Cyprus and the Financial Crisis

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Cyprus and the Financial Crisis The Controversial Bailout and What It Means for the Eurozone John Theodore and

Jonathan Theodore

Palgrave

macmillan

© John Theodore and Jonathan Theodore 2015 Foreword © Michael Sarris 2015 Softcover reprint of the hardcover 1st edition 2015 978-1-137-45274-0

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN 978-1-349-55792-9 DOI 10.1057/9781137452757

ISBN 978-1-137-45275-7 (eBook)

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Theodore, John, 1945– Cyprus and the financial crisis : the controversial bailout and what it means for the eurozone / John Theodore, Jonathan Theodore. pages cm 1. Cyprus—Economic conditions—21st century. 2. Finance— Cyprus—History—21st century. 3. Banks and banking— Cyprus—History—21st century. 4. European Union countries— Foreign economic relations—Cyprus. 5. Cyprus—Foreign economic relations—European Union countries. I. Theodore, Jonathan, 1985– II. Title. HC415.2.T42 2015 330.95693—dc23 2015002670

This book is dedicated to all Cypriots and their hopes and aspirations for a better economic and united political future.

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Contents

Foreword by Michael Sarris

ix

Preface and Acknowledgements

xiv

About the Authors

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Introduction

1

1 Birth of a Nation The Road to Independence Nationhood, Its Costs and Consequences A Unified Country Breaks Down, 1963–1964

6 6 8 12

2 Forever Divided? The Turkish Invasion and Its Aftermath A Final Hope? The Annan Plan, 2002–2004

19 19 27

3 The Financial Crisis Spreads to Cyprus The Single Currency and International Finance AKEL: An Easy Target for Blame? Greece, the PSI, and Sacrifice of Cyprus Greek Fallout in Cyprus Casino Economics and Political Games From Bailouts to Bail-in

38 38 46 50 57 61 67

4 Bailouts and Bail-Ins The Cyprus Experiment International Reactions to the Bail-In The Piraeus Asset Transfer Austerity, Banking and Housing Bubble Parallels Cyprus and the Politicised ‘Russian’ Connection

71 71 82 92 95 99

5 Economic Recovery and Strategic Challenges Banking Confidence and the Eurozone The Rapid Recovery of Cyprus

102 102 105

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Natural Gas and the Strategic Conflict with Turkey

116

6 Bail-In and the Future of the Eurozone A Dream Undone? Monetary Union: Stability or Systemic Weakness?

123 123 134

Conclusion

138

Notes

145

Bibliography

163

Index

170

Foreword

Several years after the onset of the world economic crisis, the eurozone economy continues to stagnate, with unemployment especially high in the periphery. With weak average economic growth and overall prospects uncertain, the cost of serious policy-making and crisis management failures is rising fast, both in terms of economic welfare and political polarization. The book in your hands makes an important contribution to the kind of reflection and analysis that is needed to help in charting a sustainable way forward. This debate about the origins and the management of the eurozone crisis needs to be carried out along three different axes, which have not always received the merited equal attention. First, and most frequently discussed, is the narrative of policy-making failures at the national member-state level in terms of heavy public and private indebtedness and declining external competitiveness. Second, the shortcomings in the design of the monetary union which the crisis brought to the surface but whose share in the blame for the crisis has attracted relatively little attention; and third, the mismanagement of the crisis by the eurozone leadership that has sent the necessary correction the wrong way. The origins and management of both the Greek and Cypriot crises provide vivid illustrations in all three areas. In the fifty years since independence in 1960, Cyprus had avoided major economic policy errors. In the context of a sound public/private sector partnership, Cyprus took advantage of external opportunities to build a strong service-oriented economy based on export. In parallel, during the process of joining institutions with sound economic practices such as the WTO, the EU and the eurozone, Cyprus implemented several much needed economic and structural reforms. But the arrival of the eurozone crisis found the country with serious pre-existing and homegrown imbalances. The substantial increase in capital inflows, encouraged first by the prospect and then by the actual entry into the EU and the eurozone, together with the narrow emphasis of the Maastricht criteria on fiscal performance rather than on also monitoring the potentially ix

