11 August 2015

VoxEU: Lessons from Cyprus that did not make it to Greece

This column examines the lessons that could have been drawn from the Cypriot experience by Greece in its recent attempt to seal a bailout deal. Specifically, lengthy negotiations offer little benefit for debtor countries, and capital controls, once implemented, cannot be easily undone.

With Greece in the spotlight, little attention has been paid to the other Mediterranean country striving to get back on its feet after a painful bailout in 2013 (Buchheit and Gulati 2013, Wyplosz 2013). After gradual relaxations over the past two years, Cyprus abolished the last vestiges of its capital controls in April of this year. The news is that, so far, there is no sign of any major capital outflows.

Although this is encouraging, the effects of the recent banking and fiscal crisis are still evident. Recent estimates show that one in two loans are non-performing, with this ratio being even higher for household loans. While overall growth has turned positive, it has the symptoms of a creditless recovery. The reluctance of banks to grant new loans results in growth that is concentrated in sectors that are less dependent on loans, such as tourism and non-financial services (Claessens et al. 2009, IMF 2015).

Cyprus’s financial sector experienced rapid growth during the last decade due to a large inflow of international deposits. At the same time, high demand in the property market (driven by the expansion of domestic credit) caused house prices to skyrocket. At the outburst of the Global Crisis, this period of expansion came to an end leaving the island’s real estate market in tatters and its banking sector with accumulated financial liabilities amounting to 750% of GDP. Moreover, the large exposure of the banking sector to Greece left the country in an even more vulnerable state, with the restructuring of Greek bonds costing its two largest banks the equivalent of 25% of GDP. Cyprus Popular Bank, the island’s second largest, needed a capital injection of €1.8 billion in order to meet its capital requirements in 2012.

Raising money was difficult for Cyprus, which had already lost market access after the government’s credit rating was downgraded to ‘junk’ in 2012. The left-wing government at the time, in an attempt to avoid the harsh austerity measures that would accompany a European bailout, examined the option of obtaining a bilateral loan from Russia or China. In 2011, a €2.5 billion loan was obtained from Russia and used for refinancing the debt in that year. Nevertheless, Cyprus applied for a bailout from the EFSF/ESM in late June 2012. Despite the urgent need for money, an agreement on a bailout plan was not reached until a year later, after a right-wing party came into power.

We believe that there are important lessons from the Cypriot experience that could have been beneficial for Greece in its recent attempt to seal a bailout deal. Even though it may be too late for Greece, these lessons can be important for countries in need of financial assistance in the future.

Full article on VoxEU

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