Currently the Euro area is on its way to a bailout of one of its smallest economies. You might think that it would be able to deal with any issues here with ease. After all it is a small economy and on January the first 2008 it took the step which Euro area leaders tell us is the nearest to economic nirvana that there is. Yes they switched their currency to the Euro! If we look back we see that before then as part of the Euro entry procedure Cyprus had come under the aegis of the Growth and Stability Pact where she was supposed to run a fiscal deficit of less than 3% of Gross Domestic Product and a national deficit of one of less than 60% of GDP. Fairly quickly she had hit the former target -with the fact that it has been partly by “one-off measures” as is usual bothering no-one- and she joined the Euro.
Did this fix things?
No, rather than the economic nirvana of Euro dreams the credit crunch happened and this was the impact on Cyprus in 2009 according to the European Commission.
According to data published by the statistical service of Cyprus, real GDP contracted in the year 2009 by 1.7%.
Now plenty of other countries bith inside and outside the Euro were taking a hit to economic activity at this time but Cyprus was pushed back beyond the pale of the Growth and Stability Pact again.
In 2009, the general government deficit reached 6.1% of GDP. Well in excess of 3% of GDP, the deficit is not close to the Treaty reference value.
Worse than that the deficit was forecast by the European Commission was that the deficit would be over 7% in both 2010 and 2011. This was unacceptable to the Growth and Stability Pact which from the point of view of Cyprus was grim as she had done this between 2003 and 2008.
Cyprus implemented a fiscal adjustment of about 7½ pp of GDP
But in response to the first decline in economic output for 35 years she found the European Commission asking her to do this.
reverse the projected fiscal loosening in 2010 and beyond, by restraining expenditures in order to ensure a sound fiscal position in the medium term
So she was seeing something then with which we are familiar now which is that Euro era austerity appears never to actually end! Even worse the Euro area leaders were in fact behaving like fans of Diana Ross.
Upside down Boy,
you turn me Inside out
And round and round
Why? Well take a look at this from the year before.
the Commission called for a fiscal stimulus in its November 2008 European Economic Recovery Plan (EERP),
Yes up for them is indeed the new down!
A shark was in the water
Less remarked on at the time but looking back clearly a warning sign of trouble to come was the fact that to help her banking sector the Cypriot government used Treasury Bills to borrow the equivalent of 8% of her GDP.
Did this work?
You may be wondering how going forwards and backwards simultaneously could work. Indeed Cypriots may have had time to rue this European Commission paper from February 2005.
Convergence and Reunification in Cyprus: Scope for a Virtuous Circle.
Unfortunately if we jump forwards to May of last year we see the European Commission had changed its tune somewhat.
The deterioration of the economic outlook and the fiscal situation as well as the implications from the exposure of the banking sector to Greece add to concerns on the challenges involved in adjusting to imbalances in other sectors of the economy
So convergence had in fact been with a Greece hurtling downwards and the virtuous circle had been replaced by a vicious one.
The banking sector in Cyprus
At this point let us reintroduce the financial sector in Cyprus into the equation. It has a relatively large one which is approximately five times its economic output and even worse considering what has happened some one third of this was related to the Greek economy. So the debt haircut or PSI (Private Sector Initiative) of last spring in Greece exploded like a bomb on the balance sheet of many Cypriot financial institutions. Or as the European Commission put it.
The financial system in Cyprus is in the midst of formidable re-capitalization efforts following the latest EU aid package to Greece and the PSI
Yes “aid” for one Euro area member has put another in serious trouble! So we see yet another example of Euro area efforts backfiring and having unintended consequences. Also those who argued that an answer to the difficulties was for banks to hold more sovereign debt have been exposed as making matters worse rather than better.
The Cypriot economy
In spite of the troubles outlined above the Cypriot economy edged forwards in 2010 and 2011 easing much of 2009′s decline. But for 2012 even the European Commission forecast another decline. And even with such a performance there were issues building in her public finances.
Public finances deteriorated further in 2011. The budget deficit increased to 6.3% of GDP compared to 5.3% in 2010.
Added to this the national debt was also rising quickly expected to reach some 72% of GDP in 2012 if we look a gross government debt. So poor Cyprus which had worked so hard to get her deficit and debt levels under the Stability and Growth Pact levels found that austerity was required one more time.
The total structural adjustment over the period 2012-2015 is estimated at around 5¾ percentage points of GDP. This corresponds to an average annual adjustment of about 1½ percentage points of GDP,
This will be imposed in the ratio of 4 Euros of expenditure cuts to every one Euro of tax rises.
If we stay with the overall economy of Cyprus we see that she was slowing and a brake is being applied. Also her links with Greece were likely to be a brake on her economy too. even the European Commission had learnt from this a little as of last autumn.
Deep recession to prevail over the forecast horizon
An expected 0.5% decline in 2012 had become a 2.3% fall which is about par for the course for the European Commission. But as we review the fact that even it expects further declines this year and next another measure started to run amok.
The government’s participation in the recapitalisation of a commercial bank (which was unsuccessful in implementing its capital enhancement plan) is expected to increase the general government debt significantly from 71.1% in 2011 to about 90% of GDP in 2012.
Ouch! Also remember that is the effect of only one bank on her national debt.
How much will the Cypriot banking sector cost to repair?
The PSI for Greece cost Cypriot banks around 4 billion Euros and the ratings agency Moody’s has estimated that a bailout of around 10 billion Euros will be required for her banking sector once other problems are added in too. If we compare this to a Gross Domestic Product of 17.9 billion Euros (and falling) we see the scale of the problem.
If we look at Cyprus we see that a weakening economy is about to face an “Ireland type” problem where a very large amount of debt is moved from the private-sector to the public-sector. As we consider the implications of (past) private profits becoming (present and future) public losses one more time we see that Cyprus will not be able to cope with this on her own. Indeed she would look like Greece in the way that her national debt to GDP ratio would blast upwards like a rocket.
So she needs help from her Euro area colleagues and the amount required for such a small economy would be like a mouse for an elephant. But as we know mice can unsettle elephants and if we look at an obvious solution which would be a debt haircut we find our elephant does indeed have a problem. You see it was badged as a “one-off”! As we review that issue we also see that Cypriot banks copied their Greek neighbours and bought a lot of their own country’s sovereign debt. So in the odd arithmetic of these times a bailout designed to help Cyprus (and her banks) would also need another bailout for her banks.
The situation is not helped by the fact that a fairly high percentage of the depositors at Cypriot banks are Russian and Germany in particular wants clarity on where any aid will go because of this.Indeed there are much wider Russian links including a loan of some 2.5 billion Euros. Maybe they should have joined the rouble…….?
So we see how a relatively small problem as Cyprus is only 0.2% of Euro area economic activity can become a large one! For now there is sense in delaying a deal as elections are due and in such difficult times a democratic mandate is important but the problems are much deeper than that. We also know that the “solutions” applied so far in the Euro area have invariably made matters worse and accordingly I fear for Cyprus and her economy.