Saturday, 10 August 2013

Cyprus: a Ponzi scheme economy

Below is a pretty good piece from Sofronis Clerides, associate professor of economics at the University of Cyprus and member of the country’s National Economy Council, summing up how Cyprus arrived at the economic crisis currently overwhelming it. Still, even if he is right that Cyprus’ predicament has been exacerbated rather than cured as a result of policy failures at the EU level, it is worth pointing out that as the Cypriot economy has unravelled, a picture of it as a large Ponzi scheme has emerged, in which it is evident that the island’s political, trade union and commercial elites were colluding to gain access to money generated by the island’s banks, pension funds and state-owned companies, taking out or issuing uncollateralized ‘loans’ in order to enrich themselves or their families and friends or in support of pet businesses and organisations, including football clubs, political parties and enterprises linked to political parties. This looting, rather than the misdirected money-laundering and ‘casino economy’ accusations, is the form of corruption that accompanied and characterised Cyprus’ financial boom and made ludicrous Cyprus’ stated aspiration to become the Switzerland of the Mediterranean.

Clerides’ article originally appeared in this collections of papers, Greek Myths and Reality.

Cyprus Pays for Its Own Failures, by Sofronis Clerides

An untimely experiment
In March 2013 Cyprus became the fourth Eurozone country to receive a rescue package from the troika of international lenders. It was perhaps the most controversial of the four agreements because of the ‘bail-in’ element: for the first time, depositor money was to be used to recapitalize banks in trouble. The idea had been quietly discussed in policy circles for many months but its actual implementation in Cyprus came as a surprise to most and caused a stir. The inclusion of secured depositors in the original haircut decision was indeed a stunning outcome that has been subject to serious criticism.

The economic principle behind the bail-in is sound. Rather than being bailed out with state (taxpayer) support, ailing banks must self-finance their capital shortfalls by bailing in bondholders and – if necessary – depositors. This is a move in the right direction, yet there are several reasons why March 15, 2013 was not the right time to begin implementing it:

1. A formal framework for bail-ins did not exist at the time and the decision was applied in Cyprus in a haphazard and improvised manner. For example, there was no distinction between long-term deposits earning high returns and short-term deposits in current accounts. As a result, many companies lost large chunks of their working capital, leading to severe liquidity problems in the daily functioning of the economy. At least, we seem to have learned our lesson: the draft EU directive agreed upon in June has explicit provisions to protect small businesses.

2. Rules must be clear ahead of time. People who deposited their money at the banks were not aware that a bail-in was a policy option.

3. The bail-in was applied to Cyprus’ two systemic banks and effectively decimated the country’s banking sector.

4. Cypriot banks are deposit-based and had very few outstanding bonds. As a result, the burden fell almost exclusively on unsuspecting depositors.

5. There was no prior assessment of the impact of the bail-in on the Cyprus economy.

The economic consequences of the bail-in are nothing short of catastrophic. Total depositor losses have been estimated at around €8.3 billion, or 46% of GDP (€17.9 billion in 2012). The financial and business services sector that had been the most important growth engine for the Cypriot economy for the last several years has been crippled and there is nothing on the horizon to pick up the slack. It may take years to rebuild the image and credibility of Cyprus and develop new export sectors. The decision to shrink the banking sector to half its size overnight has resulted in a liquidity crunch that will stifle growth prospects for the short to medium term. Most analysts expect a contraction of 20-25% over the next three years. Unemployment was already at 15% prior to the haircut and is bound to rise well above 20%.

Did Cyprus really deserve this? Why was such a blunt and untested instrument used with little apparent regard for its tremendous social cost? Was there no alternative path that would provide Cyprus with the necessary support in a manner consistent with EU principles but without causing so much social disruption?

Ring-fencing Greece
Europe should have shown more solidarity towards Cyprus. It could have recognized the fact that the economic woes of Cyprus were to a large extent due to Europe’s poor handling of the Greek crisis, including the mistimed haircut of Greek government bonds that cost Cypriot banks €4.5 billion (25% of GDP). The prolonged recession in Greece hurt Cypriot banks even more as they had extensive operations in Greece. Cypriot banks in Greece were in effect Greek banks, one of them being actually managed by a Greek group. It would have been justified to make provisions for capitalizing the Greek operations of Cypriot banks the same way that Greek banks were capitalized after the losses they took as a result of the Greek haircut.

