ΣΧΕΤΙΚΑ ΑΡΘΡΑ
By George C. Georgiou
The Cyprus Economic Problem
Cyprus has existed as a potential flashpoint of international conflict from the very beginning of its existence as an independent nation in 1960, when its anticolonial liberation struggle from Britain by the 80 percent Greek majority failed to achieve its national aspirations for enosis (union with Greece). Enosis failed in the face of fierce opposition from Turkey, acting as protector of the 18 percent Turkish minority on the Island, and by the lackluster enthusiasm of Britain, whose age-old policy of “divide and rule” had served its foreign interest for decades.
While the economic problems of this small island economy in the eastern Mediterranean have paralleled its rollercoaster political problems, until the present banking and sovereign debt crisis it was always thought that the real threat Cyprus posed for the international community rose from the conflicting nationalistic interests of Greece and Turkey. Other interested parties included not only Britain but, by extension, a wider set of Cold War–era players, beginning with the United States and the North Atlantic Treaty Organization, on the one hand, and the then Soviet Union (now Russia), on the other hand, each eyeing closely this important piece of real estate in eastern Mediterranean. Along the way, additional interested parties were drawn into the fray including the United Nations and more recently the European Union, after Cyprus first became a full member in 2004 and subsequently adopted the euro currency in 2008.
At the time of independence in 1960 the Cypriot economy, although battered by the effect of the anticolonial liberation struggle against British rule from 1955–59, was in relatively good shape thanks to British outlays in terms of building up Cyprus’s civilian infrastructure.[1] The early years following Cyprus’s independence saw remarkable economic progress, in spite of intercommunal clashes in 1963–64 and 1967, as the economy moved from one based primarily on import-substitution manufacturing to a more export- and service-oriented one focused on tourism and banking. This brief post independence economic miracle in Cyprus came to an abrupt halt in July 1974 when Turkey invaded the island, purportedly to restore constitutional order following the coup carried out by the military junta then ruling Greece with the collusion of Greek-Cypriot collaborators on the island. The economic consequences of the Turkish invasion and subsequent occupation of approximately one-third of the island were catastrophic, resulting in the displacement of one-third of the population, the contraction of the economy by two-thirds, and the separation of the historically intermingled Greek- and Turkish-Cypriot ethnic communities into two separate geographic entities.[2]
In 1983 the Turkish-occupied northern area instigated an attempted secession through a declaration of unilateral independence, calling itself the “Turkish Republic of Northern Cyprus” (TRNC), which has since been recognized only by Turkey. The Greek-dominated and internationally recognized Republic of Cyprus has since managed to restructure its economy after the loss of the most productive and resource-rich northern areas by investing heavily in tourism, banking, shipping, and financial services. The per capita gross domestic product (GDP) of the Republic of Cyprus reached $23,735 in 2004 when it became a full member of the EU, while the north lagged behind, internationally isolated and subsidized heavily by Turkey, managing at best a per capita GDP one-third that of the more dynamic and prosperous south.[3] The 2004 Treaty of Accession to the EU encompasses the Republic of Cyprus, with provision for the suspension of the application of the acquis in the northern Turkish-occupied part of the Island, to be lifted when the island is reunited.[4]
In 2008, Cyprus became the fourteenth member state of the EU to join the eurozone, adopting the euro currency and abandoning the Cypriot pound. It appeared at the time that the economic success story of the Republic of Cyprus, together with its accession to the EU, was a palatable alternative to, if not full compensation for, the political and social cost of the “Cyprus problem” that had plagued this small island nation since its creation in 1960. By 2008 the per capita GDP had risen to $29,400 in the republic, while in the Turkish occupied north the figure continued to remain at approximately one-third of that.[5] Unfortunately, the jubilation of the Greek-dominated Republic of Cyprus resulting from its accession to the EU and the adoption of the euro would be short lived.
The Cyprus Problem Takes a Turn
Just as the Cyprus problem had begun to take on a perennial nature, to the point of being abandoned by the international community as one of those intractable conflicts that had no plausible resolution, the picture began to change quickly, taking many astute international observers by surprise. The surprise did not come from the political arena or entail a possible breakthrough in the interminable UN-sponsored intercommunal discussions that have been held on-and-off for decades; it came from the economic arena.
The economy of Cyprus can generally be characterized as small, open, and dynamic, with services constituting its engine of growth. For the most part the economy since Cyprus’s independence is what would be considered in the economic literature a success story. More recently, with the accession of Cyprus to the EU in 2004 and the subsequent preparation to adopt the euro in 2008, wide-ranging structural reforms were promoted covering the areas of competition, the financial sector, and the enterprise sector. Interest rates had been liberalized and price controls had been lifted, together with full liberalization of the foreign direct investment (FDI) regime.
