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Beware of German gifts near their elections: How Cyprus got here and why it is currently more out than in the Eurozone

By Alexander Apostolides, Lecturer, European University of Cyprus1

Key points: The situation in Cyprus arose due to banking overreach, insufficient regulation,

excessive government deficits, poor debt management and collateral damage from previous Eurogroup bailouts The amount needed is small in absolute values, but large relative to the size of the economy. The Troika was unwilling to fund more than 10bn Euros. Extreme delay from the departing Christofias government and persistence from the Troika led to the bailing-in depositors to cover the gap. An attempt to spread the pain by suggesting a shares-for-deposits swap for all Cypriot depositors, (bailing-in even insured depositors) was defeated in the Cypriot parliament. In subsequent negotiations, insured depositors were unharmed: uninsured depositors in the largest two Systemically Important Financial Institutions, Laiki Bank and Bank of Cyprus were affected Local debt default and forced rollover are part of the bailout, but as it currently stands, holders of external debt are to be paid in full. The exception is the Russian Federal Republic: the Troika has demanded that Cyprus negotiate a restructuring of that direct government loan. As a result of the above actions, Cyprus is left facing an unprecedented economic depression; the link between weak financial institutions and a weak state has not been broken, making a second bailout very likely. Cyprus has capital controls, deteriorating financial situation and needs to defend itself against local and domestic lawsuits that might overturn decisions. Cyprus is still dangling precariously from the Euro exit cliff.

1. What happened in March 2013?

Cyprus has dominated news across the world since the early morning of the 16th of March, when the Eurogroup and the recently inaugurated President of Cyprus, Nicos Anastasiades agreed to a rescue deal that would include the bail-in of uninsured and insured depositors in all Cypriot financial institutions2. The bailout Cyprus needed (for government debt expiration, projected government deficits and supporting the financial system) was calculated then as 1bn The Troika, comprising of the European Commission (EC), the International Monetary Fund (IMF), and the European Central Bank (ECB), was only willing to fund 10bn.

1 Corresponding Address: 6 Diogenes Street, 2404 Engomi, Nicosia, Cyprus. a.apostolides@euc.ac.cy

2P Spiegel, ypriot bank deposits tapped as part of 1bn eurozone bailout Financial Times (2013), 16th of March

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The reasons for the large gap between the yprus needs and the Troikas desire were twofold yprus needed bn for the recapitalization of the financial sector, which Germany was not willing to pay; and the IMF would not participate in a programme that would push the debt of Cyprus into what it argued were unsustainable (i.e. Greek) levels. The Eurogroup demanded that out of the bn, junior bondholders of the banks would lose 12bn, but the remaining bn could only be raised by bailing-in depositors. The final deal in the early morning of the 16th of March led to all depositors in Cypriot financial institutions being affected and not only those in the banks that needed urgent recapitalization. Those who had

deposits over the insured 1, would have % of their deposits converted into shares of the financial institutions which would receive their deposits to recapitalize. Surprisingly, insured depositors were also affected, having 6.75% of their deposits similarly affected.

The decision to bail-in even insured depositors was immediately regretted by the Eurogroup, and the resulting rejection of the bailout from the Cypriot Parliament saved the Eurozone of a lot of blushes3. While the Cyprus government scrambled to find alternative solutions, the Eurogroup made clear that a decision not including a bail-in of depositors would not be accepted4. Cyprus had became a hot issue in the upcoming German elections, and it was deemed politically necessary to introduce a bail-in of depositors for the deal to go through the German (and other) parliaments.

The banks in Cyprus remained closed while a new bailout deal was being hatched and a flurry of foreign media correspondents descended on the island. Cyprus modern economy quickly descended into cash-only exchange as all bank accounts remained frozen and no one was allowed to take more than 3 a day from the ATMs: the Eurozone had its first Corralito moment.

On March 25th, a new deal was reached, and three days later the banks opened after a twelve day banking holiday, a world record5. Bank runs did not occur but the banking system was operating under strict capital controls, which are still largely in place at the time of writing.

3 Stockwatch (2013) 30th of April

http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=173400 4 One alternative that was ignored was debt restructuring that would include external debt: M. Gulati and L.

Buchheit, Walking back from yprus Vox Columns (2013) http://www.voxeu.org/article/walking-back-cyprus However the German Minister warned that unless there was a bail-in there would be no bailout: A. Breidthardt & J 'onnell Insight - How Europe stumbled into scheme to punish yprus savers Reuters (2013) 18th March. 5 On average bank holidays occur at only 10% of the IMF database on financial crises. They last on average 5

days aeven and Valencia, Systemic Banking rises An Update IMF Working Papers (2012) 12/163

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The new deal indicated how severe was the damage caused by the bank closure and the uncertainty; the bailout needs jumped to 2 - 23bn, an increase of 20.1 - 33.5% of Cypriot GDP 6 . Despite the fact that such an increase means that Cyprus will miss the budgetary and other targets set by the troika, the agreed second bailout agreement remained effectively unchanged, with just the way depositors in Cyprus would be bailed-in being different, as well as the new Eurogroup demand that all the Greek branches of Cypriot banks should be sold.

The way the Eurogroup decision on the 25th of March chose to cover the bank recapitalization needs has doomed Cyprus into a deep depression7. The European commission argues at Cyprus will have a cumulative fall of nominal GDP of just 15% over three years; the IMF suggests that the GDP will fall by more than 12% just this year. The Economics Research Centre of the University of Cyprus suggests that even a cumulative fall of real GDP of over

30% in four years is probable8.

Tragically, the deepening recession in Cyprus that stems directly from the 25th of March agreement is set to make a mockery of the projected debt sustainability assessment of the European Commission. Debt sustainability was the basis of Troikas demands for Cyprus to avoid reaching levels of high debt that would make repayment of the official sector loan difficult9. Yet despite predicting a recession of -12% in 2013, the budget deficit target for the year is -2.4%10. This is impossible. Even if the fiscal multiplier of government purchases is at par (which is very unlikely) Cyprus would require a reduction of the government deficit by 20% in the seven remaining months of the year to achieve the debt sustainability target; this is impossible, especially since the bailout took place prior to the end of the tax season.

