- 1 Introduction – The pre-crisis boom years
- 2 Crisis – Beginning of the programme
- 3 Restructuring of the financial sector
- 4 Budget consolidation
- 5 Structural reforms
- 6 Conclusion – Remaining challenges
1 Introduction – The pre-crisis boom years
During the decade preceding the global economic and financial crisis, Cyprus experienced an economic boom. Cyprus, which has a relatively small economy and a population of less than 1 million, posted real GDP growth of around 4% annually on average (see Figure 1), roughly twice as much as the eurozone average. This growth was mainly driven by domestic demand. Strong growth could be observed in private consumption and private investment in real estate. In the latter sector, this was partly due to foreign demand, which also led to a steep increase in real estate prices (see Figure 2). Confidence was boosted when Cyprus joined the European Union in 2004 and again when it adopted the euro in 2008. With unemployment rates below 5%, the labour market was close to full employment. Rising demand for labour was covered by a strong influx of foreign workers.
However, marked macroeconomic imbalances also built up during the boom years. In particular, the banking sector grew excessively. In 2009, banks’ total assets were equivalent to around 750% of GDP, which was more than twice as much as the eurozone average (see Figure 3). This trend was driven by an influx of foreign deposits. The strong increase in foreign deposits contributed to expansionary lending behaviour on the part of the banks, resulting in extremely high debt levels in the domestic private sector. In 2012, Cyprus’s private-sector debt amounted to around 300% of GDP (Germany: 107%, France: 141%). The current account also illustrates the role that foreign capital inflows played in the boom. Cyprus’s current account deficit became increasingly large, amounting to more than 10% of GDP from 2007 to 2009 (see Figure 4). The deteriorating current account balance was mainly due to an increase in the country’s traditional trade deficit. Being a small island economy, Cyprus imports many more goods than it exports. Furthermore, a deterioration in price competitiveness led to a decline in the balance of services surplus in the areas of tourism and business-related services.
2 Crisis – Beginning of the programme
In the course of the global economic crisis, Cyprus entered a recession in 2009. The economy shrank, although the decline in GDP of 2% was initially smaller than in the rest of the eurozone. However, this put an end to the credit-driven upturn, which was also accompanied by a decline in real estate prices.
The effects of the crisis were particularly negative for Cyprus’s banking sector, which had become extremely large. A rising number of domestic defaults on real estate loans and other loans collateralised by real estate led to significant losses. Furthermore, Cypriot banks were highly exposed to Greece. Lending activities in Greece and investments in Greek sovereign bonds would both lead to heavy losses.
The Cypriot government initially responded to the crisis by launching a stimulus package. The related expenses as well as tax revenue shortfalls caused by the recession soon led to a massive deterioration in the budgetary situation. While the general government budget had posted a surplus at the end of the boom in 2008, a deficit amounting to more than 5% of GDP was recorded in 2009. The budget deficit remained at a similar level during the following years, leading to a steep increase in public debt. Additionally, in 2012 the government had to conduct a €1.8bn recapitalisation of one of the country’s largest banks, Laiki Bank, as it was not possible to find sufficient private investors. This measure alone caused the government debt ratio to increase by 9 percentage points of GDP.
At this time, the international capital market viewed Cyprus as increasingly high risk, which was reflected in rising yields on Cypriot government bonds. Over the course of 2011, yields had increased so much that Cyprus had virtually lost access to the international capital market. From then on, the country was only able to cover its deficit temporarily through short-term internal loans and bilateral loans.
In the end, partly as a result of a further deterioration in the state of its banking sector, Cyprus reached an agreement on a macroeconomic adjustment programme with the European Stability Mechanism (ESM) and the IMF at the beginning of 2013. This programme has three objectives: first, to restore the stability of the financial sector; second, to strengthen the sustainability of public finances; and third, to support sustainable and balanced economic growth by means of structural reforms. As part of the programme, loans totalling €10bn were committed to Cyprus for the three-year period from the second quarter of 2013 to the first quarter of 2016, subject to compliance with the programme conditions. Of this amount, €9bn is being made available by the ESM while €1bn is being provided by the IMF.
3 Restructuring of the financial sector
Cyprus’s primary objective was to stabilise its banking sector, which had been weakened by high losses, in order to regain the trust of depositors. To that end, a far‑reaching restructuring and downsizing of the banking sector was agreed as part of the adjustment programme. The aim was to recapitalise banks on the basis of measures already taken by Cyprus. It was also agreed that banking supervision should be improved.
Given the amount of losses incurred, it was not possible to recapitalise the Bank of Cyprus and Laiki Bank, the country’s two largest banks in early 2013, using government funds. This would have overburdened the country’s debt sustainability. The losses had to be borne primarily by these banks’ shareholders and bondholders. In addition, there was no alternative but to involve depositors whose deposits were not guaranteed. To recapitalise the Bank of Cyprus, 47.5% of the deposits not covered by the deposit guarantee scheme were converted into shares. Before that happened, the shares of former shareholders and bondholders had been written off. The recapitalization measures were based on a balance sheet review conducted by Pacific Investment Management Company, LLC (PIMCO). In the summer of 2014, the Bank of Cyprus was able to carry out a regular capital increase by issuing new shares. Laiki Bank, in contrast, was not viable. It was therefore closed and is now being wound up. The deposits covered by a deposit guarantee scheme and the bank’s loan portfolio were both transferred to the Bank of Cyprus.
