Boston University Undergraduate Economics Association

Case Competition: The Cypriot Bailout

Written and edited by: Fadi Humaid | Daniel Currie | Cassandra Chin | Federico Mele

The following material has been written and prepared by E-Board members of the Boston University Undergraduate Economics Association (BU UEA). The case has been assembled through student research based on publicly available information and data. The material is not intended and should not be used for commercial applications. The material has been written for participants of the BU UEA Case Competition. The case is centered around a fictional event based on a current economic issue. Participants are to assume the position of economic consultants to high ranking government individuals confronted with an intricate and complex economic issue. Figures and data are based on factual, publicly available statistics. The material is to be used as a basis for the participants research. The paper is not an exhaustive composition of the economic issue. Participants are expected to perform their own due diligence and extensive research to accommodate their final recommendation.

In the Eye of the Storm Since June 2012, it has been known that Cyprus needs approximately 17 to 18 billion to recapitalize its banks (around 10 billion) and to finance general government operations including debt servicing (around 7 to 8 billion).1 Today is March 8, 2013, Michalis Sarris, Cypriot Minister of Finance, under the instruction of Cypriot Prime Minister Nicos Anastasiades, has called together a group of economic consultants to analyze the current economic situation and propose a solution to alleviate the crisis that has plagued the Cypriot economy. Although a bailout package structured with the support of the Troika, currently lead by the European Central Bank (ECB), the European Commission (EC), and the International Monetary Fund (IMF) seems to be inevitable, Nicos Anastasiades is placed in a precarious position. Not only must he consider whether to accept a package with the Troikas support, but he must also consider how the package should be structured and assess the economic and political repercussions of his decision. Thus far, various options have been considered to generate the required funding. Plans that have already been analyzed include the privatization of state assets, increases in corporate taxes (from 10% to 12.5%), withholding taxes on capital income (to 28%), and restructuring of existing bank or sovereign debt. Debt restructuring options also included a 'bail-in' of creditors (the new fashionable term for a write off of principal). It would also entail easing terms and lengthening maturities of (up to) 30 billion in loans from Russian banks to Cypriot companies of Russian origin.2 Despite the plethora of propositions, no concrete plan of action has been undertaken yet. There are a myriad of propositions and possible solutions to the current economic crisis. Michalis Sarris and Nicos Anastasiades hope that the selected group of economic consultants will aid them in demystifying the wide array of options available. They are looking for an explanation of how the current crisis has formed, a best-case bailout package to negotiate towards with the Troika, and how this package will influence the Cypriot economy. The Republic of Cyprus The Republic of Cyprus, an island country located in the Eastern Mediterranean Sea, is one the smallest countries in Europe with a population of a little over 1 million people3 and about 0.5% of the European Union GDP. Cyprus joined the European Union on May 1st, 2004 and on January 1, 2008, the euro replaced the Cyprus pound (CYP) at the conversion rate of 0.59 CYP per euro,4 making Cyprus the 14th member of the Eurozone. Cyprus is the third most populous island in the Mediterranean Sea, notorious for being a popular tourist destination and having an advanced, high income economy with a very high Human Development Index.5 [Figure 1] Cyprus estimated nominal GDP in 2012 was $24 billion and had a GDP per capita of $28,961.6 In
1

Satyajit Das, "The Case of Cyprus Another European One-Off!", The Daily Reckoning, http://www.dailyreckoning.com.au/the-case-of-cyprus-another-european-one-off/2013/03/26/. 2 Ibid. 3 Including Northern Cyprus, the UN buffer zone, and Akrotiri and Dhekelia 4 General Secretariat of the Council, "Cyprus," Eurozone Portal, http://www.eurozone.europa.eu/euro-area/euro-areamember-states/cyprus. 5 "Human Development Index (HDI)2011 Rankings," United Nations Development Programme. 6 "Report for Cyprus," International Monetary Fund.