The service sector of the economy was the fastest growing sector and accounted for about 80.5 percent of GDP in 2011. This reflects the gradual restructuring of the Cyprus economy from an exporter of minerals and agricultural products from 1960 to 1974 to an exporter of light manufactured goods through the early part of the 1980s and to an international tourist, banking, shipping, and financial services center since then. The manufacturing sector accounted for about 17.1 percent of GDP in 2011, while the primary sector (agriculture and fishing) continued to shrink, reaching 2.4 percent of GDP in 2011. The economy of Cyprus is open, with a share of total imports and exports to GDP of over 90 percent. The major trading partners of Cyprus are Greece, UK, Germany, and Israel.[6]
For a number of years leading up to the financial crisis starting in 2012, Cyprus had been experiencing rising living standards, as shown by the high level of real economic convergence with the EU, with the per capita GDP standing at around 92 percent of the average for the EU27 in 2011. Erratic growth rates over the previous decade, however, have reflected the economy’s reliance on tourism, the profitability of which fluctuated with political instability in the region and economic conditions in Western Europe. Nevertheless, the economy had grown at a rate well above the EU average since 2000. An aggressive austerity program in the preceding years, aimed at paving the way for the euro, helped turn a deteriorating fiscal deficit (6.3 percent in 2003) into a surplus of 1.2 percent in 2008 and reduced inflation to 4.7 percent. This prosperity came under pressure in 2009, as construction and tourism slowed in the face of reduced foreign demand triggered by the ongoing global financial crisis. Although Cyprus lagged behind its EU peers in showing signs of stress from the crisis, the economy slipped into recession in 2009, contracting by 1.7 percent and posting anemic growth in 2010–11 before contracting again by 2.3 percent in 2012.[7]
Serious problems surfaced in the Cypriot banking and financial sector in early 2011 as the Greek fiscal crisis and eurozone debt crisis deepened. Indeed, Cyprus’s borrowing costs rose steadily because of its exposure to Greek debt. Two of Cyprus’s biggest banks (Bank of Cyprus and Cyprus Popular Bank, known on the island as Laiki Bank) were among the largest holders of Greek bonds in Europe and had a substantial presence in Greece through bank branches and subsidiaries. Cyprus experienced numerous downgrades of its credit rating in 2012 and has since been cut off from international money markets. The Cyprus economy contracted in 2012 following the 70 percent write-down of Greek bonds held by Cypriot banks. A liquidity squeeze ensued, choking the financial sector and the real economy, as many global investors were uncertain whether the Cypriot economy could survive the Greek debt crisis and the resulting losses to Cypriot banks. The budget deficit rose to 7.4 percent of GDP in 2011, a violation of the EU’s budget deficit criteria, which had been set at no more than 3 percent of GDP. In response to the country’s deteriorating finances and serious risk of contagion from the Greek debt crisis, the Cypriot government implemented measures to cut the cost of the state payroll, curb tax evasion, and revamp social benefits and trimmed the deficit to 4.2 percent of GDP in 2012. These measures, however, proved inadequate, and in June 2012 Cyprus became the fifth eurozone government to request an economic bailout program from the European Commission, the European Central Bank (ECB), and the International Monetary Fund (IMF)—known collectively as the Troika or Eurogroup.[8]
Negotiations over the final details of the bailout plan dragged on and proved difficult due not only to the seriousness of the Cyprus financial crisis but also to political considerations in both Cyprus and other EU member nations. Although Cyprus requested assistance from the Troika in June 2012, it was not until March 2013 that an initial agreement materialized, with Cyprus’s financial situation continuing to deteriorate. Without an international bailout there was no doubt that the Cypriot banking sector would collapse, and Cyprus’s bank assets being approximately seven to eight times the size of the economy, Cyprus itself would inevitably slide into default. The apparent lack of urgency on the part of the Troika leading up to the 16 March 2013 initial bailout agreement was more political than economic, with most of the hesitation coming from the governments of Germany, France, Austria, Netherlands, and Finland. German officials, in particular, had questioned the necessity of bailing out a small island economy that represents no more than 0.2 percent of eurozone output, arguing that such a small-scale sovereign default would not present a systemic risk to the eurozone. According to this argument, Cyprus was not eligible for aid unless it threatened contagion and hence the stability of the entire euro region.[9]
In stark contrast, the ECB’s position was that the approximately 17 billion euro cost of a Cyprus bailout was a small amount to pay for the peace of mind it would bring to a eurozone still recovering from the much larger bailouts of Ireland, Portugal, Spain, and especially Greece, which is directly linked to the Cyprus financial crisis. After all, it is a fact that the holdings of Cypriot banks were out of proportion to Cyprus’s economy, that Cypriot banks were overloaded with Greek debt, and that the Greek debt suffered a 70 percent haircut that ultimately led to the Cypriot banking crisis. Unlike Greece, which experienced a true sovereign debt crisis, the Cyprus crisis is primarily a banking problem. However, since the Cypriot banking sector is such a large multiple of Cyprus’s GDP, it is concurrently a sovereign debt problem. Any bailout of Cyprus, therefore, would be a bailout of the private banking sector, and vice versa.
