How Cyprus could become Europe’s biggest headache

Remember last summer in the eurozone?

It was chaos. Investors were pulling cash out of Europe’s banks; Italian and Spanish yields were spiking; emergency meetings of European leaders were taking place every other day. Some sort of crack-up seemed inevitable.

Then Mario Draghi, the head of the European Central Bank (ECB), uttered his three magic words: “whatever it takes”.

Investors believed him. The promise of unlimited intervention to keep Spain, Italy and other high-debt countries afloat calmed markets. In short, there would be no repeat of Greece, where many private lenders to the country ended up getting back just cents on the euro.

Bond yields fell. The exodus of money stopped. In fact, Dutch bank ING now thinks that, since September, nearly €100bn has come back into the peripheral countries.

And because Draghi didn’t need to print a ton of money in the end, the euro has gone up. It’s now near a 14-month high against the dollar.

But the problem with promises is that you may end up having to stand by them. And now one tiny eurozone country could see Draghi’s best-laid plans unravel.

Cyprus…

Cyprus is Greece (but with even dodgier banks)

You might think that with all the woes afflicting the euro area – such as recent revelations over Spanish corruption, and the return of Italy’s Silvio Berlusconi – Cyprus would be the last of its worries.

This tiny nation joined the European Union less than eight years ago. It accounts for just 0.2% of the eurozone’s GDP. How can it be important?

Here’s why. The one key thing pinning the eurozone together at the moment is Mario Draghi’s credibility. Cyprus could stretch that credibility to breaking point. It’s a vital test of whether the ECB means what it says.

Like the other ‘peripheral’ economies, Cyprus has high levels of state debt and a collapsing economy. As a result, it has been shut out of the bond markets for over two years, and so cannot refinance its debts – in other words, it can’t renew its existing loans.

But with the economy expected to shrink by 3.5% this year, it won’t be able to repay its loans either. A large number are due to mature in the next three years, starting with €1.5bn in June.

On its own, this isn’t a big problem. Indeed, last year the Troika (the eurozone bail-out committee) agreed to give Cyprus a €7bn loan that would allow it to meet its debt obligations.

However, this loan was dependent on Cyprus bailing out its banking system. Unfortunately, Cyprus is a bit like Iceland or Ireland (or the UK for that matter) in that its banking system is far larger than the underlying economy. Indeed, it’s about eight times the size.

This means that Cyprus needs a total of €17bn in support.

This might not be a problem either, in itself. The trouble is that Cyprus has a fairly shady reputation as being a haven for crooks looking to hide their ill-gotten gains. While this may be unfair, up to a third of deposits come from Russia.

Because of this, the idea of recapitalising the banks with European money – effectively a bail-out for criminals – is very unpopular in Germany. And Germany has the power to veto the second part of the loan – and therefore the whole package.

The ECB has been applying a lot of pressure, arguing that if Cyprus is allowed to go bust, there could be large knock-on effects. For instance, the two largest Cypriot banks control a sizable share of the Greek banking market.

And there are signs that German leader Angela Merkel may have accepted its arguments in private. However, she still has to sell it to the German people – and with an election this year, the opposition are not going to do her any favours.

Could a bail-out even work?

However, even if Germany allows the loans to go through, the problems don’t end there.

Fiona Mullen of Sapienta Economics estimates that, with the full loan, Cyprus’ state debt will hit 136% of GDP by 2016. This is clearly unsustainable, and far more than the International Monetary Fund (which forms part of the Troika) is prepared to allow. She thinks that Cyprus will need to find at least €3bn in savings.

In theory, there are many ways that these savings could be found. For instance, Cyprus could sell the rights to gas fields and state assets. Alexander Apostolides of the European University, Cyprus thinks that size of the bank bailout could also be reduced. But these would only be partial solutions.

