investment rising 9% a year. Most of the increase in investment was centered in construction, however.

Driven by the boom in domestic demand, general government revenues rose by 6.8% of GDP between 2000 and 2008. Strongly rising revenues helped shift the fiscal balance from a 6.6% of GDP deficit prior to EU accession in 2003 to surpluses in 2007 and 2008, despite substantial real increases in spending (Chart 4, previous page). Government debt declined to 49% of GDP by the end of 2008 from 70% in 2003 as a result. However, the rapid expansion in growth and fiscal surpluses concealed the accumulation of substantial macroeconomic imbalances. Key among these were the following:

The rapid expansion concealed large macroeconomic imbalances

A sharp widening in the current account deficit. With the savings rate falling from 15% in 2004 to just 7% in 2008 and the investment rate rising from 19% to 23%, the current account deficit jumped from 5.1% of GDP to 16.8% of GDP (Chart 5). (Excluding reinvested earnings and dividends, which reflect accounting entries rather than actual transactions, the deficit widened to 12% of GDP in 2008 from 1.4% of GDP in 2004.)

A marked worsening of competitiveness. Relative unit labor costs rose 20% between 2000 and 2008, more than in other periphery countries.

A sharp deterioration in the net international investment position (IIP). Persistent current account deficits and large inflows of foreign capital shifted the net IIP from a

Chart 5 Current Account Balance % GDP 2 0 -2 -4 -6 -8 -10 -12 -14 -16 2003 2005 2007 2009 2011 CAB CAB (excl. reinvested earnings and dividends

Chart 6 GDP and Unemployment Rate 12-month % change and % 14 12 10 8 6 4 2 0 -2 2007 GDP 2008 2009 2010 2011 2012
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Unemployment Rate

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positive 14% of GDP in 2004 to a negative 15% of GDP in 2008.

A large increase in private sector debt, from 160% of GDP at the end of 2004 to 235% at the end of 2008, the second largest ratio in the EU. (The risks associated with the high leverage ratio are mitigated by the large financial assets held by households, however.)

Significant increase in banks exposure to real estate and to Greece. The share of housing loans in total loans to households rose from 30% in 2005 to 45% in 2008. By June 2011, the exposure of domestic banks to Greece amounted to 28 billion, or one-third of total assets and 170% of GDP. Of the 28 billion, government bonds amounted to 4.7 billion; the rest were loans to Greek residents.

THE IMPACT OF THE FINANCIAL CRISIS Cyprus economy has suffered two rounds of external shocks since 2008: first, the fallout from the global financial crisis in 2008-2009 and second, the consequences of the destruction of the Vassilikos power plant and the restructuring of Greek government bonds in the second half of 2011 and in 2012. The global financial crisis affected the economy through a number of channels:

Cyprus economy has suffered two rounds of external shocks since 2008

Faltering foreign demand led to a sharp decline in services exports and tourism earnings. Construction came to a virtual halt as demand for housing fell, both foreign and domestic. Inflows of foreign capital slowed (and even reversed for a while late in 2008-early 2009). Growing financial fragmentation made it increasingly difficult for Cypriot banks to secure funding from abroad.

The impact of the 2009 crisis was relatively mild, with real GDP falling just 1.9% in 2009, the smallest decline in the Euro Area. Output contraction was contained thanks to a large fiscal stimulus equivalent to 4% of GDP. The latter, however, came at a steep cost. Stepped-up spending and a cyclical drop in revenues shifted the general government to a deficit of 6.1% of GDP in 2009 from a 0.9% surplus in 2008. Real GDP growth resumed for a while in 2010 and early 2012 thanks to firmer foreign demand and recovery in tourism, but growth remained much slower than before 2008.

The impact of the 2008 crisis was mitigated by sharp fiscal expansion

Despite the modest recovery, unemployment continued to grow, more than doubling from 2008 to 7.8% in 2011. This mainly reflected large job losses in construction, whose output fell by one-third between 2008 and 2011 (Chart 6, previous page).