Thus, the main reason for the reluctance of German and other Northern European governments to be more forthcoming with aid for a fellow eurozone member, as they had done in prior cases, was primarily political. It was, first, so as not to be seen as using German taxpayers’ money to aid private banks that had grown too big for their own good. Second, it would not be politically astute, particularly in an election year in Germany, to appear to be bailing out reckless foreign banks, especially whose main depositors are non-German, non-EU nationals and are primarily Russian. A German intelligence report sent to the German Bundestag in November 2012 put the amount of Russian deposits in Cyprus banks at 26 billion euros.[10] A similar estimate was also given by Moody’s Investors Service.[11] The appearance that German taxpayers would somehow be rescuing Russian deposits in offshore banks in Cyprus would be too risky, especially with German elections scheduled for September 2013. Third, the fact that the German media is full of allegations that many of these Russian bank deposits are the product of money laundering, or of tax avoidance if not outright tax evasion, did not help matters. Consequently, it had been made clear to Cyprus that the memorandum for assistance to the country would include a section on money laundering, which would set out measures that Cyprus must examine on the issue, and Cyprus’s progress would be monitored. Fourth, it is also known that these primarily northern eurozone states want taxes in the EU to be brought into line upward so they are closer to their own levels. They are afraid that lower taxes in places such as Cyprus, Luxembourg, and Ireland attract foreign capital flows and act as a source of tax evasion. Consequently, they are seeking closer EU cooperation on tax evasion and see an opportunity to squeeze countries such as Cyprus to reduce legal loop holes for tax evasion. Unfortunately, no clear distinction is made between tax avoidance and tax evasion and, by extension, money laundering allegations.[12] Last, it was just not acceptable to the well-balanced and diversified economies of Northern Europe that the financial or banking sector of a member nation of the EU could possibly be seven to eight times the size of a member state’s economy. It was thought, therefore, that such an overweight sector must be cut down to size, namely, the weighted size of the EU average, which is at most three times the size of the national economy.
The Bailout Turns Into a Bail-In
Although all of the above was common knowledge leading up to the initial bailout agreement of 16 March 2013, the actual terms were a shock not only to Cyprus but to the financial markets and many international observers. Cyprus had officially requested 17 billion euros in June 2012, but the eurozone finance ministers reached a deal to provide only 10 billion euros in bailout funds with an additional 5.8 billion euros to be generated by a bank deposit tax or a so-called haircut in current jargon. This one-off or one-time tax on bank deposits would take 6.75 percent from insured deposits of 100,000 euros or less, and 9.9 percent from uninsured amounts above 100,000 euros. Once the details of this bailout or bail-in, as it has come to be called, were made public, turmoil ensued in both Cyprus and beyond, resulting in significant push back by various stakeholders, including an unprecedented unanimous rejection of the initial bailout agreement by the fifty-six-member Cypriot Assembly.
What was most striking and a first in modern banking times is that, according to the terms of the bailout agreement, all bank deposits would bear the brunt of the haircut. The explanation for this first in modern banking history is that Cypriot banks have relatively few bondholders and someone had to shoulder the losses. The Cypriot banks hold close to 70 billion euros in deposits, and almost half of the deposits are believed to be from nonresident Russian citizens, with Russian banks having $12 billion and Russian corporations about $19 billion [Ed.1] at the end of 2012, according to Moody’s, the rating agency.[13] According to the initial agreement, Cyprus had also agreed to raise the country’s nominal corporate tax rate, the lowest in Europe, from 10.0 percent to 12.5 percent. Thus, unlike other previous euro bailouts, Cyprus would not be given a debt haircut but a deposit haircut instead.[14]
Once the Cypriot Assembly rejected the initial bailout/bail-in offer, the race was on to reach a solution to what was turning out to be a bigger problem than any of the negotiating parties had bargained for. The Eurogroup made it clear to Cyprus that it was up to the country to come up with the 5.8 billion euro bail-in part of the agreement. Cyprus dispatched its newly appointed finance minister, Michael Sarris, to Moscow to seek assistance from Russia. The form of this assistance might be in the form of leniency regarding the terms of a 2011 loan from Russia in the amount of 2.5 billion euros, either by extending the loan or reducing the interest rate. It might be in the form of a Russian investment (thus recapitalization) in either Cyprus Popular Bank or the Bank of Cyprus. Other scenarios included the granting to Russian firms development rights to Cyprus natural gas and oil deposits or even possibly the granting of a naval base for Russia on the island. Given the significant stake Russian nationals and Russian firms have in Cypriot banks, it was a surprise to many that Russia rejected all offers and sent Sarris back to Cyprus with advice no doubt to make peace with the Europeans. The Cypriot authorities were now obliged to rethink their previous rejection of the initial bailout offer.