More worryingly, the key issue that made the Cypriot bailout so difficult was that the island was facing both a banking crisis and a government debt crisis; the Eurogroup decision does

6 P Spiegel, Reexamining the ypriot bailout numbers Again Financial Times (2013) 25th April.

7Eurogroup, Eurogroup Statement on Cyprus on the 25th of March (2013) http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/136487.pdf Leaked IMF MoU (Final): Memorandum of Understanding on Specific Economic Policy Conditionality (2013) http://static.cyprus.com/troika_memo_final.pdf 8 University of yprus, Economic Research entre, April 213 Economic Outlook (2013)

http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdf 9 As leaked to the financial times: European Commission, Directorate General of Economic and Financial

Affairs Assessment of the Public Debt Sustainability of Cyprus, 9th April (2013) http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf 10

Politis (2013) http://www.politis-news.com/cgibin/hweb?-A=234663&-V=articles

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not resolve the dangerous feedback loop between these two issues11. The state is not allowed to borrow from the official sector to help the banks; yet the deepening depression will lead to banks and cooperatives needing more support as bad loan provisions are revised upward. At the same time the increased unemployment and a decrease in revenues will mean the state will need to borrow more, but the local financial institutions will not be able to help12. As a result Cyprus will need a second bailout, as the Troika is the only agent which can break the link between weak government and weak state.

The 25th of March deal requested Cyprus to resolve the issue of the largest two banks in the island, Laiki Bank (formerly Marfin Popular (Laiki) Bank) and Bank of Cyprus (BOC). Both banks failed their recapitalization targets and now they would need to be recapitalised without aid from the Troika. It was decided not to close down either bank but instead to restructure them aikis insured depositors would be transferred to Bank of yprus, along with all the performing assets. The uninsured depositors were bailed-in 100%, and they would become the shareholders of bad aiki, which would have all the non-performing assets. In the process Laiki shareholders and junior bondholders were wiped out. The BOC would also bail-in uninsured depositors, although at a yet unknown proportion and then take the insured depositors and good assets of Laiki bank. The BOC board resisted and the bank was taken over by the Central Bank of Cyprus (CBC), who sacked the board. The CBC initially cancelled all shareholders, only to reverse the decision after the local courts put a halt in the proceedings, questioning the legality of cancelling existing property rights. The CBC responded to the court by creating four categories of shares, placing the new bailed-in shareholders in the first category, with junior bondholders and existing shareholders in lower categories. Hundreds of lawsuits are already in place against Laiki, BOC, the CBC and the Cyprus government due to the way the restructuring was handled.

This was new: in every single Eurozone bailout prior to Cyprus, a rescue fund was allocated to enable banks to recapitalise through resources provided by the official sector, as it was understood that there was a risk that a government debt crisis could become a financial sector crisis that would undermine debt sustainability efforts, yet German elections due in September ensured that the Cyprus bailout would be a very different proposition. The

11 SA Zenios, The yprus debt A perfect crisis and the way forward The Wharton Financial Institutions

Center, Working Papers (2013) #13-09 12

The Economist, Through a lass, arkly (213) 2th of April

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litigation that the chosen method of bank restructuring will generate will ensure uncertainty in the Cypriot financial industry for years to come.

The bank branches of all Cypriot banks, irrespective if they were in trouble or not, were to be sold to Piraeus bank in Greece by the order of the CBC at the request of the Troika. The deal was awful for the Cyprus government but the Troika insisted that Cyprus should be isolated, cutting off the only channel of contagion to the rest of the Eurozone13. Yet this decision ensured that excluded depositors in Greece avoided the bail-in of Laiki and BOC, while Cyprus would still have to pay both the losses in Greece as well as assume the liquidity

assistance given to Greece, thus increasing the haircut of depositors in Cyprus.

How bad was the deal for Cyprus? The CBC received 2 million from Piraeus bank (effectively given by the Greek Bank Rescue Fund, set up by the Troika). For that amount, yprus sold 1bn of assets and gave away 1bn of deposits 14 . It was stuck with recapitalizing the Greek branches prior to the sale: just for Laiki bank in Greece that was estimated at 2bn. In addition up to bn in liquidity assistance given to fund withdrawals of Greek depositors from Greek branches of Cypriot banks also became liabilities of the Cypriot branches. Thus with less assets, Cyprus was forced to cover the Greek funding and liquidity gap that was created. Laiki bank refused to sign and the CBC governor ignored them and just signed on their behalf15. Lawsuits relating to the sale of the Greek branches are expected.

Perhaps the most controversial decision in regards to the banking central was the handling of the liquidity assistance provided by the ECB through the CBC. Through the Emergency Liquidity Assistance (ELA) procedure the ECB, through its local subsidiary (in this case the B) injected bn of liquidity in aiki bank, as aiki was facing substantial withdrawals16. Laiki provided discounted assets as guarantees for the ELA: this liquidity assistance remained a liability with priority of repayment for Laiki and an asset for the CBC

13 ixon, yprus bank resolution a bad joke Reuters (2013) 2nd of April http://blogs.reuters.com/hugo-

dixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/ 14Piraeus Bank, Press announcement (in Greek); Piraeus Bank has taken the Greek banking business of Bank of Cyprus, Cyprus Popular (Laiki) Bank and Hellenic Bank (2013) 26th March http://www.piraeusbankgroup.com/el/~/media/0B74D7B60CF54BE7A57C8AB42720866D.ashx 15

H. Dixon, yprus bank resolution a bad joke Reuters (2013) 2nd of April http://blogs.reuters.com/hugo-dixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/ 16

The EA directive European Union, irective 2E of the European parliament and of the council of 6th of ay Official Journal of the European Union (2009) L146/37 http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:146:0037:0043:EN:PDF

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balance sheet; the ECB is not technically part of the process, although it is the provider of the given liquidity. Yet the CBC, with the blessing of the ECB, kept providing liquidity to Laiki bank, even though it became clear in 2012 that the bank was becoming insolvent. Laiki owned bn by June17, and the current central bank governor (Panikos Demetriades) seems to have refused to shut down the bank for political reasons, meekly stating that he warned the departing Christophias government.

