A woman walks past an empty shop in Nicosia, Cyprus: the country plans to stabilize its banks and fix public finances with help from the IMF (photo: Katia Christodoulou/epa/Corbis)
CRISIS IN CYPRUS
The loan under the IMF’s Extended Fund Facility will help the country weather the difficult economic adjustment, and is part of a combined financing package with the European Stability Mechanism amounting to €10 billion.
In an interview with IMF Survey, Delia Velculescu, the IMF mission chief for Cyprus, explains how the loan will help Cyprus’s economy recover.
IMF Survey: What brought Cyprus into a crisis?
Velculescu: Cyprus had built up large imbalances over time. Key among them was an oversized banking sector that reached over eight times the country’s GDP, far exceeding the needs of the domestic economy. The banks had also been taking excessive risks by extending loans to an overheating domestic real estate sector and to Greek residents, and by investing in domestic and Greek government bonds. To finance these investments, they relied heavily on large and volatile foreign deposits. They began to lose money as the housing boom in Cyprus came to an abrupt halt and the Greek recession deepened. The Greek debt restructuring dealt another heavy blow to their balance sheets.
By mid-2012, the Cypriot banks became severely undercapitalized. While the government injected some capital in one of the banks, it became apparent that this was not sufficient. A due diligence analysis of the banks’ balance sheets finalized in early 2013 revealed capital needs of close to 60 percent of GDP needed to cover existing and future losses and a buffer for shocks.
But the government was not in a position to provide this level of support the banks. Its own balance sheet was weakened by lax fiscal policies, which led to high deficits and a rise in public debt to over 85 percent of GDP at the end of 2012. It also had no access to capital markets since mid-2011, when investors had started to realize that the large banking sector created a large contingent liability onto the state.
Market confidence waned, deposit outflows accelerated, and soon Cyprus was in a full blown crisis.
IMF Survey: Cyprus’s approach to solve its banking sector problem is a departure from the model we’ve seen to date, with depositors also footing the bill. Why does the IMF support this approach?
Velculescu: Cyprus is a complex and unique case, and there were no easy solutions to address all the challenges in Cyprus once it was face-to-face with this crisis.
Given the disproportionate size of the financial sector, supporting its large needs with public money would have overburdened the taxpayer and made the country’s debt unsustainable.
Direct recapitalization of the banks through the European Stability Mechanism would have been an appropriate solution, because the funds would have gone directly to banks and not added to the government’s debt. Unfortunately, this option was not available.
The resolution and restructuring of the troubled banks, with participation of unsecured bank creditors, was the only economically sound alternative that was left for Cyprus, although it had higher risks.
This solution deals with the problems of the banking sector upfront. It also achieves burden sharing and minimizes fiscal costs associated with bank resolution and recapitalization while maintaining debt sustainability.
IMF Survey: Why were capital controls introduced and how will they be removed?
Velculescu: Temporary restrictions on withdrawals and capital controls were introduced following the closure of the banking system for two weeks while the troubled banks were being resolved and restructured. The restrictions were necessary to prevent massive deposit outflows. However, it was recognized that if these are kept in place for too long, they can severely disrupt economic activity.
Therefore, the strategy has been to gradually remove restrictions and restore normal payment flows, while ensuring that banks have enough liquidity to meet their obligations. Several relaxations have already taken place, largely focused on domestic transactions and aimed at facilitating the operation of the business sector. Remaining restrictions are expected to be gradually relaxed as confidence returns.
IMF Survey: Can the country sustain their expected debt levels without official debt relief?
Velculescu: The approach in Cyprus has been to deal with the troubled banks upfront while minimizing fiscal costs, in order to preserve debt sustainability. And, indeed, debt is expected to be much lower now than if the banks had been fully recapitalized with public money. Given that the size of the banking sector has been significantly reduced, contingent liabilities onto the state have also diminished.
But, to ensure debt sustainability, the policies under the program will need to be fully and timely implemented, including by achieving the targeted primary fiscal surplus that is needed to place debt on a sustained downward path.
IMF Survey: How does the government’s economic program help the country resolve its fiscal problems?
Velculescu: Cyprus’s program tries to balance short-run concerns and long-run debt sustainability objectives. The government has already begun implementing an ambitious consolidation of seven percent of GDP over the next three years to reduce its fiscal deficit. In part, this unwinds a fiscal stimulus implemented just prior to the crisis.
But the program also recognizes that this adjustment and the recession will put a heavy burden on Cyprus’s people. There is an effort in the program to protect vulnerable groups including by targeting social spending to those who need it most. Also, time is allowed for the economic recovery to take hold before additional fiscal measures will need to be implemented. This final effort will be important to ensure that public debt can be put on a firmly declining path.
IMF Survey: Given the depth of Cyprus’s problems and the need to change the business model, are the IMF’s growth projections too optimistic?
Velculescu: The macroeconomic baseline underpinning the program takes into account several factors that are expected to affect growth in the short and medium run.
First, the fiscal measures underway are expected to affect consumption and investment through the so called fiscal multiplier. We have taken a conservative approach to the multiplier, learning lessons from other countries that have undergone fiscal adjustments during recessions.
Second, we analyzed how the recent policy actions in the banking sector would affect the behavior of domestic consumers and businesses. The elements that were considered included the level of participation of uninsured domestic depositors in bank recapitalization costs, the downsizing of the banking sector, the temporary payment restrictions, and the linkages between financial sector and other related business service sectors.
And finally, we have taken a close look at the experiences of other countries that have gone through banking crises.
Over the medium and long run, Cyprus is expected to adapt its business model and become less reliant on financial services, which had grown at an unsustainable pace in the run up to the crisis. Nevertheless, Cyprus will continue to benefit from a low corporate tax rate, favorable double-taxation treaties, a well-educated labor force, common law system, strong institutions, and relatively low structural barriers to growth. These are expected to support the service sector—in particular legal, accounting and consulting services, as well as tourism—which will drive medium-term growth. Over longer run, the prospect of exploitation of sizeable gas reserves provides upside potential.
Nevertheless, given Cyprus’s unprecedented situation, involving resolution of two large banks, imposition of capital controls, and the need to adapt the business model, macroeconomic uncertainties and risks to the outlook remain significant.