The whole episode would resemble a soap opera were it not for the resulting financial crisis that extended across all of Europe and impacted markets in both the United States and Asia, an indication of how financially interconnected the global markets have become, when a small country of 1.1 million people can affect not only the eurozone, the EU, and Russia but also markets as far away as the United States and Japan. In the end, the Cypriots got a revised deal but were the worse for it, as was the eurozone, and the EU came out of this whole saga bruised and weakened with its whole banking and monetary system being questioned.
Faced with an ultimatum from the ECB that emergency funding to Cypriot banks would be terminated Monday, 25 March 2013, and from a take-it-or-leave-it attitude from the Eurogroup, Cyprus agreed to the terms of a revised bailout in the early hours of that day. Unlike the initial agreement of 16 March, all bank deposits of less than 100,000 euros would be guaranteed, but it would come at the cost of agreeing to a shut-down of Cyprus’s second largest bank, Cyprus Popular Bank, with all deposits of less than 100,000 euros being transferred to Bank of Cyprus (Cyprus’s “good bank”) and all of Laiki’s nonperforming loans and deposits in excess of 100,000 euros being labeled toxic assets and separated into a “bad bank” for timely liquidation. Bondholders and shareholders are also set to lose. As of April 2013, the Bank of Cyprus will stay in business subject to restructuring and downsizing, if not dismantling, by ceding the operations of all its branches in Greece to Greek banks. Bank of Cyprus would also have to accept a one-off levy (haircut) on bank deposits exceeding 100,000 euros, estimated initially at a rate of at least 20 to 40 percent, although revised estimates now put that number as high as 60 percent, as needed, as the uninsured deposits in Laiki in excess of 100,000 euros fall far short of the 5.8 billion euros demanded by the Eurogroup. In addition, Bank of Cyprus will take over the 9 billion euros of Emergency Liquidity Assistance that the ECB has provided to Laiki. Implementation of the terms of this agreement would of course be coupled with short-term capital controls and other administrative regulations as needed.[15]
It was clear from the 28 March 2013 bailout agreement that the Cypriot economy would contract severely, matching if not surpassing the contraction of the Greek economy resulting from its bailout agreement. However, it was not long before another bombshell fell, when the terms of the agreement were “updated” at a meeting of the seventeen finance ministers of the eurozone in Dublin on 12 April 2013 to reflect a more detailed “debt sustainability analysis,” which showed that the economy would do worse than initially expected. In order to keep its debt and deficit from spinning out of control and to meet the terms of the 10 billion euro bailout secured just two weeks earlier, Cyprus would need a total of 23 billion euros of financing rather than the 17 billion euros, of which Cyprus would have to contribute 13 billion euros.
In so doing, Cyprus also agreed to sell 400 million euros of its gold reserves, or an estimated ten tons from its thirteen-ton reserve, renegotiate the terms of its 2.5 billion euro loan with Russia, and impose further losses on Bank of Cyprus depositors and creditors. It was suggested that holders of Cypriot government bonds could also be urged to agree to a debt swap (haircut). Dutch finance minister Jeroen Dijsselbloem and German finance minister Wolfgang Schauble made it clear that the extent of aid from the Eurogroup would remain at 10 billion euros, of which 9 billion would come from the ECB and the remaining 1 billion from the IMF.
No doubt the repercussions of the terms of the March 2013 bailout agreement will be far reaching, as this is the first time that bank depositors have been asked to shoulder any of the losses of bank failures. While euro officials have been quick to claim that Cyprus is a unique case and that depositors’ money is safe no matter what the circumstances, it would appear contrary to the ECB’s efforts over the past three years to reassure financial markets and depositors that the European Banking System is sound and depositors have no safer place to keep their money. Cyprus may be small in just about all respects from a global perspective, but it is once again living up to its reputation as a potential flashpoint of regional if not global significance, especially as global integration makes contagion more the norm. It remains to be seen if a eurowide unified banking system is feasible if it is perceived that there is a double standard as far as the integrity of bank deposits is concerned. This will only add to the perception that not all eurozone member states are equal, as well as the perception of a growing north-south rift in the zone.