On the contrary, Cyprus was doubly penalized. When the depositor bail-in was put on the table, the troika insisted that deposits in Cypriot banks in Greece should be exempt. The intent was clear. After a long and painful slog, the Greek economy was finally beginning to turn around. The last thing the troika wanted was to see the Greek banking system implode as a result of the bail-in of Cypriot banks. Thus, the solution adopted was to exempt Greek deposits from the haircut. It may have protected Greece but at the expense of depositors in Cyprus. Furthermore, the troika insisted that Greek operations of Cypriot banks be sold off to Greek banks, thus leading to an indirect transfer on top of the big losses already incurred because of the crisis in Greece. Thus in trying to save Greece and also cut off any transmission mechanism to the rest of the Eurozone, Europe decided to offload the cost to Cyprus – and many people think it is rather unfair.

A faulty model?
Many people have criticized the existence within Europe of low-tax jurisdictions, such as Cyprus, that serve as financial and business centers. Germany in particular has long been in favor of tax harmonization across Europe. The German finance minister, Wolfgang Schäuble, stated on several occasions that Cyprus model had failed and the country needed to chart a new course, while French finance minister, Pierre Moscovici, went so far as to call Cyprus ‘a casino economy’.

What exactly was the Cypriot business model? In the aftermath of the Turkish invasion that devastated the island’s economy, Cyprus decided to fashion itself as a financial and business center. The main attraction was a low corporate tax rate for international businesses, complemented by a good location and climate, a common law-based legal framework and the high quality services provided by UK-educated accountants and lawyers. This was highly successful and the sector became the most important growth engine, especially after Cyprus joined the EU in 2004. This growth was accompanied by a large expansion of the banking sector to nine times GDP in 2009. The rapid expansion of the banking sector caused problems. Armed with plentiful liquidity, the banks financed business and consumer loans, a construction boom in Cyprus and rapid expansion abroad, especially in Greece, where they created extensive branch networks and invested in government bonds. Ex-ante, the expansion abroad could have been part of a well-designed diversification strategy. Ex-post, it turned into a disaster as exposure to the Greek economy brought the banks to their knees.

Given the outcome, it is easy to concur with the conclusion that the model has failed (though it is still difficult to come to terms with the ‘casino economy’ reference). But it is important to understand exactly where the failure lies. Cyprus failed in letting its banking sector get too large and expand too quickly and recklessly. This does not render the strategy of a country specializing in the provision of business services as a failure. For the last twenty years Cyprus has invested in building an infrastructure that is designed to serve the needs of the international business community. It has established itself as a place where one can receive high quality accounting, legal and other business services at competitive rates. Many other countries, including several European ones, have followed similar strategies. There is nothing legally or morally wrong with being a business center, as long as the rules are followed and the banks are kept under tight control.

Did Cyprus follow the rules? In the months leading up to the March 2013 decision, the German press painted a picture of Cyprus as a laundering center for the ill-gotten gains of Russian oligarchs. This created a negative political climate and provided the moral justification for the country’s harsh treatment. Is there any truth to these allegations? Cyprus had in fact acquired a bad reputation for money-laundering in the 1990s. But in preparing for EU accession, it completely revamped its regulatory framework to meet European standards. International organizations like Moneyval rated Cyprus equally high with many other European countries for its anti-money laundering (AML) procedures. A more in-depth investigation specially commissioned by the troika pointed out weaknesses in the implementation of AML procedures in Cyprus but did not uncover anything that would justify shutting down the country’s international business sector.

Cyprus is perhaps paying for old sins and for electoral brinksmanship in other countries. The irony is that by recapitalizing the Bank of Cyprus using depositor money, the Eurogroup has handed ownership of the bank to its big depositors - purportedly those same Russian oligarchs! In reality, the vast majority of Russians with money in Cyprus are said to be owners of small and medium sized businesses rather than oligarchs (should we call them polyarchs?), while big depositors include many Cypriot pension funds, provident funds, and 401k-type investment plans who saw their savings wiped out.

Too high a price
Cyprus has made many mistakes. It allowed its banking sector to get too large and to expand quickly and recklessly abroad. It indulged in a decade of over-borrowing and over-consumption. When the international crisis first hit in 2008, it failed to appreciate the extent of the possible repercussions. Even after the Greek debt restructuring, the Cypriot government seemed oblivious to the blatantly obvious and failed to take any meaningful corrective action.