Why did the CBC governor not press the issue? There is the suggestion that his appointment

by the previous Christophias government (on the 3rd of May, 2012) was conditional to Laiki bank remaining open until after the elections, scheduled in February 2013. The fact that Laiki Bank became insolvent but was still provided liquidity became an issue in the Eurogoup negations of the 15th of March; the Eurogroup warned President Anstasiades that failure to agree on a bail-in of depositors would mean the stopping of liquidity of the ECB/CBC to Laiki bank. This has led to public conflict between the new government of President Anastasiades and the acting CBC governor.

The ELA given to Laiki has complicated attempts to restart the Cypriot financial sector. Some argue that ECBhas placed its own interest above the local legal framework, damaging the Cypriot economy further, through the actions of its local subsidiary, the CBC 18. This is because the CBC accepted discounted assets of Laiki and provided over 9.9bn of ELA to Laiki, even though it was clear by the level of withdrawals that the bank was by then insolvent. But, when Laiki was restructured the CBC did not claim the assets that were pledged to the liquidity provided, but liability of the ELA was transferred (with dubious legality) to the new Bank of Cyprus19. A question of conflict of interest clearly arises here: the CBC (and by proxy the ECB) did not want to become owner of the assets that guaranteed the ELA, but by transferring the liability to Bank of Cyprus, it has effectively reduced the recovery value of the bailed-in depositors. There have been calls for the investigation of the CBCs role in providing liquidity to Laiki and to legal avenues being explored to force the CBC to liquidate the ELA by taking the pledged assets20.

17 , Inbusiness (2013) 15th April

18 J Ewing, Blaming Europes entral Bank The New York Times (2013) 29th April

19 Xiouros, Emergency iquidity Assistance

Stockwatch http://blog.stockwatch.com.cy/?p=1754 20

C. Xiouros, Handling of the Emergency Liquidity Assistance of Laiki Bank in the Bailout Package of Cyprus http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2254499

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By placing the ELA burden in the newly restructured Bank of Cyprus the CBC ensured that both capital controls needed to be introduced, and that the new bank would be capitalised but illiquid. The new Bank of Cyprus will be capitalised fully as it received good assets the insured deposits of Laiki bank, and it bails-in its uninsured depositors. Yet this bank might not be able to lend as the ELA has priority in repayments21. In addition it was feared that as over half of the deposits of the new BOC are foreign and are expected to flee in the first opportunity, capital controls for the whole economy had to be imposed to prevent further liquidity shortages for the new BOC, as it would reach the limit allowed under ECB rules.

The author has never seen a messier or more confusing bailout. It is clear that the deal on the 25th of March might be a better deal for the Eurogroup as it avoided spooking European insured depositors, but it was a catastrophe for the financial sector of Cyprus. It is one thing to bail-in the depositors of a small bank; it is quite another to do it simultaneously to the two largest banks of a country that held 37.9% of all Cypriot deposits in February 201322. In Cyprus, you simply cannot avoid doing business with Laiki and/or Bank of Cyprus: they are by far the largest banks on the island if one takes any measurement and were the most accommodating in terms of international business due to their global presence. The Cypriot banking system was mostly funded by depositors being bn or 1% of liabilities in June 2012. Out of those just 40% were by Cypriot residents, with 34% being non-residents using Cyprus as a business centre, 19% from Greece and 7% from other countries (Russia citizens directly provided only 2% of deposits)23.

So why was the bail-in of depositors as a method of financing bank recapitalisation chosen? The bail-in was considered as ideal by some in the Troika as Cypriot banks were overwhelmingly dependent on deposits (there was very limited unsecured debt) 24 . The German press and government also backed it, arguing that if Troika funds were used to help out the banking sector, it would effectively help rich Russians who deposited their money in

21 SA Zenios, Stockwatch

http://blog.stockwatch.com.cy/?p=1734 22

Source entral Bank of yprus, arket Shares of Banks, ebruary (213) http://www.centralbank.gov.cy/nqcontent.cfm?a_id=11912 23

Ibid p.9 24

J otterill, A stupid idea whose time had come Financial Times Alphaville (2013) 16th March http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/

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Cyprus due to the high interest rate25. The claim of Russian presence / high interest rates has a grain of truth, but they are essentially misleading as to who suffered the real damage of the bail-in.

The outflow Russian depositors prior to March 15th was significant as the German and other northern European statesmen made no secret of the fact that a bail-in of uninsured depositors would be part of the Cyprus bailout deal26. Although the interest rates for saving accounts in Cyprus were higher than in Germany, inflation was also higher, averaging at 2.7% in the last

three years, meaning that some of the interest rate differential could be explained away; in any case, the bail-in was on all uninsured accounts, even non-interest bearing business accounts 27 . As a result the majority of those affected are business accounts of Cypriot companies and not saving accounts, taking away all working capital of most large Cypriot businesses. The decision to bail-in the uninsured depositors of these two banks has wiped out the liquidity from the Cypriot economy. Firms following sound financial planning during a recession (cut costs and accumulate a cash reserve) suddenly found their whole reserve amount over 1, turned into illiquid shares. While this was mainly expected for Laiki Bank, it was largely unexpected for the case of bank of Cyprus, which had only missed its recapitalisation needs in ay 213 by just 23 million28. Thus most large firms and pension funds in Cyprus were caught out; the resulting liquidity tightening means that the local market has crashed. The business confidence index has reached a historical low, with consumers stopping all but non-essential consumption29.