The fiscal situation did not improve. A slight reduction in the deficit in 2010, due mainly to one-off factors, was followed by renewed widening to 6.3% of GDP in 2011.

The fiscal situation did not improve

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On the positive side, a larger drop in import than in export volumes and reduced income payments (mainly reflecting lower reinvested earnings) helped cut the current account deficit from the 17% peak in 2008. At more than 7% of GDP in 2011, the current account shortfall remained outsized and well above the 2004-2005 level.

The current account deficit adjusted as financing pressures intensified

Financing pressures intensified, especially for the government, which has largely lost market access since 2010. To ease the financing difficulties, the government negotiated in late 2011 a 2.5 billion four-year loan from Russia at an interest rate of 4.5%.

The mild recovery was interrupted in the summer of 2011 when another round of external shocks hit the economy:

The explosion of a weapons cache in July 2011 destroyed Vassilikos, the country's largest and newest power plant, knocking out half of the island's power supply and resulting in rolling blackouts. Reconstruction would cost up to 3% of GDP, with the plant unlikely to be fully operational before the end of this year.

An even larger shock followed as a result of the restructuring of Greek government bonds. Cyprus two largest banksBank of Cyprus (BoC) and Popular Bank (Laiki), together held 4.7 billion of Greek government bonds at the end of 2011. The 75% PSI haircut resulted in losses equal to roughly 3.5 billion, or 33% of both banks aggregate capital and 20% of GDP.

The Greek PSI deal dealt a severe blow to domestic banks

Even before the Greek PSI, the EBA estimated that both banks would need an additional 3.6 billion in capital to meet the 9% Core Tier 1 capital ratio and create adequate buffers for mark-to-market losses on their holdings of government debt. (The latter already incorporated losses on the Greek bond portfolio equivalent to 11%.) PSI-related losses and the further drop in prices of Cypriot government debt probably doubled the capital shortfall from the initial EBA estimate. Both BoC and Laiki have been unable to raise the needed capital, prompting the government to recapitalize them with 1.8 billion in one-year government bonds. This added 10% of GDP to government debt.

Both the Vassilikos accident and the drop in confidence following the Greek PSI have had a much stronger negative effect on the economy than the financial turmoil in 2008-2009.

The Greek PSI deal and the Vassilikos incident have had a strong negative effect on the economy

Real GDP declined in seasonally-adjusted terms in the third quarter of 2011 and has remained on a declining trend ever since, with a cumulative decline of 4% from the middle of 2011 through the end of 2012.

Output contraction has been exacerbated by renewed fiscal adjustment in 2012 and growing financing constraints.

The deteriorated growth outlook and worries about the solvency of Cyprus large banking system triggered a slew of rating downgrades, pulling Cyprus' sovereign rating well into junk category. This has made access to markets even more difficult for both the sovereign and the banks and eventually made local banks ineligible for direct ECB refinancing.

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Cyprus entered 2013 with an economy mired in deep recession, sizable macroeconomic imbalances and largely insolvent banks without access to market funding.

UNSUSTAINABLE PUBLIC FINANCES Government finances have deteriorated sharply since the 2008 crisis. Cyclical factors have combined with significant shifts in the structure of growth to cut government revenues 5% in nominal terms between 2008 and 2012, a decline equal to 5.2% of GDP.

Government finances have deteriorated sharply since 2008

Most of the reduction in tax receipts reflected the shrinkage of the tax base. Private consumption fell 9% from 2008 through 2012, three times as much as GDP, and fixed investment dropped 27%.

The drop in revenues was accompanied by a marked increase in noninterest spending. The latter rose 6% in real terms between 2008 and 2012, or by 3.6% of GDP.