It is now time to pay the bill for these mistakes. This is perfectly acceptable, except that the bill is unjustifiably high. Cyprus is not paying just for its own mistakes. It is paying for a series of policy mistakes committed by the EU over the handling of the debt crisis. It is paying for the fact that it is small and thus can serve both as a testing ground and as an example to other profligate countries. This may be an instructive tool and an effective disciplining approach, but it hardly abides by the principles of fairness and solidarity espoused by the European Union. As it watches yet another European country sink into depression, the EU needs to take a long, hard look in the mirror.


Hermes said...

A reasonably good piece. As I expected, over the course of time, Greek Cypriots would come to accept their role in their downfall. As more and more people on the island move from denial and blaming everyone else to acceptance, then there is a greater possibility of moving to the next phase: renewal. I have greater confidence that Greeks in Cyprus will go through this process much quicker than Greeks in Greece.

John Akritas said...

It was never the case that Cypriots did not blame themselves. They did so from the beginning. I agree with the second part of your comment. Greece's problems are far more intractable and deep-rooted than Cyprus', and the left in Cyprus has been completely discredited so the discourse of resistance and fanciful alternatives has less resonance.

John Akritas said...

The other thing worth mentioning regarding difference between Greece and Cyprus is that Cypriot intellectuals/professors/etc – particularly their economists – seem to be very much of the liberal rather than Marxist variety (Clerides is one example, but there are others).

Hermes said...

I would qualify that by saying far Left rather than Social Democratic Left. The far Left in Greece, SYRIZA and KKE (although SYRIZA is sort of moving to the centre-Left) is far too powerful. In a way, its a pity PASOK has collapsed so terribly because it has left a vacuum which can only be filled by SYRIZA. Or, let's pray a new Social Democratic political formation might take the space but that might be too late. However, PASOK created this problem. They pandered too much to the radical Left, to neutralise them, for too many years rather than attacking it. Radical Leftist politics are too baked in for change to happen quickly.

There are liberal economists in Greece. However, liberalism as an ideology is probably the least popular political ideology in Greece. It gets squeezed in a clientelist system because by virtue of its ideology, it cannot hand out jobs and favours. But, even now, as the clientelist system collapses, the rhetorical momentum remains with the extremes. Its a pity because Greece did have interesting liberal parties before '74.

Greek Cypriot intellectuals/professors seem to be more tied to the real world. Facts actually mean something to them rather than purely theoretical constructs. Where does that come from? Not sure, you would know better John. Perhaps, the fact that the EU came later, meant that they knew the Cypriot state had to rely largely on its own means; and therefore, did not have the luxury to indulge in fantasies.

John Akritas said...

It’s true that Cypriots are suspicious of abstract and grandiose theories. They leave that to the church. Cypriots are even a little anti-intellectual and as a society Cyprus doesn’t have much time for artistic fancies. If you want beauty, peace, justice, order, meaning, then you have the church. Your role in life is different. This is no doubt changing now with globalisation, urbanisation, Europe and so on, but that Byzantine undercurrent is still powerful in Cyprus. I think it’s what a lot of Greeks who visit Cyprus for the first time find quite charming about the island, even if for more ‘sophisticated’, ‘educated’ Cypriots, the island’s conservatism can be stifling.

Alexander said...

Hi John, your point about Cyprus still having a 'Byzantine' undercurrent in contrast to Greece - which probably doesn't have quite as much as one - is quite interesting and got me thinking. The more I read about Greece, Cyprus and Greek history as whole, the more Greeks from Greece I meet the more I realise that actually there are quite a few differences in outlook and mentality between Cypriot Greeks and Greeks from Greece. It probably boils down to the fact that Cyprus wasn't incorporated into Greece after independence and hasn't shared the same institutions (bar the Church & military to an extent)and hence Cypriots haven't all migrated to Athens. I'd be interested to hear your thoughts on the Cypriot mentality and outlook compared to mainland Greeks, and how and why it differs.



John Akritas said...