Economic Consequences of the Bailout Agreement
From a financial or banking perspective, the Cyprus bailout agreement presents numerous problems that go well beyond the shores of this small island nation. First, the initial agreement, which Cypriot lawmakers rejected, would have called on all depositors, both insured and noninsured, to bear the brunt of the losses of failed banks. The final agreement, negotiated ten days later, still called on uninsured depositors to bear the majority of losses. This creates a dangerous precedent for future banking crises. Bank deposits have been guaranteed through state-sponsored insurance mechanisms ever since the massive bank failures following the US stock market crash of 1929. In the United States, for example, bank deposits are insured through the Federal Deposit Insurance Corporation (FDIC), presently up to $250,000 per account. In the EU, bank deposits are now guaranteed up to 100,000 euros per account. In fact, in the case of the FDIC, deposit accounts have been covered in full when banks fail no matter what the size of the deposits ever since the inception of the program in 1933. This is just an indication of how important banking authorities believe it is to maintain confidence in their nation’s banking system and the integrity of their nation’s money supply. In the case of Cyprus it is clear, based on the initial bailout agreement of 16 March 2013, that the euro group was prepared to violate this fundamental principle of modern banking. It now remains to be seen if the Cypriot case is a template for future bailouts as Dutch finance minister Dijsselbloem suggested in an interview with Reuters and the Financial Times, when he indicated that future bank rescues on the continent might follow the Cyprus model and penalize large depositors. He quickly retracted his comments after they instantly damaged confidence in other European banks and sent stocks tumbling across Europe.[16] It was later claimed by the Eurogroup, that the Cyprus case was unique and was not a prescription for future bailouts, but observers remain skeptical and time will tell whether bondholders and depositors will now both be called upon to shoulder the risk of future bank failures.
Second, the risk of contagion has not been eradicated by the Cyprus agreement as intended, but in fact the agreement has stoked fear and uncertainty. In none of the prior bailouts for Ireland, Greece, Portugal, and Spain were depositors called upon to pay for the mistakes of the banks. It was this fact that prevented the run on banks witnessed before bank deposit insurance was introduced. If bank authorities and politicians can change the law in such a manner, then nobody’s money is safe from the tax collector. Citizens’ private property can be confiscated at will. With the seed of uncertainty planted by this agreement it is highly likely that the contagion will be more likely in other vulnerable and, more important, larger countries such as Spain or Italy at the hint of another banking crisis.
Third, the concept of a single euro currency has in principle been violated even if it proves temporary. Banks in Cyprus were closed from 16 to 27 March (twelve days). During that period, euros in bank accounts in Cyprus were inaccessible, meaning that they were not the same as euros in other euro countries. Even when banks opened their doors for business on 28 March, bank controls were imposed to prevent runs on banks and to prevent mass outflows of deposits not only from banks but also out of the country. Until full freedom of movement of capital flows is restored, a euro in Cyprus cannot be considered the same as a euro in the rest of Europe. No doubt, with or without capital controls, there will be a significant outflow of capital from Cyprus, which will further weaken the already critically wounded Cypriot banking sector.
Fourth, the Cyprus banking sector was deemed by the Eurogroup to be “oversized” or out of proportion to the size of the Cyprus economy. But this concern does not hold water if the purported intent and current policy of the Eurogroup is a unified European banking system with a single currency (euro), one central bank (ECB), and a Europe-wide monetary policy. In that case, the size of the banking sector in Cyprus should be viewed in terms of the eurozone economy as a whole. In that context, the Cyprus banking sector is quite small and the Cyprus banking model is both viable and in fact a success story, except that Cyprus banks miscalculated when they put all their eggs in one very risky basket of Greek government bonds. Of course, this is a major violation of the first rule of traditionally conservative bank management, but that has to do with bad investment behavior of individual players or decision makers and not the Cyprus banking model per se, which sought offshore deposits by offering very competitive rates. During the banking crisis of 2008–9 in the United States, numerous banks, including many that were considered “too big to fail,” were under great stress due to equally bad investment and loan decisions. They have all come under much criticism but have all been rescued by the US government exactly because they are too big to fail, meaning that to let them fail would endanger not only the whole banking and financial system of the United States but also the whole economy. Thus to save Main Street the US government had to save Wall Street. Unfortunately, the Eurogroup did not consider the Main Street of Cyprus worth saving, and that does not bode well for the Main Street of Portugal tomorrow or possibly that of Spain, Italy, or any other EU member.
