Paradise Lost in Cyprus

Welcome to Cyprus. A Greek-Turkish island populated by less than a million, with a high-income economy, suddenly taking over the headlines around the world

Paradise is not what it used to be
Fernando Menendez
On 27 March 2013 09:35

Imagine you live on a beautiful island where tourists dream of retiring. Of all the cities in the Mediterranean, your island has the city with the warmest winters making it a natural tourist magnet and encouraging retirees. Sunshine defines your coastline.

With a per capita GDP of just over $28,000 you live above the average lifestyle in the European Union (EU), of which you are a part. For several years now the tourism industry and offshore investors have been beating a path to your island, and real estate prices have been rising across the country.

Welcome to Cyprus. A Greek-Turkish island populated by less than a million, with a high-income economy, suddenly taking over the headlines around the world and focusing the minds of investors from New York to London to Hong Kong.

Unfortunately, Cyprus is also the latest victim of the European-wide financial crisis. The origins of the Cypriot crisis stem from the island’s banking sector, estimated at eight times its own GDP. Cypriot banks’ high interest rates assured that Russians and Britons, among others, held nearly $80 billion of the total $120 billion deposited in Cypriot banks as an offshore tax haven. One such example is the Russian oligarch Dmitry Ryboloviev who owns an estimated 10 percent of the Bank of Cyprus.

In the meantime, Cypriot banks had amassed about 22 billion euros in Greek private sector debt. When the Greek economy collapsed these investors took a major haircut. The loss in Greek bonds meant the Cypriot banking industry faced imminent collapse too. Failing to access liquidity in world financial markets the Cypriot government requested a bailout from the EU. The little island of Cyprus joined the chorus of Portugal, Ireland, Spain and Greece in asking for a European handout.

In its second economic recession since 2008, Cyprus’ economy has been slowing and events in Europe have put a strain on the tourist and other industries that had otherwise been growing on the island. The fall of tourism and shipping contributed to a contraction of the Cypriot economy leading to rising unemployment. The banking crisis further exacerbated private and public debt.

A 40 percent hair cut

In order to secure an EU rescue, the government has now proposed confiscating up to 40 percent of Cypriots’ savings to bail out the island’s imprudent banks. Businesses and individuals with deposits greater than $129,480 will face significant losses.

As part of the plan, for example, uninsured deposits and toxic assets in the largest private bank, Laiki, will be transferred into a so-called “bad bank” and the remaining insured deposits will be transferred to the Bank of Cyprus. Laiki’s bondholders will be wiped out.

Depositors, justifiably worried, have been threatening runs on the banks for weeks. Following the bailout, Cyprus’ economy is expected to shrink by about 10 percent. World markets have also reacted badly as the EU financial secretary recently praised the taking of depositors’ savings as a model for structuring future bailouts.

The resulting bailout bodes ill for the rest of the region. “Banks will be more cautious, consumers more timid, bank depositors a little more wary and growth across Europe a little weaker even than it was before,” Kit Juckes, head of foreign exchange research at Société Générale SA in London told Bloomberg. Malta, Luxembourg, and Estonia, three countries with large foreign deposits in their banks, may face similar problems as foreign investors begin reducing their own exposure.

Moral hazard

Economists have long been familiar with a concept known as “moral hazard,” meaning an incentive for individuals to act in costly, and otherwise imprudent, ways. For instance, by insuring your car against loss you might be less careful in locking your doors. By insuring risk, governments create perverse incentives making banks less cautious and less willing to put a higher price on substantial risk.

In the Cypriot case, instead of the banks making provisions in the event of financial trouble, the government assured cheap credit and assumed bank risks. The resulting, and unprecedented, confiscation of private accounts by the government is but the final straw for many Cypriots.

The Cypriot precedent confirms that a person’s savings are no longer private property but a political tool used by governments to accomplish their goals. The lesson of Cyprus is in the unintended consequences of government intervention into an economy which while at first seems commendable later turns paradise into a nightmare.

Fernando Menéndez is an economist and principal of the Cordoba Group International, a strategic consulting firm providing political and economic analysis to clients

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