We are generalising wildly here, but it’s true that Cypriots have a slightly different mentality to cosmopolitan Greeks – they’re more reserved – but no doubt Cretans have a different mentality to Kerkyraioi, who have a different mentality to Rhodians who have a different mentality to Epiriotes and so on and so on. Even in Cyprus, Lefkosiates regard Limassolians as being hot-heads while everyone thinks of Paphians as being stern and joyless. It doesn’t tell us much. Certainly, I’d say, however, that the particular form of culture and society that developed in Cyprus emerged from the isolation and depredations it experienced following the collapse of Greek rule on the island in 1191. I don't think any other part of the Greek world was as cut off from 'civilisation' as Cyprus with the collapse of Byzantium.

Hermes said...

The problem with these sort of discussions is that because of the fragmentary nature of modern Greek history, at least since the loss of Catepanate of Italy, we can always find some exceptions. For example, John states that, "I don't think any other part of the Greek world was as cut off from 'civilisation' as Cyprus with the collapse of Byzantium".

If we are to use modern survivals as a measuring stick, then the Greeks of southern Italy were cut off earlier from Constantinople than Cyprus. The Catepanate of Italy was decisively lost 1071 but most of the territory was lost 20-30 years before. However, the Greeks of southern Italy survive, somewhat Latinised, in tiny remnants. Another example, are Kappadokes. They were cut off from Constantinople around 1071 and Byzantium never gained control of that area. However, they survived into modern times and thrive in parts of Greece (after the Exchange and massacres) and in the Diaspora.

John Akritas said...

Yes, it's good to remember how, before the Greek nation-state, Hellenism developed a variety of societies and had a variety of experiences. It is a pity that Hellenism has become homogenised. I wasn't trying to say that Cyprus' isolation was unique among Greek societies, only that it might go some way to explaining why the unique form of Hellenism on the island developed as it did – the isolation of the island is particularly important when analysing the form and durability of the Cypriot dialect, for example. I prefer this isolation argument to the argument that suggests influence of British colonial rule or the fact that Cyprus was never incorporated into the Greek state.

I should add that another key difference between Cyprus and Greece is that our food is better.

Hermes said...

Actually, I have been thinking about diversity a lot. There are two models of diversity Greece can follow. There is the American-European model of creating a multi-cultural society where Pakistanis, Congolese, Tadjiks and Baluchis live with Greeks in Greece as equals. Personally, I believe this is an abomination.

Then there is what I think is the "Greek" model of diversity, where Greek Pontians, Cypriots, Northern Epirots, Rhodians, Mauriopolians and Salentinians live together in a Greek world that spans across political borders. Of course, exposure to standard Demotic Greek would mean they all understand each but they are free to pursue their dialects and practices as they see fit with the support of the centre. Ultimately, I think this model is more durable than expecting the periphery to conform to the centre.

Actually, we could go further, and rotate presidencies much like the EU does. For two years, the Greek presidency is in Kerkyra and focuses on issues impacting western Greece. Later, the Greek presidency moves to Lefkosia. Then, Herakleion and so on.

I have reservations about Greek cuisine as well. I have always preferred the heavy but spicy stews of the Eptanisia.

John Akritas said...

I like this vision of a diverse Hellenism, and I don’t think it’s anything new. Dragoumis often talks about his contempt for the Greek state and how Hellenism outside of the kingdom of Greece can thrive without being incorporated into it. However, as far as I can tell, he says this when it appeared that the Greek kingdom was too weak to force expansion and by the time of the Balkan wars and, later, the Asia Minor campaign, he had changed his view and supported the expansion of Greece’s borders. It must have appeared inconceivable to him in the early 1900s, when he wrote My Hellenism and the Greeks, that Asia Minor and even Constantinople could be liberated – in which case, Hellenism needed to find a way of existing outside of the kingdom of Greece – but 10 years later bringing these territories within the Greek state would have been more feasible and desirable.

John Akritas said...

Ultimately, though, in Cyprus' case – and in the case of N. Epirus – it has been a disaster that they have remained outside of the control of the Greek state. N. Epirus has fared even worse than Cyprus. Regarding Cyprus, not only has the northern part of the island been lost to the Turks, but the rest of the island – as far as I can tell – is more amenable to British influence than it was during the colonial period.

Hermes said...

Of course. I was going to write that political unity is still the ultimate goal for regions which remain under nominal Hellenic control i.e. northern Epirus and Cyprus.