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The forgotten crisis

17 March 2014 By Hugo Dixon

Sunday marked the anniversary of Cyprus’ shock plan to raid the tiny island’s bank deposits. The envisaged tax, backed by the euro zone, covered all banks and all deposits, whether insured or not.

Although that unwise scheme was later rescinded, much damage was done to a country already deep in financial crisis. Uninsured deposits of the island’s two large troubled lenders still suffered big haircuts. Capital controls were imposed as well.

These restrictions were supposed to be a short-term measure, not that this ever seemed likely. A year on, the most important controls – preventing people or companies taking more than small sums of money out of the country – are still in place and depressing the economy’s animal spirits.

Cyprus bears most of the blame for its predicament. But the euro zone is also culpable, as it connived in the proposed deposit grab and went along with other bad decisions too. It should now offer a helping hand, principally by enabling the lifting of capital controls.

The good news is that the Cypriot economy shrank “only” 5.4 percent last year. The troika – the European Commission, the European Central Bank and the International Monetary Fund – had initially projected a drop of nearly 9 percent.

There are three main reasons for the relatively good performance. First, tourism – especially from Russia – has held up well. Second, the Cypriot economy is flexible. This has meant that companies have mostly been free to cut wages and survive, points out Fiona Mullen of Sapienta Economics, a local consultancy.

Third, domestic consumption has fallen less than expected. This may be because most ordinary people were not hit by the deposit haircut after it was restricted to accounts larger than 100,000 euros. They have also dipped into their savings.

However, all is not well. One concern is that the Crimean crisis may have a knock-on effect on Cyprus – if economic problems in Russia or visa restrictions imposed by the West cut the flow of tourists.

But even without worrying about Russia, there are problems closer to home. For a start, investment has collapsed. The IMF forecasts that it will end this year 60 percent below its 2008 peak.

Some of the decline is healthy: Cyprus had engaged in a real estate binge. But the drop-off in investment in machinery means the country is not building for its future.

Part of the explanation is that companies are loaded up with debt. What’s more, they can’t get access to new finance because local banks are themselves up to their eyeballs in bad debts. Total private-sector borrowing is nearly 300 percent of GDP – and, under a stress scenario by Pimco, the asset management firm, 60 percent of this could turn sour.

The high debt means that both companies and consumers will have to tighten their belts. The IMF says that to get borrowing to a sustainable level, companies will have to cut debt by the equivalent of 45 percent of GDP while households will have to slash it by 55 percent of GDP. This will be a drag on the economy, which the IMF expects to shrink another 4.8 percent this year.

There are two things the euro zone should do to help. First, it should enable Cyprus to lift capital controls. It is easy to understand why this hasn’t happened: the troika is worried that people will rush to take their money abroad. The banks would then run out of cash, unless the ECB was willing to authorise the Cypriot central bank to inject liquidity.

While this fear is understandable, there could be imaginative ways round the problem. One, suggested by Marios Zachariadis, a member of the country’s national economic council, would be to lift the controls but at the same time impose a large tax, of say 35 percent, on capital exports. The government could then say it intended to reduce the tax over time, eventually to zero.

The advantage of such a scheme is that, if there wasn’t much capital flight, after a couple of months the tax could be cut to say 30 percent. Meanwhile, the prospect of the tax coming down over time would mean that depositors would have less incentive to run immediately.

There would, of course, still be a risk, which the national central bank and ECB would ultimately have to underwrite. But it would be worth taking.

The second way of helping Cyprus would be to create a “bad bank” to take over the bad loans that are infecting the banking system. Such a scheme has been deployed successfully in two other euro zone crisis countries, Spain and Ireland.

The advantage is two-fold. Freed of its bad loans, the banking system could focus on financing healthy companies. Meanwhile, the bad bank could operate like an investor – converting debt into equity when borrowers have viable operations, or shutting them down when they don’t.

The IMF and the ECB normally like bad banks following crises. The snag is that somebody needs to finance them – and the euro zone doesn’t seem keen to commit more money than the 9 billion euros it is already lending the country.

Cyprus may be small enough to forget about, but it is also small enough to help. It has been virtually a model pupil since it came under the troika’s tutelage. Now it should be rewarded.


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