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Transcript of a Conference Call on the Approval of an Extended Fund Facility (EFF) for Cyprus with IMF Mission Chief Delia Velculescu
May 20, 2013
MS. GAVIRIA: Good morning and good afternoon to those in Europe. I'm Angela Gaviria with the Communications Department of the IMF. Welcome to this conference call on the staff report for the approval of the Extended Fund Facility for Cyprus. As you know, the approval took place on Wednesday and we published a related press release. Let me now introduce the main speaker, Delia Velculescu, who is the mission chief for Cyprus. Delia will make some brief remarks and then she'll take your questions. Delia?
MS. VELCULESCU: Hello everyone. Let me start by briefly taking you through the effects and the main challenges facing Cyprus and the way the program addresses these.
The first and main challenge for Cyprus is an oversized and highly vulnerable banking sector. At over eight times the size of the economy, Cyprus' banking system far exceeded the domestic needs for financial services. Moreover, the banks' balance sheets had built large vulnerabilities. These included:
First, a high exposure to the domestic housing market, which suffered a boom and bust that eventually led to increasing non-performing loans on the banks' balance sheets.
Second, the banks had a high and concentrated exposure to Greece through deposits, loans to Greek residents, as well as investments in Greek government bonds. The Greek debt restructuring last year dealt a heavy blow to banks' balance sheets.
Third, these investments were financed with reliance on large and volatile foreign deposits, which started to flow out since early last year. Earlier this year, a bank due diligence report suggested that the two largest banks were insolvent, and capital needs for the entire banking sector were estimated at about 60 percent of GDP.
The second challenge facing Cyprus is related to weak public finances. Lax fiscal policies after 2008 led to high fiscal deficits and rapidly rising public debt, which reached about 86 percent of GDP at end 2012.
The sovereign and the banks were tightly interlinked. Banks held a large share of government bonds on their balance sheets. Moreover, given their size and amount of capital needs, they posed a large contingent liability onto the sovereign. Clearly bailing them out with public money would have resulted in an unsustainable public debt.
So, how does the program address these challenges? The main problem has been addressed upfront by resolving and restructuring the two largest and insolvent banks. The Greek branches of these banks have been sold, reducing the banks’ Greek exposure and shrinking the size of the sector substantially.
Given no room to finance resolution costs through the public sector balance sheet, the contribution of unsecured bank creditors was needed.
But since junior and unsecured senior debt was limited, uninsured depositors also had to share in the cost. This approach limited taxpayer costs and achieved broad burden sharing, preventing debt from becoming unsustainable.
The program builds on this early action to finalize the resolution process for the restructured banks and complete the recapitalization of remaining solvent financial institutions, including through public support, as needed. The cooperative sector will also be recapitalized and restructured.
Given the need to impose payment restrictions and capital controls following the closure of the banking sector for two weeks to allow time for the resolution of the two banks, the program strategy aims to relax these restrictions gradually so as to maintain financial stability. Measures are also included in the program to strengthen bank and cooperative supervision to prevent the buildup of vulnerabilities in the future.
The problem related to public finances is being addressed through significant upfront fiscal consolidation. An estimated seven percent of GDP in measures has already been implemented, which is roughly balanced between spending and revenues. But recognizing the need to allow time for the recovery to take hold, the program does not envisage additional measures until the outer years. During 2015-18 additional consolidation of about five percent of GDP will be needed to put debt on a downward path.
Structural fiscal measures will complement the adjustment. Here again, significant reforms have already been implemented, and I will mention the two most important ones. The first one is the reform of the public wage indexation mechanism (COLA), which will help to contain wage costs for the government in the future, as well as improve competitiveness in the economy at large. Second, the pension system has been reformed to improve its long-term sustainability.
Going forward, the program recognizes the need to protect vulnerable groups by better targeting social programs. Other reforms aim to strengthen the medium-term budget framework, improve revenue administration, and privatize state-owned enterprises.
