Cyprus’ Financial Maelstrom

Where did it come from and what needs to be done?

Originally published in the March 2013 issue

Cyprus is in the middle of a financial maelstrom – where did it come from and what needs to be done about it now? Cyprus is the third smallest euro area economy (0.2% of euro area GDP). The total debt to GDP ratio reached 90% as of 2012, rising from 60% during the last presidency. The country joined the euro in January 2008. The Russian business community which is well established in Monaco, the UK, and Cyprus has contributed to the total level of foreign deposits in the region. 30-45% of total bank deposits in Cyprus are held by non-Cypriot residents including Greek residents and 80% of those are non-EU. The high level of deposits was exploited by the banks and the Cypriot private sector became one of the most leveraged in Europe with a ratio of 130% household loans to GDP as recorded by the end of 2011. The financial services sector grew to correspond to 40% of the country’s GDP, contributing €8 billion to the national budget.

Over time, the Central Bank of Cyprus and the Cyprus Securities and Exchange Commission have applied stringent capital adequacy rules to banks and Cyprus investment firms (recently tightened further in line with EU regulations). Given these measures, how was it possible to overextend with such dire consequences?

To help us provide historical reference let us go over the changes that have taken place in Cyprus since 2004 (Cyprus joined the EU in 2004). The double tax treaties with a number of FSU countries made Cyprus very attractive for tax purposes. A stable tax regime attracted international companies and provided significant growth on the island and in Limassol (which is the international business capital of the island offering an excellent communications infrastructure). The audit, tax and project consulting practices of the Big Four grew to service companies linked to shipping and finance amongst others. Legal and accounting systems based on UK law and practice provided familiarity and confidence in handling economic development activity. Many Cypriots educated and trained internationally returned to Cyprus to work, and a number of foreign expatriates made the island their home, resulting in a population of 840,000 in the 2011 census.

Economic success made the Cypriots think that nothing could puncture their feel-good bubble. They became complacent and started asking fewer questions of their government.

A series of problems and decisions at European level together with the structure of the Cyprus economy being close to the Greek economy, led the country into escalating liquidity problems. It all started with the decision to impair the Greek government bonds. This devastated the capital base of the Cyprus banks because they had substantial positions in Greek bonds estimated at €5 billion. The government of Cyprus, acting in the spirit of European solidarity, voted in favor of the haircut. The problem was immediately compounded by the worsening economic conditions in Greece resulting in non-performing loans and losses accrued in Cyprus banks’ branches abroad.

In 2011 many significant events took place; one of them made international news. The explosion of confiscated weaponry and ammunition at a Cyprus navy base near Limassol destroyed the nearby newest and largest power plant of the republic. Unfortunately for Cyprus the explosion required an estimated €2 billion to repair. The accident report indicated procrastination and lack of communication by the presidency.

Cyprus has wasted valuable time in implementing the necessary steps to avert this humiliating crisis. The old government brazenly deferred the issue to the next presidency. The new government did not have enough time to deconstruct the entire problem and finesse the solutions. Nevertheless they knew of the problems and they should have been better prepared to manage the crisis.

After its assessment the troika stated that the total package, including the recapitalisation of the financial sector, should be €17.5 billion but during the discussions with the IMF, ECB and European Commission it was stated that only €10 billion can be provided through the programme. That was because IMF set as a viable government debt threshold the level of 120% of GDP. That meant that Cyprus should have found around €5.8 billion immediately from its own sources, something which was never requested in the cases of other countries where a memorandum was agreed.

The first decision of the euro group, which was unprecedented, was to impose a haircut in all deposits in all financial institutions in Cyprus. The parliament rejected the proposed bill and the Government proposed several alternatives for finding the €5.8 billion requested, which were all rejected by the troika. The decision to reject the bill and not to tax deposits was motivated in part by domestic considerations and very importantly by international capital market considerations recognizing Cyprus’s role as an international banking and wealth management centre.

The position now is that bank restructuring is taking place involving two banks: Laiki Bank, which is the worst hit, and Bank of Cyprus. Each depositor in Laiki Bank will have €100,000 secured and re-deposited at the Bank of Cyprus. Additionally, the Bank of Cyprus will be recapitalised through a deposit/equity conversion of uninsured deposits with full contribution of equity holders and bond holders.