It is my opinion, proponents of the bail-in did not understand how complicated it is in practice and how difficult it was for Cyprus to resolve the banking sector quickly and

25P. Schuseil, The yprus Bailout ontroversy in erman edia and Politics Bruegel (2013) 22nd of March http://www.bruegel.org/nc/blog/detail/article/1049-the-cyprus-bailout-controversy-in-german-media-and-politics/ and erman views on Aid for yprus Bruegel (2013) http://www.bruegel.org/nc/blog/detail/article/985-german-views-on-aid-for-cyprus/ 16th of January 26

Jr Thomas, In yprus Bailout, Questions in Whether epositors Should Shoulder the Bill New York Times (2013) 10th of January T Barber yprus must pay the price for joining the Euro Financial Times, Global Insight (2012) 9th of ctober and Walker Inside erkels Bet on the Euros future Wall Street Journal (2013) 23rd of April 27

Statistical Service of the Republic of yprus, Inflation, 1-2012, 8th of January update (213) http://www.mof.gov.cy/mof/cystat/statistics.nsf/economy_finance_14main_en/economy_finance_14main_en?OpenForm&sub=4&sel=2 28

A liades, Truth and ies (in reek) Politis (2013)) 3rd April p.9 29

University of yprus, Economic Research entre, April 213 Research in the Economic Attitudes (In Greek) (2013) http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdfhttp://www.ucy.ac.cy/data/ecorece/erevnes%20oikonomikis%20sigkirias_04_2013.pdf

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effectively. The CBC needs to take over and administer two banks that are far larger than itself: this created manpower shortages and delays. In addition both the Eurozone and the Cyprus government have demanded exemptions to the bail-ins, creating further delays. The Eurozone has demanded that all inter-bank loans should be exempt, while the government, fearing that the bail-in will also cause a pension crisis, has asked for exceptions for the affected pension funds. The list of exemptions has now widened to include charities, educational institutions and local government, but at the time of writing the list has been removed from the central bank website; there is still uncertainty if any exemptions will be

granted, but the size of the exemptions will determine the amount the depositors are bailed-in30. It has also proven difficult to distinguish who is uninsured: for example, is the joint bank account of a family of three to count as insured for 300,000 or for 100,000?

The resulting confusion has created delays and increased local and international litigation claims creating ever greater uncertainty. The letter by the Governor of the Central bank to the Acting Executive Officer of Laiki, dated 11th of February 2013, clearly states that the Governor considered bailing-in depositors illegal under the constitution of Cyprus and the European onvention of uman Rights, calling it legally unfounded; the same governor would now have to defend such bail-ins in local and foreign courts.

The delay in the resolution of the bail-ins and the existence of capital controls is destroying any chance of effective resolution of the banking crisis. As there are strict limits to what one can do with their deposits in Cyprus, the Cyprus banking sector loses its credibility and utility, damaging even healthy institutions. This creates a catch-22 the longer capital controls are in place the more depositors become flighty and consumption plummets; the resulting deterioration on the Cypriot economy delays the final resolution of BOC and Laiki, as more provisions against bad loans need to be undertaken. At the time of writing just 10% of the uninsured Bank of Cyprus depositors has been released to the clients; a 37.5% has been converted to shares, and the remaining 52.5% is held frozen by the Central Bank until September, when hopefully the final bail-in percentage will be announced. Yet as it seems likely that capital controls will remain in place at least until then, the situation of the financial

industry will deteriorate further, leading to much more severe bail-ins for the uninsured

30 Stockwatch (2013) 10th April

http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=171716

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depositors. Controls have begun to have very negative effect in the remaining competitive industry of Cyprus, that of business services.

The banking sectors problems are still unresolved and the resulting uncertainty it generates has led to a sudden stop of lending and borrowing. Unless that link between a weak financial sector and a weak government is broken, depositors worry that a second bail-in might take place as the economic outlook deteriorates, prompting them to make the rational decision of taking their money out of the country. This fact, combined by the lack of

unlimited liquidity by the ECB, requires the existence of capital controls, which further damage the economy. In addition the Cypriot capital controls, although granted an exemption by the ECB and the IMF, may still be in breach of Bilateral Investment Treaties entered into by Cyprus, providing further litigation against the republic and the restructured banks.

The final bailout amount and its breakdown is still fuzzy and confusing, indicating how messy the Cyprus bailout is in practice. The European Commission suggests a breakdown of what the government of Cyprus needs to provide for itself as 1bn raised from the depositor bail-in m from increases in taxation m from the sale of all the gold of the B, 1bn from privatisations, 1bn on local debt rollover and 1m from lower interest through the debt restructuring of the direct loan by the Russian Federation31. The numbers and their estimations vary depending on different versions of the document, with other recent documents suggesting a smaller depositor bail-in might be necessary32. The Troika will provide Cyprus 10bn, out of which 2 will go to support the cooperative sector and other banks, 3bn is given for the fiscal needs of the state over the period 2013-2016, and 1bn will go to pay in full maturing foreign loans of the Republic of Cyprus.

The most surprising issue in this whole mess is the decisions relating to the countrys sovereign debt. All private sector participants, even bank depositors, will be affected, but the foreign law sovereign bondholders are to be paid on time and in full. The IMF had instructed the previous government to pass legal instruments allowing the arbitrary restructuring of locally issued debt. The new government will now use that privilege to roll over 1bn of debt,

31 European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt

sustainability of Cyprus, 9th April (2013) http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf p.10 32

P Spiegel, Reexamining the ypriot bailout numbers Again Financial Times (2013) 25th March http://blogs.ft.com/brusselsblog/2013/04/reexamining-the-cypriot-bailout-numbers-again/

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and will reduce the debt it has with the B by swapping it with land worth of 1bn33. The direct loan with the Russian Federation, whose terms have never been made public and whose maturity is due in 2016 will also be restructured, becoming a five year loan with repayment starting in 2018, and providing a lower interest rate.