MS. GAVIRIA: Thank you, Delia. We're ready for questions now.
QUESTIONER: Hi, thank you for doing this. We've been reading a lot and hearing a lot about all the Russian money in Cyprus. So, I wanted to ask you if you could give us an idea of the actual amount, the scope of exposure.
MS. VELCULESCU: We don’t have detailed information on deposits on a residency basis, except distinguishing between Cypriot and non-Cypriot depositors in the banking sector. Indeed, the share of non-resident depositors, as I've said upfront, had been a significant source of funding for the banks.
QUESTIONER: Can you put a figure on it?
MS. VELCULESCU: Not at this stage. This has also been changing over time.
QUESTIONER: What about spillovers for other countries? Maybe the spillover is not the right term here for a country, for a lender such as Russia, but do you have an idea as to how much this whole operation can influence the well-being of the Russians or maybe others, like the British. I understand the British have a lot of money there, too.
MS. VELCULESCU: We have tried to analyze the spillovers in our staff report. We have seen spillovers from Cyprus being limited in magnitude. In particular, we have seen some impact in asset markets of countries more directly exposed to developments in Cyprus, as you mentioned, such as Greek government bonds, Greek and Russian bank stocks, and subordinated debt in some peripheral countries. However, we have also seen that this reaction has been temporary and with most of the asset markets having recovered ever since.
QUESTIONER: Thanks for doing this. I'm just wondering if you could elaborate a little bit about the risks on the program. I've seen that you mentioned in the beginning of the staff report that risks are unusually high. And I just wondered whether you might elaborate a little bit on the rest of the program.
MS. VELCULESCU: Sure. This is a very good question. As you know, the situation of Cyprus is quite unique and unprecedented, involving resolution of very large banks upfront, closure of the system and imposition of capital controls, and needing to adapt the business model away from financial services in the future.
All of these add to macroeconomic uncertainty and risks. For example, the impact of the banking crisis, as well as the fiscal consolidation, on growth and the deflator, remain uncertain at this time. A deeper recession could have feedback loops on the fiscal accounts and on public debt. QUESTIONER: Have you made any prognosis on the unemployment rates?
MS. VELCULESCU: Yes, certainly. We have made these analyses. Given that we expect a deep recession, we project the unemployment rate to peak at around 17 percent in 2014 and to gradually decline thereafter.
QUESTIONER: If I may, isn't it right now about 17 percent?
MS. VELCULESCU: Our current figures, based on the Eurostat definition, are lower.
QUESTIONER: I read in a footnote that the debt sustainability is given at about 100 percent of GDP and I just wonder whether I can generalize this to other countries or what are the factors which determine such a number? And then the second question, you write that you have introduced a buffer in this debt sustainability analysis. I just wonder whether that was done in other analyses as well or whether this is specific to Cyprus because the uncertainly is so huge. And does that mean that we can be more confident about this debt sustainability analysis than we could have been with Greece, for example?
MS. VELCULESCU: On the assessment of debt sustainability, we normally look at it on a case by case basis, and analyze the specifics of each country when assessing this. In the case of Cyprus, we have looked at its own past performance with sustaining primary fiscal surpluses, and also at the cross-country experience to see how other countries going through recessions have been able to achieve surpluses so as to reduce debt.
In the case of Cyprus we assess that with the full implementation of the program, the long run debt level of close to 100 percent of GDP and on a sustained downward path could be considered sustainable. Importantly, we are looking both at the level and at the debt dynamics, as well as the vulnerability of debt to shocks.
Finally, you have raised a good point on the buffer. Indeed, as I mentioned before, the risks to the program are significant given the large uncertainty. For this reason, we have included a buffer to cover for these contingencies in case fiscal needs are higher or banking sector needs are higher, or both. This provides some cushion to allow for deviations in our macroeconomic projections.
MS. GAVIRIA: Thank you, Delia. If there are no further questions, we'll end our conference call here. Thank you all for participating. Goodbye.
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