Most of the increase reflected the 4% of GDP fiscal stimulus extended in 2009. After remaining little changed relative to GDP in 2010 and 2011, noninterest outlays were cut 5% in real terms last year, or by 0.8% of GDP. Most of the decline reflected cuts in discretionary spending, while mandated expenditures such as social outlays and wage payments rose further relative to GDP.
The persistent increase in mandated spending points to a structural problem

Compared with 2008, the former were 1.8% of GDP larger in 2011 than in 2008, and the latter 3.2% higher. This points to a structural spending problem, which would require corresponding structural reforms rather than ad-hoc cuts (Chart 7).

Spending restraint last year helped cut the fiscal deficit to 5.5% of GDP from 6.3% in 2011. Adjusted for the cycle and net interest outlays, the 2012 outcome reflected underlying tightening of perhaps 0.7% of GDP, largely offsetting a similar easing in 2011. Relative to
Spending restraint helped cut the deficit to 5.5% of GDP last year

Chart 7 General Government Revenue and Expenditure % GDP 50 Expenditure 45

Chart 8 General Government Debt by Creditor % GDP 100 Bank Recapitalization Nonresidents Domestic Nonbanks Domestic Banks

80

60 40 Revenue 35 20 30 2007 2008 2009 2010 2011 2012 40

2008

2009

2010

2011

2012
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2009, the underlying fiscal stance has tightened by less than 1% of GDP, much less than required under the Stability and Growth Pact and the fiscal compact. Aware of the predominantly structural nature of the deficit, late last year the Cypriot parliament passed a number of measures aimed at correcting the structural fiscal problems.

The draft MoU calls for large fiscal adjustment, most of which has been legislated already

These measures, totaling 7.3% of GDP over three years, have been identified by the Troika and incorporated in the Memorandum of Understanding. Parliament had passed two-third of these, equivalent to about 4.5% of GDP by the end of last year.

If implemented, these measures should be sufficient to cut the deficit to less than 5% of GDP next year and close to 4% in 2014.

A reduction towards 3% of GDP does not look likely before 2015, and then only if growth rebounds strongly, which looks unlikely at present.

GOVERNMENT DEBT: LITTLE SCOPE FOR PSI The combination of low growth and high fiscal deficit has led to an explosion of government debt. Preliminary estimates suggest that the latter jumped to 87% of GDP at the end of last year from 71% at the end of 2011 and 49% at the end of 2008. Two-thirds of last years increase, or 10.5% of GDP, reflected the issue of 1.9 billion in one-year bonds to recapitalize the two largest domestic banks. A closer look at developments in recent years points to substantial structural shifts:

Low growth and high deficits have led to an explosion of government debt

Of the 15 billion in general government debt at the end of September 2012 (the latest period for which detailed data are available), some 6.6 billion, or 45%, were held by nonresidents according to the external debt statistics (Chart 8, previous page).

Nonresidents hold 45% of government debt, mostly official bilateral loans

Some 40% of the government debt held by nonresidents represented medium- and longterm bonds, with the remaining 3.9 billion loans mostly from official creditors. These include the 2.5 billion loans from Russia and 1.1 billion or so in loans from the EIB and the Council of Europe Development Bank.

Nonresident holdings of government bonds have been gradually declining since 2010 and by September 2012 amounted to 2.8 billion.

No data are available on the specific composition of foreign holdings of government securities, but it appears that these are almost exclusively Euro Medium Term Notes (EMTN) issued under British Law.

Nonresidents holding of government bonds mostly represent EMTNs

This suggests that a voluntary restructuring of the EMTNs will be very difficult and would require a high threshold for triggering the collective action clauses (CACs).