comparison, the average nominal GDP per capita in the European Union for the same time period was $35,116. Despite the below average GDP per capita, Cyprus boasted low inequality, expressed by the low Gini index of 29, ranking it as 19th on a global scale.7 Following an aggressive austerity program aimed at paving the way for the euro, Cyprus turned a soaring fiscal deficit of 6.3% in 2003 into a surplus of 1.2%, and reduced inflation to 4.7% in 2008. 8 Although Cyprus economy grew above EU rates, the countrys economy came under pressure in 2009. Construction and tourism slowed in the face of reduced foreign demand, triggering fallout during the ongoing global financial crisis; Cyprus economy began contracting. Although Cyprus lagged behind its EU peers in showing signs of stress from the global crisis, the economy inevitably tipped into recession in 2009, contracting by 1.7%. The economy has since been slow to bounce back, posting anemic growth in 2010-11 before contracting again by 2.3% in 2012.9 Although the Cyprus economy has prospered and diversified in recent years, Cyprus is currently dominated by the service sector. Tourism, financial services, and real estate are the countrys key industries.10 The service sector contributes an estimated 78% to the countrys GDP.11 In addition, the industrial sector contributes 19% to GDP while 3% is from the agricultural sector. [Figure 2] Cyprus has based its economy on operating as an international banking center. Strictly speaking like many other financial centers, it is a low-tax jurisdiction, not a tax haven as frequently described in the press.12 For this reason, Cyprus banking sector has grown to eight times its GDP. The Cyprus population is comprised of primarily Greeks (77%), Turks (18%), and other nationalities (5%). 13 According to the World Bank, the Cyprus labor force totaled 584,452. Since 2008, the seasonally adjusted unemployment rate has risen, ultimately reaching 10.7% in March of 2012 a figure that is not as devastating as Spains, 24.1%, and Greeces, 22.1% The bulk of Cyprus population is aged between 15 and 34 [Figure 3]. With such a young population, there must be particular socioeconomic issues to contend with in the island.14 In addition, the population growth has varied over the years with a sharp decline after 1971, following the Greek and Turkish invasion of Cyprus. However, there has generally been an upward trend in population growth. [Figure 4] A Sunny Place For Shady People Cyprus' banking system is relatively large compared to the countrys GDP which is consistent with its status as an offshore financial center. To be more precise, total bank assets have grown to 896% of GDP in 2010. In comparison, the average for the EU and the Eurozone was 357% and 334%, respectively, in 2009. Even if one excludes the overseas operations of domestically-owned banks, the size of the banking system exceeds 7

Wikimedia Foundation, Inc., "List of countries by income equality," http://en.wikipedia.org/wiki/List_of_countries_by_income_equality. 8 "Cyprus," Central Intelligence Agency, www.cia.gov/library/publications/the-world-factbook/geos/cy.html. 9 Ibid. 10 Ibid. 11 Stanley St Labs, "Cyprus Economy," http://www.economywatch.com/world_economy/cyprus. 12 Satyajit Das, "The Case of Cyprus Another European One-Off!" 13 "Cyprus," Central Intelligence Agency. 14 "Cyprus Age structure," http://www.indexmundi.com/cyprus/age_structure.html.