That will result in a haircut of deposits exceeding €100,000 of approximately 40% (although this could rise to as high as 60%) and in a core tier 1 ratio for Bank of Cyprus exceeding 9%. The secured loans of Laiki will also be transferred to the Bank of Cyprus. Unsecured loans, some assets and investments, and all deposits above €100,000 will stay at Laiki Bank and be subject to liquidation. It is estimated that up to a maximum of only 30% will be recovered over five to seven years to be returned to depositors. Laiki Bank was recently bought by the government.

The government, through its involvement in Laiki Bank (which was part-nationalised in June 2012) holds bonds whose expiry needs to be renegotiated to a longer term. The bridging loan is of the order of €3 billion. It is paramount to secure this funding in order to provide stability and avert ruin and disaster. The arrangement would provide much needed breathing space for additional solutions to be implemented including the creation of a “Special Situation Fund”. Speaking about the personal tragedy of people involved in the crisis, we recount one businessman who having sold his business kept the proceeds of €7 million at Laiki Bank and now he has only €100,000 to be transferred under a controlled withdrawal regime from the Bank of Cyprus. Others have lost all the cash flow operating their business, and lifetime savings.

It is not the intention of anyone involved for Cyprus to depart the euro. The Central Bank of Cyprus must be led in such a way as to help deliver workable solutions both with the local economic population, and the international requirements for rationalisation.

Despite the bleak picture, in recent days, many Cyprus-based international companies have reconfirmed their commitment to Cyprus to their clients and local service providers. Cyprus still offers one of the best relationships between cost efficiency and business infrastructure available in the EU,even at the increased corporate tax rates of 12.5%, and the education, legal, and administration system is based on UK standards.

For Europe it is important that states around the periphery remain strong and viable through their own ability and volition as they contribute to the overall trading balance and wealth of Europe.

The agreement of the financial support package for Cyprus, although onerous, will bring back stability in the market and eliminate uncertainty together with the Emergency Liquidity Assistance mechanism.

Cyprus-based businesses and professionals recognise that the country has a tremendous opportunity ahead, and this crisis can be a catalyst for the country to modernise itself. Cyprus is a country of team workers, hungry for recognition and committed to success, with every chance of achieving it. But they now also realise that they must demand accountability from the government, a stable fiscal environment going forward and transparent and lucid plans for the necessary investment in infrastructure.

Because of its geography, Cyprus is decentralised and organised around four major cities (excluding the occupied north of the island), and the economic growth of Cyprus depends on supporting the growth in each one of these vital areas. The lack of overall planning and investment in large infrastructure projects has been apparent for many years, with the government apparently idle and reactive in its approach.

Cyprus needs to plan for a quick recovery based on a strong private sector. The crisis, acting as a catalyst, may change Cyprus and may induce the political will to focus on its future with strategic vision.
What will happen to the Cyprus banking sector now? Cyprus bank sector assets have recently been eight times the country’s annual GDP. The EU average is three and a half times GDP. What is certain is that shrinkage of the banking specific sector as planned will undermine the country’s ability to repay its debt.

Last but not least we have to speak about natural gas (the estimated 40 trillion cubic feet within Cyprus’s Exclusive Economic Zone). The country has already granted licences for exploratory drilling in six blocks. Cyprus has so far given gas exploration licenses to Noble, Total SA (FP) and a venture of Eni SpA (ENI) and Korea Gas Corp.

From now, Cyprus should perhaps worry less about its two troubled banks and manage better for the future by optimising its position regarding natural gas and oil reserves. Planning the infrastructure and managing the projects successfully, both in terms of costs and timelines, and maintaining an open and transparent dialogue with the people and its economic counterparts will result in the best outcomes for all.

Cyprus has all the prerequisites to maintain its economic position and the resourcefulness to create a successful future. The real question is: has anybody learnt? And will it make a difference?

Elena Ambrosiadou is the Chairman and CEO of the globally regulated IKOS Structure, and has been at the forefront of hedge fund developments in Europe for over two decades.  After graduating in Chemical Engineering from Leeds University, Elena obtained an MSc in Technology and Development from Imperial College London, and an MBA from Cranfield School of Management. Elena worked internationally with British Petroleum, as a chemical engineer, before joining KPMG as a management consultant in Bahrain. In October 2011, Elena was featured in the FN100’s most influential European Women in Finance four years in a row, and was ranked in the Top 50 Leading Women in Hedge Funds, by The Hedge Fund Journal/Ernst & Young in 2010 & 2011. Elena was awarded the Cranfield Distinguished Alumnus Award in 2007.