Residents hold some 8.4 billion in government debt, or roughly 45% of GDP. A sixth of these, or 1.4 billion, represent medium- and long-term loans from the central bank. Other
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Table 1 Cyprus General Government Debt billion 2011Q1 General Government Debt Currency and Deposits Central government Owed to SSFs Securities Long-term Resident Central Bank Deposit Money Banks Nonbanks SSFs Central Government Held By SSFs Other Nonresident Short-term Resident Central Bank Deposit Money Banks o/w Cyprus Popular Recap. Nonbanks SSF and Administered Funds Central Government Held By Admin Funds and SSFs Nonresident Loans Long-term Resident Central Bank Other Nonresidents Official Russia EIB France EDB EFSF Other Short-term Resident Nonresidents 11.1 0.0 7.2 -7.2 7.9 6.6 2.8 0.0 1.7 0.5 0.0 0.3 -0.3 0.6 3.8 1.3 1.2 0.0 1.2 0.0 0.0 0.0 0.2 -0.2 0.1 3.2 3.2 2.3 1.5 0.8 0.9 0.0 0.0 0.9 0.0 0.0 0.0 2011Q2 11.9 0.0 7.3 -7.3 8.5 6.7 2.8 0.0 1.8 0.5 0.0 0.4 -0.4 0.5 3.9 1.8 1.4 0.0 1.4 0.0 0.0 0.0 0.2 -0.2 0.4 3.4 3.4 2.3 1.5 0.8 1.0 0.0 0.0 1.0 0.0 0.0 0.0 2011Q3 11.9 0.0 7.3 -7.3 8.6 7.4 3.4 0.0 2.4 0.6 0.0 0.4 -0.4 0.4 4.0 1.1 0.7 0.0 0.7 0.0 0.0 0.0 0.2 -0.2 0.4 3.3 3.3 2.3 1.5 0.8 1.1 1.0 0.0 0.7 0.0 0.3 0.0 0.1 0.0 0.0 0.0 2011Q4 12.8 0.0 7.4 -7.4 8.9 7.4 3.2 0.0 2.4 0.6 0.0 0.4 -0.4 0.2 4.3 1.4 1.1 0.0 1.1 0.0 0.0 0.0 0.1 -0.1 0.3 3.9 3.9 2.3 1.5 0.8 1.7 1.6 0.6 0.7 0.0 0.3 0.0 0.0 0.0 0.0 0.0 2012Q1 13.4 0.0 7.5 -7.5 7.5 6.4 3.0 0.0 2.0 0.5 0.0 0.4 -0.4 0.5 3.4 1.1 0.6 0.0 0.6 0.0 0.0 0.0 0.1 -0.1 0.5 5.9 5.9 2.2 1.5 0.7 3.7 3.6 2.5 0.7 0.0 0.3 0.1 0.1 0.0 0.0 0.0 2012Q2 14.8 0.0 7.5 -7.5 8.8 6.3 3.5 0.0 2.0 0.5 0.0 0.4 -0.4 1.0 2.9 2.5 2.5 0.0 2.5 1.9 0.0 0.0 0.2 -0.2 0.0 6.0 6.0 2.2 1.5 0.7 3.8 3.7 2.5 0.7 0.0 0.3 0.2 0.1 0.0 0.0 0.0 2012Q3 15.0 0.0 7.6 -7.6 9.0 6.3 3.6 0.0 2.0 0.5 0.0 0.4 -0.4 1.1 2.8 2.6 2.6 0.0 2.6 1.9 0.0 0.0 0.1 -0.1 0.0 6.1 6.1 2.2 1.4 0.8 3.9 3.8 2.5 0.8 0.0 0.3 0.2 0.0 0.0 0.0 0.0

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domestic creditors hold 7 billion, one-third of which are short-term.

Most of the short-term debt, however, represents the 1.9 billion in bank recapitalization bonds, which were issued with maturity of one year.

Much of the remaining short-term debt, or 0.7 billion, reflects regular Treasury bill holdings by domestic banks, which have fallen by one-third since the start of 2011.

Domestic holdings of medium- and long-term government debt other than by the central bank amounted to roughly 4.4 billion, the bulk of which is in the form of securities.

Domestic banks hold most of domestically-issued government bonds

Loans held by entities other than the central bank amounted to 0.8 billion, apparently under special legislation, and have remained stable since 2010.

