It is often quoted that crises create opportunities. However, the Cypriot authorities have wasted the financial crisis of 2013 in not taking the opportunity to implement many of the policy measures and reforms agreed to with the troika of international institutions (European Commission, the ECB and the IMF referred to below as the Troika). In this respect they have squandered also the opportunity to create and utilize the conditions to generate sustainable and broad-based economic growth.
Program with Troika provided opportunities
The memoranda of understanding or essentially the Program agreed with the Troika, though placing excessive emphasis on fiscal austerity, committed the Cyprus authorities to undertake measures and reforms that were directed to stabilising Cyprus’s financial system and restoring economic growth. In exchange for executing these commitments a combined financing package of 10 billion euro from the IMF and the European Stability Mechanism was extended to cover financing needs over the period from the second quarter of 2013 to the first quarter of 2016.
According to the IMF the Cyprus authorities were committed to a “program focusing on two key objectives aimed at achieving sustainable long-run growth”:
--- restoring financial sector stability through policy actions aimed at placing the banking system on a sustainable footing so as to enhance financial intermediation and support economic activity. Following the resolution or restructuring and capitalization (mainly by deposit haircuts) of troubled banks, the Program called for actions including completing the financial sector recapitalization process, private sector debt restructuring, and reforming the sector’s supervision and regulation through among other things strengthening the anti-money laundering framework for credit institutions; and
--- achieving sustainable public finances through harsh cuts in current expenditures including substantial reductions in the wage bill and boosting tax revenue mostly by revamping tax administration. These actions were to be complemented by structural fiscal reforms, with privatization and reforms to the public wage indexation mechanism that would also help to raise the economy’s efficiency and competitiveness.
Mixed Implementation of the Program
Cyprus exited the economic adjustment program with the troika of institutions early in March 2016, with the IMF praising the impressive policy achievements. It was noted that the positive growth of real GDP had returned earlier than expected in 2015, despite large fiscal consolidation.
The Cypriot authorities were commended on implementing strong fiscal adjustment and at the same time protecting the most vulnerable through the adoption of a well-targeted income support scheme. Although being encouraged by the “Finance Minister Harris Georgiades committing to maintain prudent policies and to continue to implement reforms after the program period”, the IMF cautioned that “the pending reform of the public administration as particularly important” and that there was a need “to ensure that the wage bill does not once again outpace the overall economy as it did before the crisis”.
The IMF reported also that impressive progress had been achieved in the banking sector with the restoration of their capital and liquidity to adequate levels. In addition, somewhat naively IMF staff referred to “new foreclosure and insolvency rules as encouraging banks and borrowers to come together to find workable solutions for unpaid loans”.
But the IMF and EU institutions in assessing Program performance underestimated the lack of economic adjustment in the private sector. Indeed, this lack of adjustment was reflected in households and corporations largely maintaining their pre-crisis expenditure levels by not paying their loans and running down their savings and, thus, was the main factor causing the return to positive real GDP growth in 2015 occurring earlier than expected by the Troika.
Wasteful Post-Program Developments
While the program with the Troika had certain deficiencies in design including the imposition of excessive fiscal austerity and insufficient focus on the private debt problem, two of the key objectives of the program, namely, placing the government finances on a sustainable footing and restoring capital and liquidity to the banking sector, were achieved with its implementation. These achievements along with the carrying out of pending reforms were supposed to create the conditions for supporting sustainable long-term growth. However, the Cyprus authorities including bank leaders and supervisors have wasted the opportunity to build upon these achievements and have persistently delayed the implementation of reforms agreed with the Troika.
Indeed, with government policies no longer under surveillance from the Troika the Anastasiades administration largely returned to the business model of promoting mass tourism and property development backed by buoyant private consumption that had contributed importantly to causing the 2013 financial crisis. In these years property development rather than being financed by new bank loans was backed increasingly by funds from the golden passport scheme whereby essentially cash for purchase of property was exchanged for the receipt of Cyprus (EU) passports.
Although the government accounts recorded surpluses over the period 2016 to 2019 the quality of the government finances deteriorated. Greater reliance was placed on regressive taxation and new government borrowing to finance surging current expenditures highlighted by large increases in the government’s wage bill.
Indeed, rather than using its surpluses to help pay down its debt that was around 105% of GDP at the time of exit from the Program, the government borrowed sizable amounts externally, which raised its outstanding debt by another 2 billion euro by end-2019.
And the government failed to carry out promised reforms aimed at raising the efficiency of the public services as well as importantly in doing almost nothing to strengthen the appalling state of tax administration that has greatly facilitated massive tax evasion. Indeed, huge amounts of tax arrears and unpaid private debt continue to menacingly overhang and harm the Cyprus economy.
At the time of the exit of Cyprus from the program with the Troika banks were equipped with the resources including capital and liquidity and tools such as the new foreclosure and insolvency rules that would enable them to play a major role in rebuilding the economy. In fact, following the recapitalization of the Bank of Cyprus in 2013 the Government injected 1.5 billion euro of capital into the Cooperative Central Bank in 2015 and a further 95 million euro in 2016. But despite Cyprus banks being well-capitalized and possessing abundant liquidity, they have persistently fallen short in extending significant amounts of new credits and in productively restructuring their very large amount of NPLs so as to place private sector entities in a much better financial position to contribute to real growth, particularly with economically viable investments. In fact, the latest data for end-June 2021 reveals that the systemically important banks of Cyprus had only 42% of their assets in loans and advances compared with an average for euro area banks of 56%. And on the same date these Cyprus banks had incredibly 36% of their assets in cash and balances at Central banks “earning” negative interest of 0.5%, whereas the average for euro area banks was 17%.
Most notably, rather than demonstrating real action in supporting the Cyprus economy with productive loans, bankers appear to be pre-occupied with removing NPLs from their balance sheets by selling such loans and their collateral to third parties, usually investment funds, which in turn aspire to sell the property collateral at a profit.
Furthermore, the IMF and the European Commission have continually stressed the need to strengthen bank supervision and regulation. But, such supervision has proved to be grossly inadequate. Even though supervision of the Cooperative Central Bank was transferred from the Ministry of Commerce to the ECB’S Single Supervisory Mechanism and the bank was recapitalized with nearly 1.6 billion euro from Troika loans, the poor monitoring of and the failure to act against the incompetent and often fraudulent lending activities of the bank led to its demise and the gifting of its good assets to Hellenic Bank. In addition, the supervisory authorities have failed also to exercise proper oversight over financial institutions in implementing the anti-money laundering framework, in the process facilitating the inflow of illicit money into Cyprus including the large amount of money that was associated with the discredited golden passport scheme.
Thus, Cyprus having wasted the opportunities to significantly reduce its huge indebtedness and undertake reforms to boost the growth potential and resilience of the economy, entered the Covid-crisis year of 2021 with an economy relying heavily on debt-fueled private and public consumption and foreign demand for Cyprus properties to promote economic growth. Undeniably, the Cyprus authorities in the years after exiting the troika program squandered opportunities to address the large macroeconomic imbalances, such as a current account deficit averaging 5% of the GDP in the period 2016 to 2019, and largely returned to pursuing similar policies that contributed importantly to causing the financial crisis of 2013.