times Cyprus GDP [Figure 5, 6, 7, 8].15 Some suspect that the scale of Cyprus financial services sector is due to its reputation as a tax haven and money laundering center for Russian businesses and British tax evaders. The UK Daily Telegraph described the island as 'a sunny place for shady people.'16 Cyprus traditionally has been a popular tax haven for Russian businesses thanks to lax rules on reporting the source of the money, which has led to accusations of money laundering.17 German media at the end of last year warned that Cypriot banks have been used to avoid taxes and launder primarily Russian money. 18 The ratings agency Moody's estimated that Russian holdings in Cypriot banks have amounted to about $31 billion. Russians are believed to have billions of euros in Cypriot accounts in amounts of 100,000 euros ($128,200) and above - 100,000 being the deposit amount insured by the Cypriot government.19 According to reports in the magazine, Newsweek, bank deposits from Russian business corporations total $60 billion out of total deposits of $120 billion. The Russian depositors are believed to be medium sized businesses, large state enterprises, oligarchs, billionaires, millionaires, and even mobsters. Despite the size of Russian deposits, BBC Russian Services has reported that sizeable Russian holdings have already been removed. However, despite the medias infatuation with the size of Cyprus banking sector relative to its GDP and the source of the funds, a number of other economies have large banking systems, involving substantial levels of offshore deposits. For example, Luxembourg's bank assets are over 21 times its GDP, Great Britain and Switzerland's bank assets are over 5 times its GDP and Malta's is comparable to Cyprus'. 20 Many Western economies, including Britain, Germany and France, have benefitted from flight capital from various parts of the world, including Russia. A number of Western banks have been found to have had illegal dealings with unsavory interests, including narcotics dealers and rogue states. In this regard, Cyprus' banking sector is not the first to deal with shady depositors. These systems grew significantly over the past decade as a result of an accommodating global environment and policy measures by national authorities aimed at promoting them as international financial centers.21 The Cypriot banking sector is primarily distinguished from other large banking sectors in two ways. First, domestically-owned credit institutions - in the form of both cooperatives and commercial banks - play an important role, accounting for 63% of total banking system assets in 2009.22 Second, even though the biggest domestically-owned banks in Cyprus are small in absolute terms, their large size as a proportion of GDP sets them apart from those of other countries.23 Other European countries do not have domestically-owned banks as large relative to their GDP as Cyprus does. Cyprus' three largest banks Bank of Cyprus, Marfin Popular Bank, and Hellenic Bank control 56% of the domestic deposits and 48% of domestic loans as of March 2011.24
15

Constantinos Stephanou, "The Banking System in Cyprus: Time to Rethink the Business Model?", http://www.ucy.ac.cy/data/ecorece/STEPHANOU_123-130.pdf. 16 Satyajit Das, "The Case of Cyprus Another European One-Off!" 17 Alec Luhn, "Russia's support for Cyprus' seizures of deposits may mean big money already out," www.foxnews.com/world/2013/03/28/russia-support-for-cyprus-seizures-deposits-may-mean-big-money-already-out/. 18 Martin Essex, "Could Cyprus Bring Down the Euro?", http://blogs.wsj.com/eurocrisis/2013/01/11/could-cyprus-bringdown-the-euro-zone/. 19 "Cyprus crisis: Moscow will not bail out Russian savers," http://www.bbc.co.uk/news/world-europe-21992745. 20 Satyajit Das, "The Case of Cyprus Another European One-Off!" 21 Constantinos Stephanou, "The Banking System in Cyprus: Time to Rethink the Business Model?", http://www.ucy.ac.cy/data/ecorece/STEPHANOU_123-130.pdf. 22 Ibid. 23 Ibid. 24 ibid.

Despite the potentially shady origins of funds, the significant expansion of Cyprus' financial sector has had a tremendously positive impact on the countrys economy, in contribution to both GDP and employment. This same growth has brought a great disadvantage to the Cypriot economy in the form of systematic risk. Given the size and the paramount importance of the financial sector, a collapse of one of the major Cypriot financial institutions would have a detrimental effect on the Cypriot financial sector and a significant spillover to the rest of Cyprus economy. While the largest Cypriot banks are too big to fail, the same banks may also prove to be too big to save, as was the case with Icelands banking sector. The bailing out and privatization of the banking sector could as well drive the Cypriot government into bankruptcy. Something Hit The Fan After the global economic meltdown, elicited by the United States' subprime mortgage crisis in 2007 - 2008, the Cypriot economy contracted by 1.67%.25 The contraction was caused by a sharp decline in the shipping and tourism sectors. Following the contraction, Cyprus experienced continuously increasing unemployment, pushing the country into a recession. Although the Cypriot recession, the increasing unemployment, and the increasing state debt in the form of expenditure on unemployment benefits contributed to a negative impact on the Cypriot financial sector, the true blow to the banking sector was the result of the European Union haircutting Greek bonds upwards of 50% in 2011.26 Many of the Cypriot banking assets that grew to be seven times the size of the countrys economy consisted of corporate, construction, and mortgage loans to the Cypriot and Greek economies, which tied the health of these banks directly to those sagging economies.27 The countrys banks had amassed 22 billion of Greek private sector debt. When those economies, most prominently Greece, plunged into recession, the banks' balance sheets began to deteriorate sharply. Soon the Cypriot banks could no longer absorb the losses. Some of the risk practices of Cypriot banks have been criticized for being egregious and speculative by nature.28 For instance, investigations in the operations of the Bank of Cyprus point out to ventures into Greek bonds that could have been avoided: Local bankers say the bank [Bank of Cyprus] had more or less sold out of its Greek bond position by early 2010 as Greeces problems became evident. But then, in late spring of 2010, as an international bailout of Greece looked increasingly likely, the Bank of Cyprus plunged back into the market, buying 2.1 billion euros, $ 2.7 billion worth of the troubled bonds, lured by the increasingly high yields that went with the risk. At the time, the bonds were trading around 70 cents on the euro, and bankers say that, in essence, when the Bank of Cyprus bought the securities, it was betting that the loss, when it occurred, would be less than the market had expected. Such a risky strategy is frequently used by hedge funds dabbling in distressed debt. But it is generally not seen as the expertise of large, deposit-reliant institutions like the Bank of Cyprus. This was pure speculation European banks like Deutsche Bank

