In the last Eurogroup meeting, Eurozone officials were ‘contented’ as it seemed that Cyprus has been officially rescued. The bailout was approved: Cyprus would raise approximately €17bn itself, and its creditors would pay about €10bn. However, the reality about the bail-out/in implications is somewhat different.

Given the structure of the agreement, the recession in Cyprus will be far deeper and longer than was envisaged, requiring greater government spending on ‘benefits’ and increases in taxes. Troubled local banks might require further recapitalisation due to the knock-on increase in non-performing loans and consequently loan provisions. That will ‘squeeze’ large depositors even further, who currently face the potential of losing a great chunk of their funds above €100k. Importantly, the tough austerity and the current recessionary environment will ‘lock’ Cyprus into a negative feedback loop with the catastrophic consequence and the possibility of a second bailout. Imposing heavy austerity measures in the middle of an economic recession has turned out to be much more damaging for those economies than policymakers had actually anticipated. To this end, Cyprus is expected to carry out fiscal consolidation equivalent to circa 5-7% of GDP which is likely to shrink its economy by 16-18%. Cyprus’ debts are still expected by the EU to increase, peaking at 140% of GDP, a level that many consider unsustainable.

The immediate problem facing Cyprus is how to restore confidence in its banking sector. Commercial banks and COOPs need to keep the flow of money to the local economy. Disrupting that flow is similar to disrupting the blood flow to the heart. Capital controls and the ‘suspension’ of lending, prevent the normal economic operation with disastrous consequences to individuals and businesses. Today, even if the measures have somewhat been relaxed, the Central Bank must note that there are potentially ‘permanent’ implications if these measures stay in place for too long. For instance, when businesses face limits on their ability to pay suppliers (especially international ones) for an extended period of time, they will have to lay off staff (and consequently increase unemployment) and sell off valuable assets (at distressed assets) in order to survive as suppliers will be unwilling to maintain existing credit lines. Importantly, they may also default on existing performing loans, thus damaging the bank’s loan portfolio with catastrophic implications for the local economy and banking sector (i.e. demanding additional capital, therefore a possibility of a second bailout package). Temporary measures to assist those borrowers who are facing problems in servicing their debt such as to grant a grace period of 60 days, (i.e. during that time loans are not transferred to the debt recovery divisions and no legal measures are initiated), could be beneficial but are only temporary and do not form a holistic solution to the actual problems facing the banks and its borrowers.

Another potential implication of Cyprus’ continuing banking crisis is that even if confidence could potentially be restored and restrictions lifted, the banks will be unable to perform their role as systemic lenders for years to come (especially Bank of Cyprus which will have to lift the burden of Laiki Bank’s ELA funding and the administration of all the problematic loans of Laiki Bank and of course its own). To restore confidence in the system, the ECB should provide ‘unlimited’ liquidity to the Cypriot banks (especially to Bank of Cyprus) once they are restructured and recapitalised. Cyprus is only the smallest of many countries to find itself between a heavy bank deleveraging and the significant government austerity. It is noteworthy that Spain, Italy, Ireland, Greece and, increasingly, France are all experiencing the same tough consequences for their economies. So it could be that Germany soon finds itself in a minority over its demands for additional austerity.

A long-term concern is whether Cyprus’ financial/banking services sector (which currently contributes circa 9% of GDP) has a prospering future. Germany’s officials suggested that a condition of the bailout was that ‘offshore depositors’ should also bear the deposit losses as local depositors. Russian and Eastern European businessmen have undoubtedly lost a lot of money in Cyprus. However, it is unclear whether the loss of depositors will affect such business from using Cyprus as their financial hub. Using Cyprus as a tax jurisdiction does not necessarily require such investors to hold all their funds in the country. Whether the offshore/fiduciary businesses have a prospering future ultimately depends on political decisions made in Moscow, Brussels and Berlin. Cyprus should promote itself as a transparent and professional financial centre with the aim of attracting Asian and other international investors, while maintaining existing international businessmen currently operating in Cyprus.

The banking sector will also be severely affected from the deflation of the ‘property bubble’. Property prices rose significantly between 2004-2008 as the banks over-lend home buyers, landlords and property developers, with demand and price having fallen significantly since 2008. This had a negative impact on business activity and employment. It has also affected confidence among mortgage borrowers, the ability of companies to borrow against property and use it as collateral to finance investment, and the ability of property developers to service existing loans.

Nobody doubts that after such a severe blow to Cyprus’ lucrative banking sector, the country will be pushed into a deep recession. Perhaps the key question one could ask is this: once the banks have been ‘cleaned up’, recapitalised and shrunk, where will Cyprus find real economic growth? The promise of offshore gas deposits is still too uncertain, and tourism may well decline if Russians suddenly find the island to be less ‘hospitable’ (although early signs indicate that this is not the case).

No matter how small Cyprus is, its bailout forms an embarrassing reminder that the euro remains vulnerable to banking and sovereign debt problems. The risk for the eurozone is that this cessation of the free movement of money across borders is seen as a precedent – and therefore nervous investors and lenders would pull their money out of other economies and banking systems perceived to be weak, such as those of Italy and Spain.

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