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destabilising activities of the private sector, and on nominal rather than real convergence to the better-performing member-states, set the stage for eventual trouble. National policymakers and external analysts failed to realize that dangerous imbalances could lurk beneath an apparently stable macroeconomic surface. Actual output was growing at its potential rate, inflation was low and stable and unemployment was at its natural rate, despite significant economic migration. But the structure of output was in fact unsustainable due to excessive investment in the construction sector. At the same time excessive bank credit expansion supported by capital inflows and excessively leveraged financial institutions, led to a build-up of large household and business indebtedness, and high-risk investments. Poor bank corporate governance was largely unchecked by the Central Bank because of the widespread and ECB – supported philosophy of ‘light touch’ supervision. Rising money wages without productivity or quality improvements led a significant erosion of external competitiveness. When in five short years between 2007 and 2012, through unprecedented fiscal laxity, the best fiscal performer in the eurozone was transformed into one of the worst and Cypriot government debt rose sharply from 48% to 75% of GDP, Cyprus was faced with a homegrown deadly combination of banking and fiscal irresponsibility. By 2012, Cyprus was deep into the trap of mutually reinforcing sovereign and banking risks: weak public finances unable to support banks needing capital and banks underestimating risk, getting into trouble and, thereby, undermining the sustainability of public finances. The period 2011–2012 was characterized by a number of missed opportunities to conclude agreement on an EU support program and minimize the impact of this adverse loop between the sovereign and the banks. This could have been done as early as May 2011 when Cyprus was shut out of financial markets, or in October 2011 when the Greek PSI resulted in huge losses for the two largest Cypriot banks, and finally in the second half of 2012 when endless disputes over relatively unimportant items in a draft Memorandum of Understanding delayed an agreement until it was too late to save the banks. By the time the new government took office in March 2013, the deposit outflows of the previous several months of uncertainly, and the worsening of the quality of bank portfolios, raised the capital requirements of the banks to much higher levels than was the case

Foreword xi

just a few months earlier. This led Cyprus’ official creditors to the conclusion that the country could not sustain borrowing the full amount of its required rescue package. The thrust of the rationale for the ‘bail-in’ of depositors was that taxpayers should not have to bear the full cost of the policy failures and bank excesses outlined above. Furthermore, the argument went, some of the depositors sharing in rescuing the Cyprus economy included Russian ‘oligarchs’ taking advantage of a ‘tax haven’ and perhaps engaging in ‘money laundering’. Moreover, according to this viewpoint, the ‘bail-in’ would help reduce significantly the size of the unsustainably large Cypriot financial services sector and, if successfully implemented, send a message of market discipline to depositors everywhere in the eurozone. A proposal to ‘bail-in’ a relatively small part of deposits in all banks from all depositors was rejected by Cypriot law makers and was followed by the imposition of a much more drastic solution involving the closing of Laiki Bank and the exchange of almost half the uninsured deposits into shares at the Bank of Cyprus. As should have been expected, confidence in the banking system was shuttered and capital controls were imposed. Although the impact on the economy was not as severe as had been feared, at present we are not in a position to know if the impact of this solution on debt sustainability is any better than if the whole amount needed was loaned to Cyprus. Future economic historians might be able to throw more light on this issue. While several of the newer member countries missed the opportunity of eurozone membership to reform their domestic structures to achieve real convergence with the market-based economies of the North, and suffered the consequences, ‘design faults’ of the Monetary Union have also contributed to the troubles of the eurozone. Substantial capital flows from surplus economies have sustained large and persistent imbalances in deficit countries masking lagging competitiveness and increasing financial vulnerability. Furthermore, these capital inflows facilitated excessive domestic bank credit expansion and unsustainable real estate bubbles. These developments exposed the assumption implicit in the architecture of the monetary union that threats to stability could only come from the public sector. The lack of focus on surveillance of private bank credit expansion rates and competitiveness indicators, together with the lack of

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policy coordination and the possibility of exchange rate adjustments, allowed current account imbalances in several countries to reach unsustainable levels. When it comes to correcting these large imbalances, the refusal of Germany in particular but also other surplus countries, to expand domestic demand means that the only alternative option is through ‘internal devaluation’ in deficit countries. Full reliance on this mechanism has proven to be not only extremely painful but also very slow. It is now increasingly recognized in Europe that the ‘repair agenda’ needs to be a two-way process; the fiscally stronger countries of the North, many with large current account surpluses, should make a greater contribution to economic rebalancing in the eurozone through a domestic demand boost, thereby giving a chance to economic adjustment and reforms in the indebted countries of the periphery to succeed. This is not currently in the ‘rule book’ of the monetary union, but it ought to be. Another key ‘design fault’, which is being corrected through a painfully slow process, is the absence of a banking union, which has exposed the potentially lethal interdependence between governments and the banking system. As noted above in the case of Cyprus, potentially insolvent national banks, under inadequate national supervision, become a sovereign liability, while these banks are exposed to the risk of holding their governments’ debt. The potentially disastrous impact of this interdependence is compounded by the lack of access of governments to borrowing from their national banks. This provision can easily turn a liquidity crisis into a solvency crisis when governments lose access to international financial markets to cover national liquidity shortages. In early 2010 European leaders and the eurozone institutions were faced with a crisis of large in balances built over the years which they were not expecting and were not prepared to deal with. Because of the design gaps in the monetary union there were no agreed rules for managing a crisis. Economic decisions were taken with political criteria, sometimes connected with the electoral cycle in powerful countries. The Greek PSI and the Cyprus bail-in stand out. They respectively introduced credit risk in euro area sovereign debt and raised the cost of borrowing, and risk in the safety of bank deposits putting additional pressures in banks in the periphery. Initiatives such as the European Stability Mechanism, the ECB’s Outright

