Financing the end of the crisis in Cyprus: what are the prospects?

Summary:

– The real estate crisis and the deterioration of loan portfolios in Greece are the two causes of the crisis in Cyprus

– Uncertainty surrounds the stability of the financial system and the balance sheet risk of a market concentrated in just three commercial banks

– An improvement in the public debt-to-GDP ratio through refinancing of the public debt stock seems appropriate. A restructuring of the debt stock is unlikely.

– The economic outlook is unfavorable in the short term (recession in 2013 and 2014) but favorable in the long term (natural gas exploitation).

Approval of the financing of a bailout plan for the Cypriot economy on March 16, 2013, was obtained on two conditions: that the public debt sustainability threshold defined by the IMF not be exceeded, and that the structural effort be shared between resident and non-resident agents.

The first condition was necessary for the IMF to contribute to the financing by becoming a creditor to the tune of €1 billion. The second condition was essential to obtain the agreement of the majority of Eurogroup members, who had until then been opposed to the European Union financing « Russian assets in Cyprus. »

As a result, the aid package will be financed by the European Union and the IMF to the tune of €10 billion, which will be redistributed to the banking system, while nearly €6 billion will be obtained through a tax on the deposits of residents and non-residents. This €6 billion will make it possible to limit Cyprus’s debt-to-GDP ratio to a « sustainable » level  » (the IMF had announced 120% of GDP in December 2012) by limiting the amount of the aid package (€10 billion instead of the expected €17 billion) and promoting the stability of public finances by financing the budget deficit and maturing long-term bond issues.

Uncertainty remains regarding the conditions attached to the memorandum linked to the bailout plan. In this article, we propose to put the economic and financial issues in Cyprus into perspective: a real estate crisis and loan portfolios exposed to Greece (1), the risk of contagion in the eurozone (2), solutions to improve the trajectory of public debt (3), the bailout plan and the long-term economic outlook (4).

1 – An economic and financial crisis: real estate and deterioration of loan portfolios in Greece

Cyprus faces two challenges: the depreciation of real estate assets and the deterioration of loan portfolios in Greece. These two problems pose a balance sheet risk [1] to the three major Cypriot commercial banks (insolvency and an increase in non-performing loans to nearly 30% at the end of 2012).

The real estate market has deteriorated by 15% since 2007. A 30% decline would be justified to return to pre-crisis price levels, but this is being contained by fiscal measures (purchase incentives) implemented by the government since 2010.

However, Cypriot households’ real estate debt poses a limited risk to the banking system’s loan portfolios. Loans have increased in value since 2010 and the household debt ratio is estimated at 134% in 2011 (compared with 112% in Ireland and 82% in Spain), but their net financial wealth (financial assets excluding debt) exceeds 100% and the share of gross financial assets held by thesehouseholds isover 250% of GDP, compared with an average of 200% in the eurozone. In addition to these two advantages, there is a personal bankruptcy procedure [2], which broadly confirms the repayment capacity of Cypriot households. However, the evolution of the real estate market is not only dependent on residential demand from Cypriot households but also on demand from non-residents (50% of total demand), which has been declining since 2008, and on the growth of new and old housing stock, which exceeds the growth in real estate demand, hence the risk of a price correction that weighs on residential investment, construction, and therefore on activity in Cyprus, the only economy in the eurozone forecast to be in recession in 2014.

The major risk concerns the Cypriot economy’s exposure to the Greek crisis. The portfolio of loans granted by Cypriot commercial banks in Greece stood at €22.5 billion at the end of 2012, representing 140% of GDP and 40% of the €55 billion loan portfolio.

The Greek PSI[3] plan of March 2012 thus caused Cypriot banks to lose €2.5 billion. Participation in the restructuring of Greek debt required the Cypriot government to recapitalize the Popular Bank of Cyprus and the Bank of Cyprus to the tune of around €2 billion (recapitalization financed by the government through the financial markets, of which €1.8 billion matures in June 2013).

This example of a loss on the loan portfolio was compounded by an increase in the rate of non-performing loans (from 10% at the end of 2011 to nearly 30% at the end of 2012), requiring an increase in provisions and thus making it more difficult for banks to meet solvency and liquidity ratios.

2 – What is the risk of contagion in the eurozone through the banking system?

The banking sector has €140 billion in financial assets, 60% of which are held by three commercial banks: Bank of Cyprus (€37 billion, 28% of activity), the Popular Bank of Cyprus (€31 billion, 25% of activity) and the Hellenic Bank (€8 billion, 6% of activity). The Russian subsidiary of VTB Bank has financial assets of close to €10 billion, but it is only involved in the transfer of deposits of Russian origin and does not directly finance the Cypriot economy.