If an agreement can’t be reached, then the only real option left that would put Cypriot debt on a sound footing, is for private holders of government debt to take a ‘haircut’. In other words, to be repaid less than the face value of the bond. This is usually in the form of a lower interest rate or a longer term. Indeed, the Cypriot finance minister has explicitly talked about this possibility.

Since Cypriot banks hold a large amount of Cyprus’ debt, most of the pain will have to be pushed onto foreign bondholders. This is exactly what happened to Greece, and it’s exactly what investors had hoped the ECB would never allow to happen again.

So if holders of Cypriot debt do take a haircut, it will damage the credibility of Draghi’s promise to holders of Spanish and Italian debt. In turn, they will start to pull out of European debt markets again, leading to capital flight and higher yields – once again.

The ECB will then be forced to choose between printing money or letting some of the weaker countries leave. While either solution will be good for output in the euro area (a weaker currency would boost exports across the region), they will both hit the value of the euro.

There are several ways to protect your portfolio from this. One option is to buy gold. However, my colleague John Stepek has a look at the one currency which should do best out of the coming crisis here: How to avoid a pounding in the currency wars.

17 Responses

  1. 05/02/2013, Boris MacDonut wrote

    Cyprus is tiny. The whole economy is about £12 billion. But it is a problem for the EU.
    It is a problem as rich Russians use it as a tax haven and a backdoor to legitimise their ill gotten gains. There are over 100,000 Russians in Cyprus now.
    It is a problem because it houses two ethnic groups with a violent and history of atrocious animosity and the Turks who live there are a wild, uncivilised bunch.
    It is a problem because Turkey wants to join the EU and will use it as a bargaining tool.
    It is a problem because it is 52 miles from Syria.
    It’s economy is irrelevant.

  2. 05/02/2013, C H Ingoldby wrote

    Who was stupid enough to let Cyprus into the Euro?

    Time to stand well back. To remember the phrase ‘moral hazard’ and let anyone stupid enough to lend money to Cyprus to take a loss.

    No doubt the bondholders will shriek to high heaven that the sky will fall in if they are not bailed out with copious amounts of taxpayers cash. That is just blackmail and a nonsense.

    Let the Cypriot banks fall.

  3. 05/02/2013, Mohammed Helsinki-dishu wrote

    Russia will bail out Cyprus. No issues there. Too many vested interests.

    Russia is buying most of Finland at the moment, and still indirectly controls the Baltic states. Only a matter of time until they ‘assist’ the other weaker southern euro countries alongside/in conjunction with the Chinese. Holding major influence in any future conflicts.

    May Allah protect us all

  4. 05/02/2013, Boris MacDonut wrote

    Oops,forgot to mention. Europe’s biggest headache is Spain. Spain is Sixty Three….63 ….times as big as Cyprus,so unless Cyprus is in 64 times as much dodo then it is nowhere near the Spanish debacle.

  5. 06/02/2013, Sammy Clarkson wrote

    Dear Boris, how can you call the Turkish Cypriots “wild, uncivilised bunch.” on what basis do you make these presumsions?
    they are living in peace, and have established a country with embargos unjustly placed on them due to intense greek lobbying and lying. May I suggest you learn your history. You have proven yourself to be a uncivilized and wild creature.

  6. 06/02/2013, Boris MacDonut wrote

    #5 Sammy. That is exactly what I have been doing. Recently read Giles Milton’s Paradise Lost about the Turk’s destruction of Smyrna. Of course I should have said these are the descendants of a wild uncivilised bunch. The Greeks did not cover themselves in glory either.
    I know Turkey is now among the more modern and progressive of Middle eastern nations, but their history is riddled with examples of not being trustworthy. Their entry to the EU is politically desirable but will be very difficult especially with so many Russians in tow.

  7. 06/02/2013, Margaret Georgiadou wrote

    What everyone seems to be happily ‘forgetting’ is that it was the Greek ‘haircut’ which bankrupted the Cyprus banks! So an action taken by the EU was to a very large extent the cause of the collapse of the Cypriot banks. And also – do remember that the Russians arent the only folk using tax havens. Members of the current British government, and also big UK businesses use tax havens such as the Caymans, Lichtenstein and Luxembourg. I cant speak for the Germans, but it would not at all surprise me to learn that many of them too are in a tax-haven heaven somewhere on the planet.