The irony is that although Greece PSI was meant to be an exemption, both Public Sector Involvement and Official Sector Involvement aspects exist in the Cyprus bailout; it is just not affecting the foreign bondholders or European Union governments. It is incredible that

foreign debt holders are to be immune from pressures to restructure their bonds, despite the Cyprus bailout requesting such a restructuring from local lenders and a foreign government34. What makes it even more astounding is that the timing of payouts to bondholders seriously restricts the viability of the Cypriot bailout plan. At a time when Cyprus is already failing to meet its deficit targets, the first tranche of 2bn of Troika financing will be receive in May. Yet 1bn will go towards paying in full Euro edium Term otes expiring in the 3rd of June, leaving only million for financial and banking needs until the first half of the year Because of this there are growing calls for foreign law bondholders to be pushed into the same restructuring that is being offered to the local institutions and the Russian government35. Questions of fairness of paying in full strategic investors who knew the risks of Cypriot Government bonds while bailing-in Cypriot grandmothers are being asked, while the amount of litigation the Cypriot bail-in and capital controls have created make the threat of further litigation on foreign debt not so prohibitive36.

The above was an attempt to explain the complicated situation that arose during the last two months in Cyprus. Yet we need to understand how Cyprus ended up in this mess and what are the challenges moving forward?

33 European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt

sustainability of Cyprus, 9th April (2013) http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf p.12 34

J otterill, The Buchheit bat-signal, a few days on Financial Times Alphaville (2013) 21st of March http://ftalphaville.ft.com/2013/03/21/1430252/the-buchheit-bat-signal-a-few-days-on/ ; J. Cotterill A stupid idea whose time had come Financial Times Alphaville (2013) 16th March http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/ 35

Public Debt Office, Cyprus, Outstanding Securities in the Foreign Market as of 31st of December (2012) http://www.mof.gov.cy/mof/pdmo/pdmo.nsf/All/0F88002C3BEA16C1C225784800373547/$file/Outstanding%20securities%20in%20the%20foreign%20market%2012_12_31.pdf 36M Zachariades, Fairness and Sustainability for Cyprus" Econbrowser (2013) http://www.econbrowser.com/archives/2013/04/guest_contribut_36.html yprus Academics Initiative, The yprus debt crisis apital lows and ebt Restructuring Stockwatch (2013)

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2. How did Cyprus end up here? Entry in the Eurozone

The republic of Cyprus joined the European Union in 2004 and like all member states (with the exception of the UK and Demark) it committed to join the Eurozone once the necessary macroeconomic conditions were met37. Joining the European Union was considered a great strategic success for a republic which has multi-communal rights enshrined in the constitution, but is effectively without Turkish-Cypriot representation since 1963 and under partial occupation since 1974. The Republic of Cyprus in the EU represents the whole island de jure, but in reality more than 42.8% of the area is under Turkish military occupation, United Nations Buffer Zone control, or British Sovereign Base Area command.

Cyprus was by far the most prosperous nation in terms of income of the ten new entrants in the EU, having the best macroeconomic indicators relative to other fellow entrants. In fact unlike other new entrants, Cyprus was and still is a (marginally) net contributor to the EU budget. Between EU entry and the entry into the Eurozone 2008, Cyprus had fulfilled the Maastricht criteria for entry, had an average yearly inflation of 2%, maintained a GDP growth rate of 4.1% and had one of the lowest European unemployment rates at 4% 38.

The Eurobarometer survey of opinions on the Euro in 2007 indicated that Cypriots were most suspicious of the Eurozone and only reluctantly left the Cypriot pound: only 40% on respondents thought the Euro would have a positive impact for Cyprus, and just 33% of Cypriots thought the adoption of the Euro was a positive experience for other countries39. This was due to the relative success of the Cyprus Pound in being a stable currency. However a rapid entry in the Eurozone was considered vital for Cyprus for two reasons: to reduce the interest rate premium on government and private borrowing. to enhance its competitive advantage in business services

Cyprus wanted to enter the Eurozone as soon as possible in order to reduce the interest rate of its lending. The republic of Cyprus had to endure high interest rates due to the risk posed by the presence of Turkish Troops on the island and the non-resolution of the communal problem. This high government rate created a high base rate for the economy: private

37 European Commission, Adopting the Euro http://ec.europa.eu/economy_finance/euro/adoption/

38 Source: IMF World Economic Outlook Database, October edition (2012)

http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx 39

European Commission, Flash Eurobarometer Introduction of the Euro in the New Member States: Analytical Report (2007) http://ec.europa.eu/public_opinion/flash/fl_214_en.pdf

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borrowing was also at high interest levels. The gradual abolition of capital controls prior to accession to the EU, combined with preparations for Eurozone entry led to a reduction of borrowing costs, creating a windfall gain for the government and for Cypriots. From 2008 onwards, both the government and Cypriots used that windfall to increase their debt to worryingly high levels

Why was Cyprus rapid entry in the Euro areas considered crucial in order to develop the emerging business service sector? Even before EU entry, the Cypriot government had

promoted itself as an offshore international banking and business services centre and considered that entry to the Eurozone would increase the islands attractiveness. One can argue that before the decision to enter Europe, anti-money laundering controls were below standard. Yet, as part of the negations for entry, successive Cypriot governments ensured compliance with increasingly more stringent directives on issues of corruption and illegality: it was a price worth paying in order to gain the advantages of EU entry.

Some suggested that Cyprus did improve its regulatory framework while at the same time relaxing the supervision of money-laundering, which might be fair. It is worth noting however that in terms of compliance Cyprus currently ranks as 7th out of the 17 Eurozone countries according to Financial Action Task Force (FATF) of the Organisation for Economic Cooperation and Development (OECD), with Germany being 14th. The issue of money-laundering and tax avoidance became a contentious issue during the negations of the Cypriot bailout, with the German press arguing that none of their contribution to the bailout should go to support tax dodging depositors of Cypriot banks. Thus, as part of the Memorandum of Understanding, a commitment was made for two anti money-laundering investigations: a customer due diligence report by the European ommissions MONEYVAL40, which has up to now given Cyprus a clean bill of health, and a separate report from a private firm. At the time of writing the MONEYVAL investigation has been concluded but not released and a contract has been signed with Deloitte to undertake the private investigation.