Fifth, the corporate tax rate adopted by Cyprus is relatively low in comparison to the rest of the EU, and in particular the Northern European countries such as Germany, Finland or Holland. Cyprus had adopted a 10 percent corporate tax rate in an effort to diversify its economy from its dependence on tourism, as it had very little else going for it, especially following the economic catastrophe resulting from the Turkish invasion in 1974 and the ensuing Turkish occupation. In that regard it was a successful economic strategy as outlined above. Unfortunately for Cyprus, its corporate tax policy was misaligned with the general tax policy of the major northern EU members, of which Germany was the most vocal. The fact that it was not just Russian corporations that flocked to Cyprus but many EU corporations, including German, Scandinavian, French, Dutch, and English companies, did not help the Cypriot position. But again, the domestic tax regime of states within a federal union is a matter of states’ rights. For example, the US federal government cannot dictate to California or Rhode Island what their state income tax rates or sales tax rates ought to be. Unless there is some violation of the federal constitution or federal laws, this is not a reason for punishment. Nonetheless, in the end, Cyprus had to accept measures that “include the increase of the withholding tax on capital income and of the statutory corporate income tax rate” for the purpose of reducing its budget deficit and helping to cover its share (5.8 billion euros) of the bailout.[17]
Sixth, there is the perception of a double-standard at multiple levels. The terms of the bailout agreement make it clear that the Cypriot banking sector is too large for the size of the Cypriot economy and needs to be curtailed. This of course is a bogus argument given the fact that other EU nations have large banking sectors, including Luxemburg, Ireland, and the UK. No one is suggesting to those countries that they should stop accepting bank deposits or that they should drastically shrink the size of their banking sectors. It appears that the real issue for the Eurogroup and Germany, in particular, is not so much the size of the Cypriot banking sector per se but the nationality of the bank depositors and the reason for these large deposits. It is understood that at least a third if not half of bank deposits in Cyprus banks are held by Russian nationals or Russian corporations. What purpose would such large deposits in Cyprus banks have other than to avoid taxes or to be laundered back into Russia as new FDI and possibly enjoy additional unwarranted tax benefits? The idea that German taxpayers’ money was flowing to Russian oligarchs was a development no German politician wished to face, especially in a closely fought election year. The fact that tax avoidance is not a crime and that do evidence of tax evasion was presented goes without saying.
Finally, the bailout terms of this agreement are likely to come back to haunt not only Cyprus, which will be thrown into a deep economic depression, but the EU as a whole. As already mentioned, the services sector of the Cypriot economy exceeds 80 percent of GDP, and the banking sector makes up most of this sector. There is no other sector of the Cypriot economy that can take its place for the foreseeable future. If the sovereign debt crisis of Greece resulted in a contraction of 25–30 percent of its GDP up to the present, the contraction in Cyprus is likely to be much greater. Consequently, the debt-to-GDP ratio is undoubtedly going to rise, making its serviceability less viable, which was one of the main reasons the Eurogroup insisted on providing only 10 billion euros in funds with the remaining 5.8 billion euros coming from Cypriot bank deposits. The purpose of this formula was to save Cyprus from permanent and unsustainable indebtedness. However, if Cyprus’s GDP contracts as predicted, the debt-to-GDP ratio will increase even further and become unmanageable unless depositors are subjected to additional haircuts, which would further contract GDP. If developments move in this direction, the Cyprus economy will surely implode and the Eurogroup will face the possibility of having to provide a second bailout—this time a “real” one, as another ‘bail-in’ by depositors would be self-defeating.
An Energy Solution?
Newly elected Cyprus president Nicos Anastasiades appealed to Cypriots the day after the terms of the initial bailout were made public to accept the levy on bank deposits as the least painful solution. He went on to say that depositors would be offered bank shares covering the full amount of their losses, while those who left their savings in banks for another two years would be rewarded with bonds backed by future income from exploiting Cyprus’s natural gas deposits. It is not clear if these were off-the-cuff remarks of a recently elected politician or actual policy prescriptions. What is clear is that no one expected the backlash that would ensue, not only from Cypriot bank depositors but also from European financial markets and beyond. Furthermore, what is also clear is that if Cypriot banks, which have represented the country’s most important sector and economic engine in recent decades, are to be downsized and if all the restrictions and conditions imposed on Cyprus through the present bailout agreement are fully implemented, it is unlikely that Cyprus will survive as a regional financial center. In fact the whole purpose of the exercise was to put an end to the Cyprus banking model, once and for all. Furthermore, given that the present terms of the proposed bailout agreement are onerous and are predicted to result in a recession at least as severe as that of Greece, there is always the possibility that Cyprus might be forced out of the eurozone or that a second bailout will be required down the road. In that case, Cyprus’s only hope will lie with future development of its oil and natural gas resources.