Foreword xiii

Monetary Transactions and ‘whatever it takes’ declarations are all attempts to strengthen the crisis management capabilities of the monetary union – but they have done too little to improve the health of the European banking system, growth prospects and the state of unemployment, which remain serious challenges. The crisis in the eurozone is a mixture of self-inflicted wounds and systemic failures. In deficit countries structural reform needs to accelerate to help achieve greater real convergence, while in surplus countries domestic demand needs to expand contributing to the imbalance repair agenda. Beyond these short-term imperatives, the improvement in the design of the monetary union through the creation of the banking union, needs to the complemented by robust mechanisms to identify and limit macroprudential credit expansion risks, and monitor competitiveness divergences. And ultimately, when sufficient progress towards political union is achieved, put in place a fiscal governance system that complements preventive surveillance at the national level with collective fiscal support in response to shocks, as is done in truly federal systems. As already mentioned above, in the case of Cyprus the jury is still out on whether the bail-in solution was a rational attempt to re-balance the Cypriot economy or a more expensive alternative to a conventional ‘bail-out’. Building on the authors’ legal and historical background and interest in history, the book presents the current financial crisis through the prism of the most significant episodes in Cyprus’ modern history. Dr Michael Sarris Ex Minister of Finance

Preface and Acknowledgements This is a book about the events leading up to and the recent Cyprus eurozone financial crisis and its aftermath. Nothing from the Cypriot perspective, of any substantial size, has been written about the recent (and unexpected) financial crisis on the island, or of the unprecedented way in which the eurozone reacted, with its controversially draconian bailout terms that impacted the whole population. Between 2011 and 2013, Cyprus experienced crippling financial problems in the fallout from the debt crisis in Greece, a country with which it had deep economic ties. In the months that followed, it implemented a host of austerity measures, including a controversial and unprecedented one-time levy on all uninsured bank deposits. The Cypriot crisis differentiates from the other PIGS bailouts in that it created a precedent contrary to international banking practices. For the very first time, depositors (local residents as well as non-Cypriot nationals) were included (contrary to EU law) in the stringent terms of the bailout provisions. The aim of this book is to assist in providing a broader viewpoint on these ongoing issues, framing them in the context of the wider Cypriot historical experience since the invasion, using it as a lens to examine the unravelling financial relationship between Cyprus, Greece, Russia and the institutions of the eurozone. The book focuses on qualitative research through face-to-face high-level interviews with Cypriot business leaders, politicians, and academics. It incorporates the views of leading protagonists in the Cyprus government and banking sectors, as well as opinions from throughout the EU, and the considerable wealth of data concerning the policies of its many institutions and associated entities, both public and private. ∗

∗

∗

We would like to express our deep thanks to all those who have kindly given us their valuable time in helping us to record the events surrounding the financial crisis in Cyprus – especially for the

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insight into the months leading up, during, and immediately after the rescue plan. In no particular order we extend our sincere gratitude to Michael Sarris, Christis Christoforou, Andreas Artemis, Yiannis Kypri, Christos Triantafyllides, Michalis Antoniou, Eleni Marianou, Demetris Zorbas, Chris Hadjisoteriou, Michael Papamichael, Robert Clarke and officials at the European Commission for their patience in explaining the details of the events as they saw them at the time. We would like to thank Manchester Metropolitan University for providing financial support for the project. We would also like to offer a very special thanks to George Pantelides of Deloitte for coordinating the arrangements for many of the interviews that took place in June 2014. Further thanks go to Barbara, the wife of John, who has provided patience and sympathy in the critical months prior to producing the manuscript, and finally to the many Cypriots who shared their views on the individual, personal, and human impacts the events of 2013 had on their families and lives.

About the Authors John Theodore is a trained barrister who has published in International law journals. He has spent over 30 years of his professional working life internationally on EU funded projects and leading teams from the UK university and banking sector advising businesses across Europe. He has been a speaker at the Committee of the Regions in Brussels and in recent years an adviser on business tourism to a number of MEPs in Brussels. He has also been an adviser and visiting professor at Warsaw University of Applied Sciences where he was awarded the Senate Medal of Merit. Jonathan Theodore graduated from Christ Church Oxford with a First in Modern History together with a postgraduate Master’s, where he also edited Cherwell. He has recently completed a PhD at King’s College London, where he has been an undergraduate tutor in Roman and Medieval history for three years. Apart from a number of consultancy assignments for companies engaged in research for the creative industries he has also worked with a university led initiative advising a group of MEPs to support SME growth in their constituencies.

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