Meanwhile the effort to clean up its act in terms of money laundering had an effect: by 2000 Cyprus was removed from the blacklist of annual reviews by the FATF; this resulted to

40 MONEYVAL: acronym of Committee of Experts on the Evaluation of Anti-Money Laundering Measures and

the Financing of Terrorism

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some loss of attractiveness for offshoring in Cyprus41. In an effort to maintain the islands attractiveness as an offshore centre, Cyprus lowered its local corporate tax rate in 2003 to the same level as the offshore rate (10%), enabling foreign firms to register as Cypriot. At that moment Cyprus gave a great advantage for offshore business to the transferred into domestic companies, creating the initial conditions that would lead to the crisis. It allowed essentially offshore firms to become European firms with all the advantages that entailed, and enabled them to continue to use Cyprus as a conduit of their tax efficiency, while being domiciled inside the Eurozone from 2008 onwards.

The combination of the above policies led to unintended consequences: Cyprus in the Eurozone did expand as a financial centre, but not in the way the policy makers envisaged. The favourable double taxation treaty of Cyprus and Russia and other countries42, combined with the low corporate tax rate for Cypriot firms led to the island becoming a conduit for deposits to and from Europe. European, Russian and Ukrainian firms registered as domestic companies in Cyprus and used it for tax efficiency purposes. Sometimes Cyprus companies would funnel capital back from other offshore centres into Russia and other countries and gain tax exemptions by registering it as foreign investment.

These practices were encouraged by Cypriot banking, accounting and law services, and over time they managed to attract an ever greater number of European and non-European firms. Firms would be established here and open accounts in Cypriot banks; at the same time they would lend the money back to their international operations, making Cyprus more of a centre for capital flows (in and out) to capitalise of tax efficiency and investment schemes. This roundtripping of deposits explains in part how Cyprus is considered one of the largest investors in Russia, and why external debt of domestic companies shot up But it must also be understood that Cyprus is neither the main centre of Russian deposits within Europe (Luxembourg and Switzerland hold far higher absolute numbers of Russian deposits), and nor were such practices isolated to Russian firms and Cypriot banks, but also involved other EU and non-EU companies and financial institutions.

41 F ullen, Economic Impact of embership, in J Ker-Lindsay, H Faustmann, F Mullen (eds.) An Island in

Europe: The EU and the Transformation of Cyprus (2011) p.72 42

The double taxation treaty has been updated in 2009 with an additional protocol. Cyprus ratified the Protocol in September 2011 whilst Russia ratified it on February 15, 2012. The Protocol came into force on April 02, 2012. Source: Inland Revenue, Republic of Cyprus, Double Taxation Agreements (2012) http://www.mof.gov.cy/mof/ird/ird.nsf/dmldtc_en/dmldtc_en

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The central bank governor at the time of Euro entry, Athanasios Orphanides (2007-2012) attempted to isolate the domestic market from these volatile, essentially foreign deposits that were used for roundtipping. The CBC asked for MONEYVAL data of country of residency and enforced stricter reserve ratios on such loans; as a result banks gave lower interest in such roundtipping deposits, as they incurred a greater cost ence the foreign press was wrong to justify the bail-in of Cypriot depositors as one of higher interest rates on savings, as at least roundtipping deposits did not receive necessarily higher rates than what they would receive in other Eurozone countries, but gained from low corporate tax rate, tax efficiency and other

efficient business services that Cyprus could provide.

The PIMCO report commissioned by the CBC clearly indicates that by 2012 this went out of hand: by 31st of March 2012 Cypriot banks had over 13bn worth of assets43, when the GDP of yprus was just 1bn. The banking system became far greater than the nations ability to monitor and support it in times of crises. This would be less of a problem if the banking sector was under majority foreign ownership, as in the case of Luxembourg, and hence under the supervision of a regulatory authority which has the capability and the backing of a much larger and solvent state.

Some did warn about big, domestically owned banking institutions and the inability of the government to support them in times of crisis, but most ignored the advice44. In fact, when the second biggest bank, then called Marfin Popular (now Laiki) Bank announced in May 2009 that it would merge its Greek and Cypriot operations and move its headquarters to Greece, (thus regulated by the Central Bank of Greece) due to claimed obstruction to its work by the CBC governor, most financial commentators in Cyprus breathed a sigh of relief. Yet the decision was reversed in September 2009 through direct political intervention by the then President of the Republic of Cyprus, Demetris Christofias (2008-2013); as a result the bank merged its Greek branches with the Cypriot operations while maintaining its headquarters in Cyprus thus increasing rather than reducing the systemic risk to the Cypriot economy45.

43 PIMCO, Independent Due Diligence of the Banking System of Cyprus (2013) p.8

44 C Stephanou, The Banking System in yprus Time to Rethink the Business odel Cyprus Economic

Policy Review, (2011) Vol. 5, No. 2, pp. 123-130 45

Alvarez and Marshall, Investigation Report, Bank of Cyprus Marfin Popular Bank Group Review of Cross Border Merger 26th March (2013) p.5 http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriot-banks-sought-state-help/20130404

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The stage was set for a serious banking crisis: it took the actions of the communist led government during the period 2008-2013, the actions of the two largest banks of Cyprus, Marfin (Laiki) bank and BOC and the decisions of the Eurogroup to make Cyprus the most intractable bailout case within the Eurozone.

3. Marfin Laiki Bank; Cypriot Bank Expansion in Greece

When the republic of Cyprus became independent in 1960, it already had a competitive domestic banking infrastructure. Bank of Cyprus (BOC) was based in Nicosia (the capital) but was already a national bank and the biggest bank on the island. Following was the Limassol Cyprus Popular (in Greek: Laiki) Bank based in the second port city, Limassol. Other financial institutions (most notably the cooperative sector) and foreign banks existed, but the aforementioned banks dominated the domestic financial landscape.