25

Neven Valev, "Cyprus: Economy Indicators," http://www.theglobaleconomy.com/Cyprus/indicatorNY.GDP.MKTP.KD.ZG/. 26 Kai Ryssdal, "Greek bond investors take big 'haircut' in bailout deal," http://www.marketplace.org/topics/world/greekdebt-crisis/greek-bond-investors-take-big-haircut-bailout-deal. 27 Landon Thomas, Jr., "Calculating Impact of Cyprus's Bailout," http://www.nytimes.com/2013/04/01/business/global/calculating-impact-of-cypruss-bank-bailout.html. 28 Ibid.

were desperately trying to get rid of these things, said a Cypriot banker familiar with the transactions who was not authorized to speak publicly.29 In addition, Cypriot banks have much lower capital requirements compared to other international financial centers. Once Cypriot banks lost 75% of the value of their Greek bond holdings, there was little capital to cushion bank losses as the banks were becoming insolvent. By June 2012, Cypriot banks could no longer take the losses. The Cypriot government stepped in, announcing it would need 1.8 billion of foreign aid to support the Cyprus Popular Bank, and this was followed by Fitch downgrading Cyprus's credit rating to junk status.30 The downgrade was mainly due to exposure of Bank of Cyprus, Cyprus Popular Bank, and Hellenic Bank (Cyprus third largest banks) to the Greek financial crisis. In its announcement, Fitch pointed out that Cyprus would need an additional 4 billion to support its banks. Although the required bailout of the Cypriot banks is necessitated by the substantial losses on the aggressive lending expansion funded by rapid growth in deposits from international sources, the bulk of the losses resulted from write-downs to loans to the Greek government worth 160% of Cyprus' GDP of 18 billion. These write-downs were the result of the debt restructuring of Greek sovereign debt, overseen by the EU.31 Alone, the Cypriot government lacks the financial firepower to absorb the losses and recapitalize its banking sector, several times larger than its GDP. Due to the size disparity between its banking sector and Cyprus' GDP, financial markets are highly unlikely to lend 18 billion to Cyprus, which is currently in a recession. Cyprus must look towards international sovereign support, most likely from EU members, in the form of a bailout, similar to Ireland, Greece, and Spain. While this bailout may be small in nominal terms and well within EU's resources, the required bailout is large, at around 100% of Cyprus' GDP. It is unlikely that Cyprus would be able to repay it, in the absence of a dramatic change in its circumstances. The Politics No macroeconomic analysis is complete without mentioning the political environment. Cyprus has a presidential representative democratic republic framework. The elected president serves both as head of the state and head of the government. Cyprus has six major political groups: 1) Democratic Rally (DISY): A center-right party led by Prime Minister Nicos Anastasiades. The party experienced great success in the last election as the DISY won 57% of the seats, making it the widest margin of victory in decades.32 2) Progressive Party of the Working People (AKEL): A left-wing party led by Andros Kyprianou. AKEL won 19 of the possible 56 seats in the last election. 3) Democratic Party (DKO): A centrist party led by Marios Garoyian. They won 9 seats in the last election.
29 30

Ibid. "Cyprus's credit rating cut to junk status by Fitch," http://www.bbc.co.uk/news/business-18577983. 31 Satyajit Das, "The Case of Cyprus Another European One-Off!" 32 "Country Information," http://www.cyprusprofile.com/en/country-information/politics#the-political-parties.