  8. 06/02/2013, Margaret Georgiadou wrote

    With regard to comments above on the Turks and uncivilised behaviour: all I can refer to are TWO genocides which they committed: 1822 they massacred 75% of the Greek population of Chios, and 1915-1916 they massacred 1-1.5 million Armenians. The Greek-Turkish ‘conflict’ is really a David and Goliath situation: Turkey has a population of 73.6 million, and an army of 1.2 million; Greece a population of 11,3 million and an army of 461 thousand; Cyprus a population of 838.8 thousand, and an army of 60 thousand. So we are talking of Turkish forces of 1.2 million massing against total Greek forces of 521 thousand! This why the Turks are regarded by many as murderous bullies.

  9. 06/02/2013, Marcus wrote

    Having visited Greece, Cyprus (north and south) and Turkey in recent years I know which I respect the most and it’s not the Greeks.

  10. 06/02/2013, Derek wrote

    Well said Marcus.

  11. 06/02/2013, Margaret Georgiadou wrote

    Having visited Greece, Cyprus (North and South) and Turkey in the last few months I know which I respect the most and it’s not Turkey. And before one jumps to conclusions I am Yorkshire born and bred.
    Guess it all depends on how well one knows the facts and the history.
    None of this of course has anything to do with money matters!!

  12. 07/02/2013, Jenski wrote

    As always, the Greeks are innocent in the present as well as the past. They are always the victim when it comes to shunting blame.

  13. 07/02/2013, Boris MacDonut wrote

    #12 .The Turk has haunted Europe with his menace for 600 years. Civilisation lost a great deal when they captured Byzantium in 1453. I can see why our politicians want him inside the tent,but everyone must sleep with one eye open.

  14. 10/02/2013, Boris MacDonut wrote

    No comments in 3 days, but this is still the “most popular” article. Weird…..or inefficient.

  15. 10/02/2013, t. andres wrote

    Three points:
    1.The present communist government has a lot to answer for. Cyprus finances were in good order when they took over but they began to give money away as though there was no tomorrow. Every old woman had a carer in to (by curtesy of gov. money.
    Child benefits and any other benefits were increased.
    Even the Turks in northern Cyprus had rights to benefits in the south.
    Immigrants claiming asylum were all sorts of benefits
    Old soldiers were receiving war pensions where there was non before. Money was dished out like confetti.

    2. When cyprus currency was valued against the euro it was 1.7 to the Cyprus pound so most people’s pay almost doubled.

    3. For the same reason tourists were lost to neighbouring countries because holidays in Cyprus became uncompetative

    4. Banks’ CEO gambled their customers cash in all sorts of ventures. Now living in the lap of luxury. Yes I know one well.
    Need I say more!

  16. 11/02/2013, Milo wrote

    Having lived in Cyprus for seven years, one of its biggest problems is the pay in the public sector, short hours, high pay, 13th salary and after one year working, a generous pension, it puts the rest of Europe to shame.

    But by far the biggest problem is the property industry, the greed and nepotism that shoots thru this has ruined many lives, but the banks lent billions to developers to construct and over valued property for years! On top of the feeding frenzy that followed, not once stopped by the all knowing govt, no one was issued with Title Deeds! now we have developers unable to service their loans and banks trying to recuperate their losses by trying to obtain back already purchased property supposedly owned by purchasers. One such case will be heard in the UK high court this year between purchasers and the greek Alpha Bank. It’s been shouted about for years, but no one stopped it, the banks only have themselves to blame, along with developers and their cohorts.

  17. 15/02/2013, Jon wrote

    As a greek cypriot once said to me…never trust a greek.

Commenting on this article closed

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