Capital shortfalls were also identified at two other banks. Private resources were used to recapitalise Hellenic Bank. The Cooperative Central Bank was recapitalised by the government with participation of the former shareholders. The European Commission approved the recapitalisation under competition law, subject to certain conditions (merger of local cooperative banks, centralised risk management).
In order to reduce the size of Cypriot banks and minimise their risks, their branches in Greece were sold. As a precautionary measure, Cyprus introduced temporary capital controls at the start of its bank restructuring programme (restrictions on transfers and withdrawals). These controls are gradually being lifted in line with progress made in implementing the adjustment programme and restoring confidence in the Cypriot banking system. The last remaining restrictions within the country were lifted at the end of May 2014. However, restrictions on cross-border transactions have not yet been completely abolished.
Cyprus has reformed its banking supervision so that it can better monitor its banks in the future. First of all, the supervision of cooperative banks, which had previously been separate, was integrated into the regular banking supervision of the Central Bank of Cyprus. The banks’ reporting obligations and liquidity requirements were made stricter. At the beginning of November 2014, the European Central Bank (ECB) assumed direct supervisory responsibility for the four largest banks of Cyprus as part of the new European Single Supervisory Mechanism. These are: the Bank of Cyprus, the Cooperative Central Bank, Hellenic Bank, and RCB Bank; the value of each bank’s total assets exceeds 20% of Cyprus’s GDP. Prior to this, the ECB subjected these four banks to a comprehensive analysis of the quality of their assets, as part of its Europe-wide Asset Quality Review, as well as to a stress test. Once capital increases at the Bank of Cyprus and the Cooperative Central Bank, which were carried out after the balance sheet date, were taken into account, the only equity gap detected was at Hellenic Bank; this has meanwhile been closed using private funds.
Currently, the main problem in the banking sector is the sharp increase in non-performing loans. According to statistics provided by the Central Bank of Cyprus, at the end of November 2014, 51.7% of all loans were affected by irregularities in interest or principal payments. Although a delayed payment by a borrower does not necessarily imply a total loss for the bank, since they might resume their regular payments or a bank could seize the loan collateral if necessary, non-performing loans do pose a significant risk to the banks. This situation is aggravated by inefficiencies in the Cypriot legal system relating to the seizure of loan collateral. This is why the programme partners have agreed with Cyprus that reforms of its insolvency and foreclosure laws will be carried out. As these reforms are currently delayed, it is not yet clear when they will come into effect. Further delays may have an adverse impact not only on the banking sector but also on the real economy, as weak banks are limited in their ability to grant loans to the real economy.
4 Budget consolidation
A key objective of the adjustment programme for Cyprus is to consolidate the government budget to ensure that government debt is sustainable. It was agreed that Cyprus would reduce its budget deficit to below the Maastricht reference value of 3% of GDP by 2016. In addition, Cyprus is to generate a primary surplus (based on the budgetary balance excluding interest expenditure) of 4% of GDP by 2018 and beyond in order to reduce the level of public debt.
Cyprus has taken a variety of measures to reduce expenditure and increase revenue in an effort to consolidate its budget, with measures on the expenditure side prevailing.
Measures aimed at reducing spending predominantly affected the public sector and social expenditures, and a pension reform was carried out. Expenditure related to the public sector, which is above average compared with the rest of Europe, was reduced by means of staff reductions and wage cuts based on a sliding scale according to income. Social spending has been reoriented to focus more on genuinely needy individuals. Moreover, a pension reform is helping to improve the long-term sustainability of public finances.
A number of taxes and levies were increased with the aim of generating more revenue: Excise duties on alcohol, tobacco, and mineral oil were raised, as were real estate taxes and fees for public services. The basic rate of VAT was gradually increased by a total of 2 percentage points to 19%. In addition, corporation tax on company profits was increased by 2.5 percentage points to 12.5%. The flat-rate tax on interest income and the levy imposed by banks on deposits were also raised.
As a result, Cyprus reduced its budget deficit from 5.8% to 3.0% of GDP between 2012 and 2014 (see Figure 5). This is a substantial reduction when one considers the severe recession during this period, when GDP shrank by 5.4% in 2013 and by 2.8% in 2014, and the associated negative impact on tax revenues and increased spending on unemployment benefits and other social benefits. Current expenditure alone was reduced by 9.5% within these two years.
A look at Cyprus’s government debt levels reveals that the country needs to continue on its course of budget consolidation. While the government debt ratio fell to approximately 45% of GDP during the pre-crisis boom in 2008 (see Figure 6), it rose sharply afterwards to reach 107% of GDP in 2014. The European Commission expects the debt ratio to be 115% of GDP in 2015, and assumes that the debt ratio will not start to fall until the following year.