4) Movement of Social Democracy (EDEK): A social democratic party led by Yiannakis Omirou. EDEK won 5 seats in the last election. Even though economic destruction looms over Cyprus, there is still a deep political divide between the Turkish North and the Cypriot South known as the Cyprus Problem [Figure 9] . The Turkish Republic of North Cyprus, wholly comprised of Turkish Cypriots, is only recognized by Turkey and Pakistan. Movements to solve this divide in the island have proven futile and have even previously culminated in brutal fighting. Anastasiades enjoys support among the Troika, particularly German Chancellor Angela Merkel, who gave him her endorsement.33 Even before the voting actually began, Anastasiades exclaimed at a campaign rally, "I ask from you a strong, clear mandate in order to immediately get to work covering lost ground, restoring our homeland's credibility and safeguarding our national interests within Europe's decision-making centers."34 However, the proposed bailout packages have made political party AKEL livid, indicating that Cyprus is being persecuted by other Eurozone countries.35 AKEL does want a bailout; however, the party does not condone the harsh austerity measures that the Troika demands from them since the Cyprus people would certainly suffer. With AKEL in second place and the sentiment of the people turning sour by the minute, Kyprianou may soon see his party gaining more votes. With other parties vying for more votes, it seems that any decision made concerning the crisis will have massive ramifications for Anastasiades and his party. While Anastasiades has claimed that he has only supported harsh austerity measures in order to receive the bailouts, he may be persuaded to take another option if it would lead to a desirable solution for Cyprus. Conclusion After examining the general historical, economic and political aspects of Cyprus, you, as a member of the consulting team, have been called to prepare a detailed economic analysis to take account of the following: 1) Should Cyprus accept a bailout package in the first place? 2) What specifications should be included in the bailout package to recommend to the Troika? 3) How should the bailout package be funded and who should fund it? 4) If a bailout package is not required, what should be done to solve the economic malaise, and why is this a better solution to the economic crisis? 5) Other than the possibility of your plan failing, what are the limitations of your propositions? Are there any ways to solve them? 6) What are the economic and political repercussions of your proposed bailout package? You must provide logical reasons and justifications for each of the requirements listed above. Remember that as with any economic decision, there will always be unintended consequences. In such a complicated situation with much discord, it is impossible to take into account every consequence of every decision. But, with a

33

FOX News Network, LLC, "Financial crisis will crown winner of Cyprus' presidential election," www.foxnews.com/world/2013/02/15/financial-crisis-will-crown-winner-cyprus-presidential-election. 34 Ibid. 35 Ibid.

country hanging in the balance of economic disaster, you must understand every single result of your plan. You must take all of the possible secondary effects into account when making your decisions. Good Luck!

FIGURES
1: Google Graphs, Nominal GDP of Cyprus (1976-2011)36

2: Percentage of Specific Sectors in the Economy37

Percentage of Specific Sectors in The Economy

Services Industrial 3% Agricultural

19%

78%

36
37

Google, Public Data. (n.d.). Google. Retrieved April 1, 2013, from https://www.google.com/publicdata/explore?ds=d5bncppjof8f9_&met_y=ny_gdp_mktp_cd

Stanley St Labs, "Cyprus Economy," http://www.economywatch.com/world_economy/cyprus.

3: Population Distribution of Cyprus, 201238

4: Population Growth (%), TradingEconomics.com39

38

Cyprus Age structure," http://www.indexmundi.com/cyprus/age_structure.html.

39

Population growth (annual %) in Cyprus. (n.d.). TRADING ECONOMICS | 300.000 INDICATORS FROM 196 COUNTRIES. Retrieved April 2, 2013, from http://www.tradingeconomics.com/cyprus/population-growth-annual-percent-wb-data.html

10

5: Size of Banking System for Selected Countries (end-2009)40

6: Evolution of Banking System Size for Selected Countries (2001-09)41

40 Stephanou, Constantinos. "The Banking System in Cyprus: Time to Rethink the Business Model?." Cyprus Economic Policy Review 5, no. 2 (2011): 123-130.
41

Ibid.