Holdings of medium- and long-term government securities amounted to perhaps 3.6 billion, the bulk of which are held by domestic banks. The latter held 3.1 billion, 2 billion of which are domestically issued bonds, and 1.1 billion in EMTNs.

Nonbank private creditors held another 0.5 billion at the end of September. Domestic holdings of medium- and long-term government bonds have in fact increased slightly since the start of 2011.

It should be noted that state-owned social security funds hold another 8 billion in government debt. These include 0.4 billion in bonds and a deposit of 7.6 billion with the central government at the ECBs refinancing rate.

Social security funds hold another 8 billion in government debt

While these obligations are netted out of the calculation of general government debt, they still remain an important source of funding for the central government, whose nonconsolidated debt stood at 120% of GDP at the end of September.

This composition of government debt suggests that a Greek-Style debt reduction exercise would be very difficult and unlikely to produce tangible results. Debt potentially eligible for restructuring amounts to only 7.2 billion, 2.1 billion of which are EMTNs held by foreigners.

A debt reduction exercise similar to that in Greece is unlikely to produce tangible results

Most of the remainder is held by domestic banks, a haircut on which will directly increase the already high bank recapitalization costs.

Haircuts on state-owned social security funds holdings would be counterproductive, too, as they would require the government to compensate them with new bonds, thus with no impact on government debt.

BANKING SYSTEM HEAVILY RELIANT ON NONRESIDENT DEPOSITS Cyprus outsized banking system has become the focal point of the current crisis. By the end of 2012, its total assets amounted to 700% of GDP. This was a marked reduction from near 750% as recently as September 2012 and more than 800% by the middle of 2011.
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Cyprus outsized banking system has become a focal point of the crisis
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Banks in Cyprus can be classified in four groups:

Domestically supervised banks account for 58% of the system's assets (at the end of September), or more than four times GDP.

The second largest group, 23% of the market in terms of assets, represents subsidiaries of foreign banks, mainly from Greece and a large state-owned Russian bank.

This group, along with foreign branches (5% of assets) are attracted to Cyprus mostly for tax reasons, have limited interaction with the local economy and are predominantly funded by their parents.

Cooperative banks (13% of assets) are fully exposed to the domestic economy, but they are regulated separately from domestic banks by a special supervisory authority.

The domestically supervised banks are dominated by three institutions (Bank of Cyprus (BoC), Popular Bank (Laiki), and Hellenic Bank, which together account for 97% of the assets of the domestic group. They also have large foreign operations, mainly in Greece but also elsewhere, especially in Eastern Europe. Unlike many others in Europe, domestic banks in Cyprus have traditionally relied on deposits for funding. As of the end last year, deposits of banks operating in Cyprus (domestically supervised banks and co-ops) amounted to 70 billion, or nearly three-fourths of total assets (Chart 9). Deposits have remained pretty stable since 2010, with a sharp decrease in July 2012 (apparently in response to the recapitalization at that time of Laiki) offsetting a slight increase earlier in the year.

Domestic banks are dominated by just three institutions

Cypriot banks rely heavily on deposits for funding

The trend appears to have changed since the start of the year, however, with deposits plummeting by 1.4 billion during January and press reports suggesting an even larger drawdown in February.

Chart 9 Bank Deposits billion 80 70 60 50 40 30 20 10 0 2010 Resident Nonresident

Chart 10 Nonresident Bank Deposits by Location billion 30

Rest of World 20

10

Euro area
2011 2012 2013

0 2010

2011

2012

2013
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Deposits raised in Cyprus accounted for three-fourths of the total, or 52 billion at the end of September (the last period for which detailed data are available) (Table 2, page 12).

Deposits raised in Cyprus accounted for two-thirds of the total...