To make medium-term budget planning more reliable, Cyprus has developed a new legal framework for budgeting, including rules for medium-term budgetary planning. In addition, an independent Fiscal Council equipped with its own staff was set up to conduct objective analysis of budgetary policy.
5 Structural reforms
Cyprus is implementing a large number of structural reforms to strengthen the economy’s growth potential and boost employment. These reforms will also help secure the sustainability of public finances. Three comprehensive reforms are being undertaken in the areas of the tax administration, pensions and social assistance.
In order to increase the efficiency of tax collection, Cyprus has merged the previously separate VAT administration and the administration for all other taxes into one government authority, which is headed by a tax commissioner appointed for a five-year term (which can be renewed once). This also allowed all taxpayer information to be consolidated, thus facilitating tax collection.
Cyprus intends to implement a real property tax reform, which will include updating the tax base. Currently, the tax is based on property values from 1980. However, the authorities have now assessed the property values for 2013, which will form the future basis for the assessment of real property tax.
Cyprus implemented a pension reform to enhance the financial sustainability of the pension system. In the case of individuals taking early retirement, a deduction on pensions of 0.5% per month of early retirement was introduced. The minimum age for drawing a full pension will be gradually raised until it corresponds to the statutory retirement age. The minimum period of employment required for receiving a pension will be gradually increased from 10 to 15 years. Finally, the Cypriot government decided that, starting in 2018, the statutory retirement age will rise automatically in line with increases in life expectancy.
In 2014, Cyprus introduced uniform, means-tested basic income support, partly as a result of increased unemployment. Monetary benefits will be supplemented by improved active labour market policy measures, such as job application training and other training designed to support participants in finding employment. Participation in these measures will be mandatory. Another reform objective is to simplify administrative procedures and increase efficiency. A large number of existing social benefits, which were often not very targeted, overlapped in places and were also administered by different ministries, have been replaced by uniform benefits administered by the Ministry of Labour and Social Insurance.
Enhancing Cyprus’s competitiveness
Cyprus’s attractiveness as a business location is influenced by a range of factors. Thus, the relevant reforms often focus on specific details and will achieve their desired effect mainly in combination. Regulated professions will be liberalised on the basis of the EU’s Services Directive and competition authorities will be strengthened. Reforms aimed at improving efficiency in the area of land registration are currently underway. Cyprus plans to conduct a comprehensive privatisation programme, which will mainly involve the Cyprus Telecommunication Authority, the national electricity supplier and the port administration.
6 Conclusion – Remaining challenges
Now that almost two years have passed since the adoption of the three-year adjustment programme, it is possible to draw a number of interim conclusions.
Cyprus quickly took decisive measures to stabilise the financial sector. Banks were recapitalised and one bank was closed. The banking sector has been downsized and the four major Cypriot banks have been placed under the direct supervision of the ECB. Currently, the most pressing issue is the high proportion of non-performing loans, which is why the reforms of the legal framework for foreclosure and insolvency need to be completed as quickly as possible. If further progress is made in stabilising the financial market, Cyprus will be able to lift the remaining capital controls.
Last year, Cyprus managed to swiftly bring down its budget deficit to the Maastricht reference value of 3% of GDP, something it achieved faster than anticipated. In order to reduce the high level of government debt, Cyprus needs to maintain a primary surplus in the long term. To achieve this, the government will need to implement further budget consolidation measures.
Progress in structural reforms has been more uneven. Some reforms were implemented quickly, such as the pension or social benefits reforms. The success of other reforms, however, cannot be assessed as yet. In the area of privatisation, some preparatory measures have been undertaken, but no major privatisations have been carried out to date. Delays and resistance have been encountered primarily with regard to the reforms in the real estate sector, such as the foreclosure and real property tax reforms.
Cyprus’s economy has reached a turning point. The severe economic downturn, which lasted for several years, is over. The European Commission projects that Cyprus’s economy will return to growth in 2015, even if GDP will only increase by a small amount. It should be noted that real GDP in 2014 was 10% lower than at its peak in 2008. Thus, it will take some time for the country’s GDP to return to its pre-crisis level. The unemployment rate is declining slowly, but is still very high at 16.4%. Both opportunities and risks exist in terms of the future course of Cyprus’s economy, which is subject to greater cyclical fluctuations than other countries. Nonetheless, high qualification levels and a widespread knowledge of English are a distinct advantage for the Cypriot economy with its strong service orientation. For 2016, the programme partners expect a growth rate of 1.6%, if the structural reforms are implemented as agreed. An internal risk is the emergence of reform fatigue, while an external risk is associated with developments in Russia, Cyprus’s second most important market for service exports after the United Kingdom.
Overall, Cyprus has made good progress to date in implementing its reform programme. If it continues to carry out the agreed reforms during the last year of its adjustment programme and beyond, Cyprus has good prospects of returning to sustainable growth and sound public finances.