When Cyprus discovered natural gas in 2011 in the Aphrodite field, an area adjoining Israel’s Leviathan find and estimated at 5 billion to 8 trillion cubic feet, the prospect of a joint exploration with Israel of oil and gas in the Levant Basin, now totaling an estimated 30 trillion to 35 trillion cubic feet, brought the two countries closer together.[18] The United States Geological Survey has estimated the natural gas reserves of the whole Levant Basin at 122 trillion cubic feet, enough to supply the world at the present rate of consumption for one year.[19] The recent partnership of Cyprus and Israel now includes very close collaboration on military, cultural, and political matters. Given the inherent dangers of alliances of smaller and weaker nations with more powerful nations that inevitably have broader national interests, one wonders if it is prudent for Cyprus to enter such a relationship. However, given the recent financial and banking problems facing Cyprus, it might no longer be a matter of choice but of national necessity.
The potential future revenue flows from the exploitation of offshore natural gas reserves came into play again when Cypriot finance minister Sarris was in Moscow a few days after the Cypriot General Assembly unanimously rejected the Eurogroup’s initial bailout offer. He suggested a role for Russia in Cyprus’s energy development in return for Russian aid with the bailout efforts. The initial Russian response was unexpectedly negative, even though Russian nationals represent at least a third and possibly up to half of bank deposits in Cypriot banks. Russia has coveted a foothold on the island for decades, both militarily (possibly a naval base, especially now that its position in Syria is in doubt) and more recently for the exploitation of Cyprus’s natural gas and oil reserves, given that Russia is Europe’s largest supplier of natural gas and Russia has a key energy objective of keeping it that way.
However, any substantive revenues from natural gas are likely to be five to ten years away at the earliest, and the development of any energy resources will now be much more difficult to orchestrate given the stark financial situation the Cypriot authorities find themselves in. Furthermore, Cyprus, following this recent major financial crisis, would be negotiating the future of its energy sector from a weakened position. It would also further accentuate the importance to Cyprus of a close energy partnership with its neighbor Israel. What might have been a matter of strategic decision making before is now possibly the only trump card Cyprus has to play. This trump card, however, is even more precarious as an inevitable Turkey-Israel rapprochement inches ever closer, especially now that Israeli prime minister Benjamin Netanyahu recently apologized to Turkey for the 2010 Gaza flotilla raid by Israeli commandos that led to the death of nine Turkish nationals.[20] Turkish prime minister Recep Tayyip Erdogan had since adopted a decidedly anti-Israeli position. This has earned Erdogan admiration across the Muslim world but it has left the Israel-Turkey relationship in shambles, much to the dismay of the United States, a key ally of both Israel and Turkey, which sees both countries playing important, but different, roles in its strategic policy for the region as a whole.
The Role of Turkey
One obviously cannot discuss the Cyprus problem without mentioning Turkey. Unfortunately, from the Greek-Cypriot perspective, it is hard to see how Turkey’s role can be constructive, considering that Turkey thwarted the ambitions of the 80 percent Greek-Cypriot majority for union with Greece in the 1950s. That Turkey used the excuse of the Greek Junta’s coup against Archbishop Makarios in 1974 to invade and occupy more than a third of the island is an inescapable problem for the rest of Cyprus. In addition, Turkey orchestrated the creation of and is the only country to recognize the self-declared “Northern Turkish Republic of Cyprus.” Furthermore, Turkey has precluded itself from EU membership by refusing to recognize the Republic of Cyprus as a member state of the EU. Most recently, Turkey has declared that the Republic of Cyprus has no right to exploit the natural gas and oil resources of Cyprus without equal participation of the Turkish Cypriots.
In that regard, one can see why Cyprus sees any Israel-Turkey rapprochement with considerable consternation and anxiety. However, it is not only the United States that would welcome such a rapprochement between two key US allies; the EU sees this development as an opportunity to bring about a settlement of the Cyprus problem once and for all, as well as the removal of a major roadblock in Turkey’s accession path to full EU membership. It is no secret that the EU has not forgiven Cyprus for rejecting overwhelmingly the UN’s Annan Plan for the reunification of Cyprus in 2004 as a bizonal, bicommunal confederation. The fact that the Annan Plan was fatally flawed in terms of its political and economic structure, held little weight with the EU.[21] Should Israel now opt for an energy partnership with Turkey rather than with Cyprus, the EU might finally be able to persuade Cyprus to reach an accommodation with Turkey and its client state on the northern part of the island. The Cyprus financial crisis might be a major headache for the EU and especially the eurozone, but for the island of Cyprus the stakes are far higher.