However, slightly more than half of these were raised from Cypriot residents. Deposits raised from nonresidents in Cyprus amounted to as much as 20 billion. Another 13 billion were raised by the Cypriot banks operating in Greece. Finally, 4.5 billion were raised from other countries (half of which from Eastern Europe, Chart 10, previous page).

but only half of these were raised by residents

Since 2010, deposits have fallen only in Greece, from 17 billion at the end of June 2011 to 13 billion at the end of September. Deposits raised by residents in Cyprus remained little changed, while those by nonresidents other than in Greece actually increased slightly. This trend, again, appears to have changed most recently, with nonresident deposits down by 7% between September 2012 and January, with most of the decline since the start of this year. (Detailed data about the breakdown among nonresidents are not available.)

After having remained stable through 2012, nonresident deposits have fallen recently

Some of the large exposure to nonresidents, however, is mitigated by a liquidity requirement that obliges domestic banks to hold liquid assets equivalent to 70% of nonresident deposits in currency other than in euro. (The latter amounted to perhaps 1012 billion at the end of September.)

Central bank data suggests that the insured deposits (of up to 100,000) amount to 30 billion, or 180% of GDP. Uninsured deposits amount to 38 billion.

The amount of insured deposits amounted to roughly 180% of GDP

Auxiliary data provided by the ECB sheds some light about the breakdown of nonresident deposits among countries. The bulk of these, as much as 85%, or 19 billion, originated from non-EU countries, presumably mainly Russia and Ukraine. Apart from deposits, interbank borrowing appears to have been the second largest source of funding. This amounted to 15 billion for the domestic banks (excluding interbank liabilities).
Chart 11 Loans billion 80 70 60 50 40 30 20 10 0 2010
0 2010 10 20
Most nonresident deposits come from Russia and Ukraine

Chart 12 Nongovernment Foreign Credit billion 25

Nonresident
15 Other

Resident

Households 5 Corporations

2011

2012

2013

2011

2012

2013
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ECB data suggests that most of this originates yet again from non-EU countries (presumably Russia). On the asset side, loans to nonfinancial corporations account for most of assets. At the end of January, these stood at 72 billion, or four times GDP.

Unlike other periphery countries, credit to nongovernment borrowers has been gradually rising since 2010 and even through most of 2012 before leveling off in the second half of the year.

Unlike other periphery countries, credit to nongovernment borrowers has yet to decline

Nearly two-thirds of loans to nongovernment borrowers were extended to residents, roughly equally split between households and corporations (Chart 11, previous page).

Loans to residents amounted to 22 billion, the bulk of which (on the order of 17 billion or so) were to Greek borrowers (mainly via their Greek operations).

Loans to nonresidents are heavily focused on corporations (Chart 12, previous page).
Exposure to government securities has fallen sharply after the Greek PSI

Exposure to government securities has declined sharply following the Greek PSI and is estimated at 5 billion or so at the end of last year (including 1.9 billion in bank recapitalization bonds). This compared with as much as 10.5 billion at the end of June 2011 (one-half of which Greek government bonds).

Table 2 Cyprus Banking System Selected Balance Sheet Items1 billion Jun-11 Assets Loans o/w to residents o/w: to Greece o/w: to other nonresidents Interbank Other 109.0 72.7 36.7 23.4 5.6 13.5 22.8 Sep-12 95.0 67.9 42.4 18.9 6.6 11.1 16.0

Liabilities Total Deposits o/w: residents o/w: raised in Greece o/w: other nonresidents Other
Source: IMF, Central Bank of Cyprus
1

109.0 78.3 32.2 17.3 23.3 30.7

95.0 70.1 32.2 13.1 20.3 24.9

Domestically supervised banks and cooperative banks

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RISING NPLS FURTHER UNDERMINE BANKS PROFITABILITY The analysis of deposits and the loan portfolio suggest that domestic banks were, at least until the end of last year, able to maintain relatively stable deposit funding and were spared the type of credit contraction that has plagued banks in other periphery countries.