Competition was mainly based on expansion in larger foreign markets. Both banks had established branches in Greece prior to the entry into the European Union due to the strong cultural links of Cyprus with Greece. The rapid inflow of deposits explained above led to a rapid expansion of their operations in Greece, as well as in new ventures in Serbia, Romania, Russia and Ukraine. In an attempt to outgrow its far larger competitor (the BOC), Laiki Bank decided in 2006 to merge with two smaller Greek banks. Greek lawyer Andreas Vgenopoulos was placed in effective control, despite not having significant ownership. In doing so the Cyprus Popular bank undertook a Faustian contract, which doomed itself and the small Cypriot economy.

Cyprus Popular (Laiki) Bank, was merged with smaller Marfin Bank and Egnatia Bank to form Marfin Popular Bank (MPB). The Greek branches of these banks were merged as Marfin Egnatia Bank (MEB) a subsidiary which with 95% ownership by MPB. The merger was a disaster for Laiki bank. MEB was one of the worst performing Greek banks, running into trouble very early in the Greek financial crisis: by 2012 over 40.1% of its Greek loanbook was non-performing46. Up to million was given in loans to third parties to buy shares in Marfin Investment Group, a company also controlled by Andreas Vgenopoulos; many of these loans were structured as bullet loans, with the principal and sometimes the

46 A Antoniou, Inbusiness (2013) 15th of April

http://www.sigmalive.com/inbusiness/news/business/40289

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interest all paid in the end of the loan period47. The decision to turn MEB into a branch of MPB in 2009 while keeping the main company under the regulatory supervision of Cyprus ensured a direct transfer of exporting the poor performance of MEB in Greece to the Cypriot state, who would have to act as the lender of last resort. What is shocking is that the merger and the convergence of MEB into a branch was not finalized until the 31st of March, 2011. By that date, it must have been clear that MEB was moribund, and that the Greek Private Sector Involvement (PSI) of Greek Government Debt was on the cards, as the Merkel/Sarkozy auville moment suggested it as far back as Octomber 2010.

It is not clear why the branching conversion of MEB by MPB was not stopped by the Cypriot Central Bank Governor. When the merger and branching was finally approved in 2011, the MPB was holding 3bn of Greek Sovereign debt, for which the CBC requested an increase of capital of 1.5bn. Yet despite increasing evidence that there would be a mandatory private sector involvement of the Greek Government Bondholders, the MPB maintained the high levels in Greek government bonds it had purchased. By July 2011 the Cyprus Government was also aware of the voluntary private sector involvement as agreed by the EU consilium, and yet no efforts were made to force MPB to realise the losses of Greek Government Bonds48. The eventual losses of Laiki Bank and Bank of Cyprus to the Greek PSI were 3bn, putting the death knell on any possibility of Cyprus being able to initiate a self-recovery.

The MPB was not the only Cypriot bank which acted recklessly in hoarding Greek Government Bonds as the Greek PSI was crystallizing. A leaked Alvarez and Marshall report indicates that the then CFO and future CEO of Bank of Cyprus, Giannis Kypri, informed the market that the bank sold 1bn reek overnment Bonds, with only 1bn left in the bank portfolio49. Yet on the same day the BOC began repurchasing Greek Government bonds reaching close to 2bn by June 21 The report highlights that in BOC (and it is assumed that similar things were taking place in MPB Laiki) kept trying to hide the emerging losses in Greece through speculation in Greek Government Bonds; up to 30% of pre tax profits were

47 Alvarez and Marshall, Investigation Report, Bank of Cyprus Margin Popular Bank Group Review of Cross

Border Merger 26th March (2013) http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriot-banks-sought-state-help/20130404 48Council of the European Union, Statement by the Heads of State of the Euro Area and Euro Institutions, (2011) 21 July http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/123978.pdf 49

Alvarez and Marshall, Investigation Report, Bank of Cyprus Holdings of Greek Government Bonds, 26th March (2013)

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coming from Greek government bond related activity in the BOC prior to the Greek PSI. The risks were there, but it seems banks preferred not to divest Greek Government Bonds, as that would mean they could avoid the crystallisation of losses50.

This is a case of clear moral hazard. By 2010 the combined investments of MPB and BOC in Greek Government Bonds were higher than the ability of the increasingly cash strapped Cyprus government to absorb them. Thus banks in Cyprus knew that if Greek bond PSI did take place, their losses would be severe enough to force the Republic of Cyprus to seek a

bailout. Thus any Greek PSI would either be vetoed by Cyprus, or Cyprus would hold out until support for the Cypriot banks or for the Cypriot government was guaranteed. This spurious strategy allowed them to invest in increasingly high risk Greek government bonds. But why did the Cyprus Government not request for a bailout when the Eurogroup decision for the Greek PSI was confirmed in EU consilium meetings in July/October 2011 and finalized in February 2012?

4. The Disastrous Government of President Christofias

There is no doubt that an emerging crisis was brewing over the island of Cyprus since 2008. Yet the above issues were then still manageable with correct leadership: At best Cyprus could have introduced measures to combat the emerging banking crisis right away and avoid a bailout; at worst the Cyprus government could have just borrowed for its stricken financial sector at the same time as Spain.

Sadly the republic of Cyprus elected a president in February 2008 with no real understanding of the issues who was also ideologically averse to the idea of the European Union. Demetris Christofias was the general secretary of the AKEL party. The party, which used to be aligned with hard line communist values, still has anti-Europe, anti-NATO, and anti-IMF views, which President Christofias has expressed frequently during his time in office.

If the banks are to blame for questionable morality, the government of Demetris Christofias is to blame for stubbornly refusing to accept the limitations of government in a weakening economy. The Christofias government can be summarised as one of unrestrained largesse:

50Alvarez and Marshall, Investigation Report, Bank of Cyprus Holdings of Greek Government Bonds, 26th March (2013)

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too much government spending, too much short term borrowing, too much solidarity to Greece, and too much delay in seeking a bailout.