George C. Georgiou is professor of economics at Towson University-University of Maryland System
[1]. Lawrence James, The Rise and Fall of the British Empire (New York: St. Martin’s, 1994).
[2]. George C. Georgiou, Alternate Trade Strategies and Employment in Cyprus (doctoral dissertation, The George Washington University, 1979).
[3]. “Cyprus GDP—Per Capita (PPP),” Index Mundi, n.d., www.indexmundi.com/cyprus/gdp_per_capita_(ppp).html, accessed 9 January 2013.
[4]. Miltos Miltiadou, The Republic of Cyprus: An Overview (Nicosia: Cyprus Government Press and Information Office, 2012).
[5]. World Bank, “GNI per Capita, Atlas Method,” Washington, DC, 2012, data.worldbank.org/indicator/NY.GNP.PCAP.CD, accessed 9 January 2013.
[6]. The figures are from the website of the Ministry of Finance, Republic of Cyprus, 15 February 2013, www.mof.gov.cy, accessed 15 February 2013.
[7]. Central Intelligence Agency, “Cyprus,” World Factbook (Washington, DC: CIA, 2013), www.cia.gov/library/publications/the-world-factbook/geos/cy.html, accessed 15 February 2013.
[8]. Ibid.
[9]. Valentina Pop, “German Musings: Is Cyprus Too Small for a Bailout?” EU Observer, 30 January 2013, www.EUobserver.com .
[10]. Scott Rose and Paul Tugwell, “Cleanliness Meets Godliness as Russia Reeled into Cyprus,” Bloomberg, 30 January 2013, www.bloomberg.com/news/2013-01-29/cleanliness-meets-godliness-as-russia-reeled-into-cyprus.html.
[11]. Rebecca Christie, James G. Neuger, and Svenja O’Donnell, “Cyprus Salvaged after EU Deal Shuts Bank to Get $13B,” Bloomberg.Com, 25 March 2013, www.bloomberg.com/news/print/2013-03-25/cyprus-to-chop-banking.
[12]. Costa Apostolides, “Not-So Hidden Agenda behind Money-Laundering Claims,” Cyprus Mail, 27 January 2013, http://www.cyprus-mail.com/opinions/not-so-hidden-agenda-behind-money-laundering-claims/20130127.
[13]. Peter Spiegel and Kerin Hope, “Cypriot Authorities in Revised Deal Talks,” Financial Times, 18 March 2013, www.ft.com/intl/cms/s/0/a2eac7d0-8fll-lle2-a39b-00144feabdc0.html.
[14]. “Hitting the Savers: Euro Zone Reaches Deal on Cyprus Bailout,” Spiegel Online, 16 March 2013, www.spiegel.de/international/europe/savers-will-b-hit-as-part-of-deal-to-bail-out-cyprus-a-889252.html.
[15]. “Cyprus Comes to Terms with Testing Bailout Agreement,” Ekathimerini.com, 25 March 2013, http://www.ekathimerini.com/4dcgi/_w_articles_wsite1_1_25/03/2013_489822.
[16]. Michael Birnbaum, “Cyprus Bailout Deal Stokes Fears about Euro,” Washington Post, 26 March 2013.
[17]. “Eurogroup Statement on Cyprus,” Eurozone Portal, 25 March 2013, www.eurozone.europa.eu/newsroom/news/2013/03/eg-statement-cyprus-25-03-13/.
[18]. Stephen Glain,“Gas Field Off of Cyprus Stokes Tensions with Turkey,”
New York Times, 12 December 2012, www.nytimes.com/2012/12/13/world/middleeast/gas-field-off-of-cyprus-stokes-tensions-with-turkey.html?pagewanted=all&_r=0.
[19]. Chris Schenk and Jessica Robertson, “Natural-Gas Potential Assessed in Eastern Mediterranean,” Sound Waves (United States Geological Survey), May 2010, http://soundwaves.usgs.gov/2010/05/research3.html.
[20]. Ian Deitch, “Israel Apologizes to Turkey over Flotilla Deaths,” HuffPost World, 22 March 2013, www.huffingtonpost.com/2013/03/22/israel-apologizes-to-turkey-flotilla_n_2932707.html.
[21]. George C. Georgiou, “Economic Consequences of Reunification,” Mediterranean Quarterly 20, no. 3 (2009): 51–62; George C. Georgiou, “Economic Consequences of the Christofias-Talat/Eroglu Plan ,” Journal of Southeast European and Black Sea Studies 10, no. 4 (2010): 411–24.
[Ed.1]If these are indeed dollar figures, please convert to euros at end-2012 rates for consistency with other figures.
Photo IMF – This paper will be published in the Summer 2013 issue of the Mediterranean Quarterly