11

7: Size of Selected Credit Institutions to GDP (end-2010)42

42

Ibid.

12

8: Contribution of Financial Intermediation in Cyprus (2000-10)43

43

Ibid.

13

9: Aphrodites Troubled Island The Economist44

44

Cyprus's history: Aphrodite's troubled island | The Economist. (n.d.). The Economist - World News, Politics, Economics, Business & Finance. Retrieved April 2, 2013, from http://www.economist.com/node/1507398

14

Bibliography
"Country Information." Cyprus Profile. http://www.cyprusprofile.com/en/country-information/politics#the-political-parties (accessed April 1, 2013). "Cyprus." Central Intelligence Agency. www.cia.gov/library/publications/the-world-factbook/geos/cy.html (accessed April 1, 2013). "Cyprus Age structure." Index Mundi. http://www.indexmundi.com/cyprus/age_structure.html (accessed April 1, 2013). "Cyprus crisis: Moscow will not bail out Russian savers." BBC. http://www.bbc.co.uk/news/world-europe-21992745 (accessed April 1, 2013). "Cyprus's credit rating cut to junk status by Fitch." BBC. http://www.bbc.co.uk/news/business-18577983 (accessed April 1, 2013). Das, Satyajit. "The Case of Cyprus Another European One-Off!." The Daily Reckoning. http://www.dailyreckoning.com.au/the-case-of-cyprus-another-european-one-off/2013/03/26/ (accessed April 1, 2013). Essex, Martin. "Could Cyprus Bring Down the Euro?." The Wall Street Journal. http://blogs.wsj.com/eurocrisis/2013/01/11/could-cyprus-bring-down-the-euro-zone/ (accessed April 1, 2013). FOX News Network, LLC. "Financial crisis will crown winner of Cyprus' presidential election." Fox News. www.foxnews.com/world/2013/02/15/financial-crisis-will-crown-winner-cyprus-presidential-election/ (accessed January 1, 2013). General Secretariat of the Council. "Cyprus." Eurozone Portal. http://www.eurozone.europa.eu/euro-area/euro-areamember-states/cyprus/ (accessed April 1, 2013). "Human Development Index (HDI)2011 Rankings." United Nations Development Programme. Retrieved 4 November 2011. Luhn, Alec. "Russia's support for Cyprus' seizures of deposits may mean big money already out." Fox News. www.foxnews.com/world/2013/03/28/russia-support-for-cyprus-seizures-deposits-may-mean-big-money-alreadyout/ (accessed January 1, 2013). "Report for Cyprus". International Monetary Fund. Retrieved 14 March 2013 Ryssdal, Kai. "Greek bond investors take big 'haircut' in bailout deal." Marketplace. http://www.marketplace.org/topics/world/greek-debt-crisis/greek-bond-investors-take-big-haircut-bailout-deal (accessed April 1, 2013). Stanley St Labs. "Cyprus Economy." Economy Watch. http://www.economywatch.com/world_economy/cyprus/ (accessed April 1, 2013). Stephanou, Constantinos. "The Banking System in Cyprus: Time to Rethink the Business Model?." Cyprus Economic Policy Review 5, no. 2 (2011): 123-130. http://www.ucy.ac.cy/data/ecorece/STEPHANOU_123-130.pdf (accessed April 1, 2013). Thomas, Landon, Jr. "Calculating Impact of Cyprus's Bailout." The New York Times. http://www.nytimes.com/2013/04/01/business/global/calculating-impact-of-cypruss-bank-bailout.html (accessed April 1, 2013). Wikimedia Foundation, Inc.. "List of countries by income equality." Wikipedia, the free encyclopedia. http://en.wikipedia.org/wiki/List_of_countries_by_income_equality (accessed April 1, 2013). Valev, Neven. "Cyprus: Economy Indicators." TheGlobalEconomy.com. http://www.theglobaleconomy.com/Cyprus/indicator-NY.GDP.MKTP.KD.ZG/ (accessed April 1, 2013).

15