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Cyprus: Just The Facts

Cyprus: Just The Facts

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Published by Yannis Koutsomitis
White paper by the IIF on the banking & fiscal crisis in Cyprus
White paper by the IIF on the banking & fiscal crisis in Cyprus

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Published by: Yannis Koutsomitis on Mar 20, 2013
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10/09/2013

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IIF RESEARCH NOTE
Cyprus: Just The Facts
March 19, 2013
IIF.com
© Copyright 2013. The Institute o International Finance, Inc. All rights reserved.
CONFIDENTIAL

 A credit-driven boom concealed large macroeconomic imbalances pre-2008

Cyprus was hit twice—by 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
Lubomir Mitov
CHIEF ECONOMISTEuropean Department1-202-857-3653lmitov@iif.com
 The purpose o this note is to shed light on the circumstances that have led to the currentcrisis in Cyprus and the vulnerabilities related to public fnances and domestic banks. Thenote does not address the implications o the recent Eurogroup decisions and theassociated political tensions in Cyprus. Instead, it provides background inormation orurther analysis. The note is organized as ollows: Section 1 (p. 2-3) looks into the buildup o macroeconomic imbalances during the boom years; section 2 (p. 4-5) discusses the impacto the crisis; sections 3 and 4 (p.6-9) summarizes the state o public fnances, and section 5(p.9-13) examines the state o the banking system.Strong output expansion in the years ollowing EU accession helped boost income and livingstandards in Cyprus, but also masked growing macroeconomic imbalances that wereuncovered by the 2008 fnancial crisis. Instead o addressing the underlying problems, theprevious government attempted to mitigate the recession with a large fscal stimulus. Thishelped initially to contain the drop in output albeit at the expense o sharply wider fscaldefcits.
Jared Bebee
 ASSOCIATE ECONOMISTEuropean Department1-202-857-3639 jbebee@iif.com
The 2008 fnancial crisisuncovered largemacroeconomic imbalancesDomestic banks were hithard by the Greek PSI
4050607080902000 2002 2004 2006 2008 2010 2012
Chart 1General GovernmentDebt
% GDP
0500100015002000Jan 11Jul 11Jan 12Jul 12Jan 13
Chart 2CDS Spreads
 basis points
IrelandPortugalCyprus
 
IIF RESEARCH NOTE
page 2
Cyprus: Just the Facts
IIF.com
© Copyright 2013. The Institute o International Finance, Inc. All rights reserved.
 
CONFIDENTIAL
However, a second shock ollowing a power plant accident in 2011 and the restructuring o Greek government debt (to which domestic banks were heavily exposed) has plunged theeconomy back into recession. Access to markets has been lost, the fscal defcit andgovernment debt has risen and domestic banks have become all but insolvent (Charts 1and 2, previous page). Attempts to secure oreign unding and recapitalize the banks wereonly partially successul, prompting the authorities to ask or EU and IMF assistance.However, reluctance by the previous government to accept key demands by the Troika hasdelayed approval o the program until now. In the meantime, the fscal defcit remains large,government debt has approached 90% o GDP and domestic banks remain operational onlythanks to a large inusion o liquidity through the Emergency Liquidity Assistance acility (ELA)o the ECB.Cyprus’ circumstances leave little room or maneuver. With most government debt held bydomestic banks, a Greek-style PSI looks impractical. On the other hand, the heavydependence o domestic banks on nonresident deposits and the large size o the systemrelative to GDP leaves banks extremely vulnerable to deposit runs. Stemming bank runs isespecially important given the large amount o insured deposits (180% o GDP).
 A CREDIT-DRIVEN BOOM MASKED GROWING IMBALANCES
During most o the preceding decade, Cyprus experienced an extended period o robustgrowth, low unemployment and strong public fnances. Real GDP rose 3.6% a year onaverage during 2000-2008, led by strong expansion in services (mainly business servicesand shipping), construction and real estate. Growth was particularly impressive ater EUentry in 2004 and ahead o euro adoption in 2007 (Chart 3), when stepped-up capital inowsand alling risk premia acilitated a surge in bank lending that ueled a real estate boom. Theunemployment rate ell rom 4.8% in 2000 to as low as 3.7% in 2008 despite the inux o alarge number o oreign workers.
Cyprus experienced anextended period o robustgrowth through most olast decade
-6-4-202468101220002001200220032004200520062007Net ExportsFixed Invest.Public ConsPrivate Cons
Chart 3Real GDP Growth, 2000-07
12-month change in % GDP
GDP
303540455020002002200420062008
Chart 4General Government Revenueand Expenditure
% GDP
ExpenditureRevenue
 
IIF RESEARCH NOTE
page 3
Cyprus: Just the Facts
IIF.com
© Copyright 2013. The Institute o International Finance, Inc. All rights reserved.
 
CONFIDENTIAL

 The rapid growth in business services reected a avorable business environment and theavailability o an educated, English-speaking labor orce.

Foreign capital was attracted by one o the lowest income tax rates in the EU (10%, zeroor dividends) and the existence o double taxation treaties with many countries.
 

Construction grew 6.7% a year on average during 2000-2008, and the number o newlybuilt 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 rising6.5% a year rom 2005 on average through 2008 and fxed investment rising 9% a year.Most o the increase in investment was centered in construction, however.Driven by the boom in domestic demand, general government revenues rose by 6.8% o GDP between 2000 and 2008. Strongly rising revenues helped shit the fscal balance rom a6.6% o GDP defcit prior to EU accession in 2003 to surpluses in 2007 and 2008, despitesubstantial real increases in spending (Chart 4, previous page). Government debt declined to49% o GDP by the end o 2008 rom 70% in 2003 as a result.However, the rapid expansion in growth and fscal surpluses concealed the accumulation o substantial macroeconomic imbalances. Key among these were the ollowing:

A sharp widening in the current account defcit.
With the savings rate alling rom 15%in 2004 to just 7% in 2008 and the investment rate rising rom 19% to 23%, the currentaccount defcit jumped rom 5.1% o GDP to 16.8% o GDP (Chart 5). (Excludingreinvested earnings and dividends, which reect accounting entries rather than actualtransactions, the defcit widened to 12% o GDP in 2008 rom 1.4% o GDP in 2004.)

A marked worsening o competitiveness.
Relative unit labor costs rose 20% between2000 and 2008, more than in other periphery countries.

A sharp deterioration in the net international investment position (IIP).
Persistentcurrent account defcits and large inows o oreign capital shited the net IIP rom a
The rapid expansionconcealed largemacroeconomic imbalances
-16-14-12-10-8-6-4-20220032005200720092011
Chart 5Current AccountBalance
% GDP
CABCAB (excl. reinvestedearnings and dividends
-202468101214UnemploymentRate
Chart 6GDP and Unemployment Rate
12-month %change and %
GDP2007 2008 2009 2010 2011 2012

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