UK: Deloitte Monday Briefing: Cyprus, Between A Rock And A Hard Place

Last Updated: 27 March 2013
Article by Ian Stewart

The Monday Briefing, written by Ian Stewart, Deloitte's Chief Economist in the UK, gives a personal view on topical financial and economic issues.

  • Given the complexity and potential significance of the Cypriot bank crisis today's Monday Briefing is longer than usual. This note was written on Sunday evening, while negotiations in Brussels were continuing.
  • Events in Cyprus underscore how dependent prosperity is on a sound financial system. Big losses on holdings of Greek government debt last year have tipped Cypriot banks close to solvency. Without a major recapitalisation some will fail.
  • Despite close links with Greece, Cyprus' problems have more in common with Ireland and Iceland's than with what went wrong in Greece.
  • Greece's problems reflect a lack of competitiveness and a build-up of government debt. Cyprus, like Iceland and Ireland before it, faces an economic crisis caused by losses sustained by an inflated banking system.
  • At the peak, Ireland, Iceland and Cyprus had bank assets worth roughly ten times as much as their GDP – almost three times as great as the EU average. The greater the value of bank assets, the harder it is for a government to finance a recapitalisation of its banking system.
  • An optimist might argue that Ireland and Iceland demonstrate that small countries can bounce back from deep financial crises. Both countries suffered deep recessions in 2009-10, but have since returned to growth. So what lessons does their experience hold for Cyprus?
  • The Irish government bailed out its banks, extended a guarantee to all deposit and bond holders and borrowed huge amounts of money to do so. Irish government debt went from 25% of GDP in 2008 to 107% in 2013. The banks' problem became the government's – and taxpayer's – problem.
  • But this precedent does not help Cyprus. The scale of the bailout Cyprus requires is equivalent to the island's annual GDP. Borrowing this money would take public sector debt to an unsustainable 145% of GDP, 50% higher even than Ireland's. The Cypriot economy is too small to sustain the necessary level of borrowing.
  • Iceland protected domestic depositors and made foreign bondholders and depositors bear the losses. This infuriated foreign investors, but prevented Icelanders from losing their cash. On the face of it this looks like a useful precedent for Cyprus where, according to Morgan Stanley, 10-20% of all Cypriot bank deposits are held by Russian investors.
  • Yet the importance of the economic and political ties between the two countries has made the Cypriot government wary of putting too much pressure on Russian investors. Cyprus has become a major offshore financial centre for Russia. Morgan Stanley estimates that in the last five years Cyprus has accounted for 23% of all foreign direct investment into Russia, most of it money which originated in Russia. Political and financial ties are strong and last year Russia provided Cyprus with an emergency loan of €2.5 billion.
  • In an attempt to avoid alienating Russian capital the Cypriot government's original plan was to combine a levy on large deposits, many of them Russian owned, with a lower levy on deposits of less than €100,000 which would have hit many Cypriots. The €6 billion raised from the deposit levy would, in turn, have unlocked a further €10 billion of assistance from the IMF and the EU.
  • But the threat to tax more modest deposits caused a storm of protest in Cyprus. Amid angry demonstrations the Parliament unanimously rejected the plan last Tuesday and the deal with the IMF and EU fell apart. It was this failure which prompted the European Central Bank to warn Cyprus that unless it came up with a solution by Monday 25th March the ECB would withdraw support from the Emergency Liquidity Assistance to Cyprus' banks, triggering a raft of bank failures.
  • Subsequent negotiations to try to secure support from Russia have also come to nothing.
  • This leaves Cyprus with few revenue raising options. Tax rises would need to be on an enormous scale and would not provide instant revenues. Cyprus could sell assets, such as nationalised industries or future revenues from off shore gas fields. But doing so would take time, could be messy and might not deliver as much as hoped.
  • At the time of writing, on Sunday evening, we are still awaiting the results of further negotiations in Brussels. Whatever the outcome it seems likely that when Cypriot banks re-open many depositors will seek to withdraw their cash. And the Cypriot economy seems set for a sharp contraction in activity this year.
  • EU officials and politicians have sought to reassure financial markets and voters elsewhere by saying that Cyprus is a "one off". But we discern a number of wider lessons.
  • The crisis highlights the interconnectedness and mutual dependence created by the Single Currency. Cyprus is a country of just over one million people and accounts for about 0.2% of euro area GDP. Yet, through the single currency, its crisis has become a headache for the rest of the euro area.
  • Over the last four years this interdependence has created significant risks and exposures for Germany. This is likely to strengthen pressure for central rules on budget deficits, government spending and banking supervision. To survive the euro will need to develop into a more Federal union, one in which countries trade sovereignty for the benefits of the euro. Yet last week's rejection of the initial bank rescue plan by the Cypriot Parliament shows that the necessary political assent is not always forthcoming.
  • The crisis in Cyprus also reveals that the EU's guarantee on bank deposits up to €100,000 is conditional. The loss of this guarantee is likely to be noted by savers in other countries and could make it harder to contain bank runs elsewhere.
  • Similarly, the threat to withdraw ECB liquidity support from Cypriot banks runs counter to the ECB's commitment to "do whatever it takes" to preserve the euro area. The actions of the ECB suggest it believes that Cypriot banks can fail – or the island could even leave the Single Currency – without serious threat to the other 16 member states.
  • Above all, the crisis shows that created a monetary union is a political process. What is economically and financially optimal has to pass muster with public opinion. Germany's tough line in negotiations over Cyprus will have been influenced by German Parliamentary elections, which take place in September. If other countries in the euro area get into difficulty in the next six months they may, too, find Germany taking a more unyielding line.
  • Last week financial markets seemed optimistic that the problems of Cyprus could be contained. What is clear is that the process of building a durable monetary union in Europe will take time – and will be subject to setbacks and challenges along the way.

MARKETS & NEWS

UK's FTSE 100 ended the week down 1.5%.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

  • The Office for Budget Responsibility (OBR) cut its forecast for economic growth in the UK to 0.6% for 2013, from a previous estimate of 1.2% growth
  • Chancellor George Osborne altered the remit of the Bank of England for the first time in over a decade, allowing it to consider deploying "new unconventional policy instruments or approaches in future" and to "look through the temporary, albeit protracted, period of above-target inflation"
  • The UK government approved the development of two nuclear reactors at Hinkley Point C in Somerset which will, when completed, produce 7% of the UK's electricity
  • The price of wholesale gas in the UK rose to a record high following the unexpected closure of one of three import pipelines due to a technical fault
  • The US Labor Department reported that applications for unemployment benefits fell to a 5-year low in March
  • Eurozone economic activity slowed more-than-expected in March according to purchasing managers survey data from Markit
  • The Japanese Ministry of Finance reported that the Japanese economy recorded a trade deficit for the eighth consecutive month in February, with exports falling and imports rising
  • UK retail sales rose 2.6% in February compared with a year earlier, with strong growth in sales of computers and technology, and goods bought online
  • Consumer price inflation rose to 2.8% in February, its highest level since May 2012, driven by rising domestic energy bills and petrol prices
  • Online fashion retailer Asos reported a 37% rise in sales in the 3 months to the end of February, with "particularly strong trading" in December
  • UK clothing firm Ted Baker announced an 18% increase in sales in the year to 26th January were up 18%, following strong international expansion
  • Marmite returned to supermarket shelves in New Zealand for the first time in over a year, following shortages caused by the Christchurch quake which damaged only factory in the country that produces the spread – "marmageddon"
  • Canadian exercise clothing firm Lululemon Athletica saw its shares fall after it was forced to recall a large batch of women's yoga pants that were made of a material deemed excessively see-through – elasticity

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