The cross-border exposure of banks, as reported by the Bank for International Settlements (excluding Russian banks, which are not accounted for by the BIS), stands at €34 billion, of which €31 billion is in the non-banking private sector, €2 billion in the banking system and €1 billion in the Cypriot government. The banks most exposed are Greek (€11 billion), German (€6 billion), and French (€2 billion). The risk of contagion is therefore limited. Cyprus suffered from the eurozone debt crisis through the Greek economy, but the reverse scenario is unlikely.

Beyond the risk of contagion through the banking system, the risk of contagion through the financial markets is difficult to measure. Combined with institutional (European Union), political (Italy), and economic (Southern Europe) concerns, the situation in Cyprus is likely to affect financial markets in the short term by increasing uncertainty.

3 – Cyprus’s public debt: three solutions, two chosen.

Public debt represents more than 89.7% of Cyprus’ GDP (source: EC, fall 2012), or €15 billion, of which €6 billion was contracted through loans and €9 billion through bond issues on the financial markets. In 2013, more than €4 billion will have to be repaid. €9 billion between now and 2016.

Given that refinancing the public debt stock is impossible under current market conditions (credit default swap at 800 points at the end of 2012, 10-year rates above 12%, 1-month maturities above 4%, while French 10-year bond issues are trading at 2%), three solutions are possible: restructuring the public debt with the involvement of the private or institutional sector, refinancing the public debt stock, or increasing the public debt.

Restructuring public debt with the involvement of the private sector requires not only that a significant portion of the public debt stock be held by private creditors, but also that these private creditors be largely non-residents. In Cyprus, private creditors accounted for 60% of the public debt stock and non-resident creditors accounted for 40% in 2010 (source: European Central Bank). In the best-case scenario, a PSI plan could have covered at most 25% of the public debt and would not have been a sufficient solution.

A restructuring of public debt involving public institutions would also be insufficient given the composition of creditors: of the €6 billion, €2.5 billion relates to Russia, while the remaining loans (€3.5 billion) were contracted with the European Investment Bank or the Eurosystem.

Refinancing of part of the public debt stock will probably be achieved in two ways. The first is a renewal of short-term maturities, which would be financed by part of the revenue from the tax on bank deposits (assuming that the €5.6 billion announced replaces the €7 billion expected in the plan to stabilize public finances—an amount that has not been announced, given that the aid package is €10 billion rather than the €17 billion expected). The second means is a refinancing of the €2.5 billion loan granted by Russia at the end of 2011 (40% of the debt owed to non-resident creditors). The maturity of the loan is expected to be extended from 2016 to 2021 and the interest rate, currently at 4.5%, is expected to be revised downwards. This refinancing could be called into question by the proposed tax on bank deposits, which could cost Russian depositors between €1 billion and €3 billion and thus weigh on Russia’s political decision to refinance the terms of the loan granted to Cyprus.

Finally, an increase in public debt would be directly linked to the €10 billion aid package. This package, expected to total €17 billion (€10 billion for the banking system and €7 billion for public finances), would have significantly increased public debt. Limiting this aid package to €10 billion therefore avoids exceeding the IMF’s threshold for unsustainable public debt (120-130% of GDP). It should be noted that the payment installments are progressive over time and therefore the debt-to-GDP ratio will not directly reach the equivalent of the sum of the debt stock and the aid plan relative to GDP.

4 – What are the long-term prospects once the aid package has been implemented?

The aid plan aims to restore stability to the financial sector, achieve fiscal adjustment, and carry out structural reforms to support competitiveness and balanced economic growth.

– Financial sector stability will be targeted by improving the non-performing loan ratio, regulation and supervision of the banking system, as well as solvency and liquidity, and by strengthening.

– The required fiscal adjustment will amount to 7.25% of GDP between 2013 and 2016. This will be broken down into 80% spending programs (reduction in public sector effects and salaries, phasing out of salary indexation, privatization programs) and 20% tax revenue programs (increase in VAT from 17% to 18% in 2013 and then to 19% in 2012, increase in energy taxation, increase in taxation on profits from 10% to 12.5%)

– Finally, structural measures will aim to reform wage indexation and the minimum wage in line with productivity and competitiveness, as well as the functioning of public administration.

Negotiations on the aid plan focus in particular on the recapitalization needs of Cypriot banks, the wage indexation system, privatization programs, the management of revenues from natural gas production, and the effect of taxation on bank deposits.

Cyprus is unique in that it has significant investment opportunities in terms of natural gas exploitation. According to the former Cypriot government, nearly €7-8 billion in investment is expected by 2018 (40% of GDP), and the number of jobs created could approach the equivalent of 20% of Cyprus’s unemployed workforce at the end of 2012 (4,000-5,000 net jobs created). These opportunities are included in the aid plan as a financial guarantee. Natural gas exploitation could thus become one of the sources of growth essential to a sustainable economic recovery and therefore conducive to an improvement in the public debt trajectory.

Conclusion

The risk in Cyprus therefore concerns less the economy’s ability to define a growth strategy than its ability to restore the stability of the financial system by correcting the balance sheet risks of the main commercial banks.