However, the restructuring of Greek government bonds and the losses incurred from marking to market holdings of Cypriot government bonds has resulted in a large capital hole.

The Greek PSI resulted in a large capital hole that has yet to be closed

The latter has been only partially filled by the July 2012 recapitalization.
The share of NPLs has risen to 27% of all loans and the pace of increase has accelerated

Another source of large losses is the rapidly rising share of NPLs. The latter were reported at 23 billion, according to the internationally accepted definition, or 27% of all loans at the end of September.

The share of NPLs amounted to 26.5% for the domestically supervised banks and 32% for the co-ops.

The pace of increase has accelerated as well, with NPLs rising as much as 10% during the third quarter of last year alone.

This compared to as little as 14% by the middle of 2011 and less than 10% at the end of 2009.

Even though a substantial portion of the NPLs appear to be fully collateralized, their sharp increase in recent months and weak growth prospects are likely to result in further losses in the months to come. This consideration has led both the IMF and a private consultant to conclude that the Cypriot banks may well need recapitalization as large as 10 billion, or 60% of the country's GDP. In the meantime, the banking system is kept afloat through the Emergency Lending Assistance (ELA) provided by the central bank and backstopped by the ECB (Table 3, next page). The amount of ECB refinancing (including ELA) is likely to have amounted to 8 billion or so at the end of last year, or nearly half the country's GDP. The recent decision by the Eurogroup to ask for a levy on deposits is all but certain to trigger large deposit withdrawals, which, according to the central banks estimate, would amount to at least 7 billion within a week after reopening the banks. With the ECB having pledged to supply liquidity, ECB refinancing to Cypriot banks would at least double to near 100% of GDP as a result. The increase could be much larger, however, if deposit withdrawals are not quickly contained.
Dependence on ECB funding would at least double to near 100% of GDP once banks reopen In the meantime, the system has been kept afloat by emergency ECB

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IIF RESEARCH NOTE

Cyprus: Just the Facts

Table 3 Central Bank Balance Sheet million Dec-10 Gold and gold receivables Claims on non-euro area residents denominated in foreign currency Claims on euro area residents denominated in foreign currency Claims on non-euro area residents denominated in euro Lending to euro area credit institutions related to monetary policy operations denominated in euro Other claims on euro area credit institutions denominated in euro Securities of euro area residents denominated in euro General government debt denominated in euro Intra-Eurosystem claims Items in course of settlement Other assets Total Assets 472 374 536 0 5466 0 2917 1503 419 29 168 11884 Jun-11 466 358 516 0 5570 0 2897 1503 523 32 185 12050 Dec-11 544 391 399 0 5521 0 2485 1454 663 57 3644 15159 Jun-12 557 431 538 0 5175 8020 2096 1454 805 23 210 19309 Dec-12 563 343 171 0 411 9400 1634 1403 976 32 116 15050

Banknotes in circulation Liabilities to euro area credit institutions related to monetary policy operations denominated in euro Other liabilities on euro area credit institutions denominated in euro Debt certificates issued Liabilities to other euro area residents denominated in euro General government Other liabilities Liabilities to non-euro area residents denominated in euro Liabilities to euro area residents denominated foreign currency Liabilities to non-euro area residents den. in foreign currency Counterpart of special drawing rights allocated by the IMF Intra-Eurosystem liabilities Items in course of settlement Other liabilities Provisions Revaluation accounts Capital and reserves Total Liabilities

1516 2289 0 0 279 270 8 103 0 0 154 6441 30 321 187 478 87 11884

1525 2361 0 0 461 449 12 80 0 0 147 6367 33 285 204 468 120 12050

1600 3173 0 0 930 924 5 87 0 0 158 7908 58 369 208 549 120 15159

1609 4463 0 0 280 278 3 84 64 0 160 11273 24 403 232 569 148 19309

1643 3984 0 0 260 257 3 29 100 0 155 7468 32 530 235 566 148 15050

Source: Central Bank of Cyprus

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