President Christofias in 2008 received an economy which was by then unaffected by the Lehman brothers crisis but it was beginning to have collateral damage from the emerging Greek crisis. The initial conditions were ideal: a low debt to GDP (48.9%) ratio and small government surplus for two years (cumulative +4.4% of GDP)51 meant that the government could have supported the banking sector initially through borrowing in external markets. However, in the first year of his presidency the economy went into a recession (-1.8% of GDP), while the Christofias government went on a reckless spending spree. Despite government revenues falling by -8.5%, the Christofias government increased expenditure by 7.8% mainly in untargeted and ineffective social benefits and in exercising the patronage that previous Presidents had also exercised by bulking out the government employment. This yawning gap between revenue and expenditure kept getting larger despite the weak recovery of the economy, as the government kept increasing expenditure faster than revenue throughout its five years in office; by 2011 the debt to GDP of Cyprus rose to 71% of GDP. Even in July 2011 when the need for reigning in government revenue was understood by the then minister of Finance, Charilaos Stavrakis, President Christofias delayed and then cancelled the implementation of mild austerity measures52. This eliminated the ability of the government to borrow to help the banks, leading to a series of credit rating downgrades: these were largely ignored by the then minister of Finance, Charilaos Stavrakis, which railed about unfair treatment by the credit rating agencies.

There was resistance to this untargeted expansionary fiscal policy by the then CBC governor Orphanides, which led to public spats. The government in turn sought to reduce the governors power by placing pro-government members in the CBC board and removing the management of public debt from the CBC, establishing a public debt office in the Ministry of finance in August 2010. This enabled the Christofias government to continue borrowing in increasingly short term foreign and local loans and bonds, while ignoring the slide in credit rating of Cypriot Debt by rating agencies: S & P downgraded Cyprus from A in March 2011 to CCC in 2013. The increase in cost of borrowing due to being downgraded led to ever more short term borrowing. This dangerously skewed debt repayment of the Cyprus debt

51Source: IMF World Economic Outlook Database, October edition (2012) http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx 52

Political row puts Cyprus austerity plans in doubt Financial Mirror (2011) 25th of July

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in an unsustainable way: over 71% of the total public debt needed to be repaid in the period 2013-2016 with median expiration dates of Cypriot debt calculated in September 2011 as 2/3 years, the shortest in the Eurozone53.

This short term borrowing was both domestic but most worryingly foreign, through the use of Euro Medium Term Notes (EMTN); over 3bn mainly short term ET were issued. The role of the EMTN in the upcoming crisis of the Cypriot government is important as it placed a deadline for which further delays would lead to default. By borrowing short the Cyprus

government ensured that Cyprus could not delay the inevitable forever as there was a 1bn repayment scheduled on the 3rd of June, 2013. This hard deadline meant the the new government of President Anastasiades had no time to negotiate away the insistence for a bank depositor bail-in he had to accept what he was offered or face default within the first 100 days of his presidency.

In 2011 several incidences occurred that should have convinced the government to enter into a bailout; instead the Christofias government kept delaying what was becoming increasingly inevitable, with disastrous results for Cyprus: problems were compounded but not resolved. By May 2011 credit rating agencies eventually downgraded Cyprus to junk status, raising borrowing costs and reducing the available liquidity for the Cypriot banks. Then on the 11th of July, confiscated explosives heading Syria were negligently left in the sun for two years, and as a result they exploded, taking thirteen lives and destroying the main power station of the island. The Vassiliko station was supplying 3% of the islands electricity capacity; an independent commission found the President and his office at fault. The destruction of Vassiliko led to higher than expected government expenditures, as well as very high electricity prices, causing first a stagnation in GDP in 211 and then a double dip recession in 2012. Meanwhile Greece and then Spain applied for support from the European Commission, which was an opportunity to tie the Cyprus issue with one of a much greater

sovereign state, especially since the Greek PSI caused billions of losses to Cypriot banks; yet Cyprus did not ask for a bailout in 2011. In August 2011 the finance minister resigned over the obstruction by the President in his plans to introduce austerity. Finance ministers came and went, but no one could change the mind of the President. By December 2011 the government announced it had secured a direct loan by the Russian Federation to the tune of

53 Votsis, , Cyprus Cooperative Central Bank (2011)

5th September

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2bn the terms of the loan were kept secret. Rather than using the amount to recapitalize the banks and introduce fiscal retrenchment, the Russian federation loan was spent for general government expenditure.

Meanwhile Troika and Eurogroup meetings were confirming that the owners of Greek Government Bonds would take increasingly ever larger losses through the implemented PSI; yet the Cypriot government did not attempt to ensure that the losses of the Cypriot banks would be accommodated. It is of great mystery why did the Cypriot government not speak

out or ensure aid to Cypriot banks while the PSI negotiations were taking place, as the resulting deal led to a 3bn loss for the ypriot banking system The acceptance of the Eurogroup decision over the Greek PSI by President Christofias without securing support for Cypriot banks ensured that Cyprus would face in 2013 not just a public deficit crisis which he created, but also a banking crisis that he failed to stop.

Time essentially run out and the Christofias government asked for a bailout officially on the 25th of June 2012. Negotiations dragged on however until the 4th of December, despite all opposition parties requesting greater fiscal restraint and swift negotiation with the Troika representatives. Despite President Christofias first accepting the bailout, he once again had a change of heart; by borrowing from provident funds and pension funds of government and semi government organisations, by providing 1bn of share capital to aiki and accepting ELA for the Cypriot banking system, he managed to finish his term of office without signing or implementing the Cyprus bailout programme.

As a result of President hristofias recalcitrance, the next president faced a perfect storm of problems. State coffers are empty while short term loans are due; reforms that were due to be implemented over a five year period need to take place within the first 100 days; any room for negotiation was removed, and the ability to secure the banking system, as well as negotiate away from a depositor bail-in, has evaporated. He and his government are the principal reason the Cyprus issue has been so complicated, and why the Troika could use yprus a a guinea pig of future templates of bailouts in the Eurozone

5. Conclusion: Where does Cyprus stand- more out that in?

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The Cyprus bailout programme was passed by a very slim majority by the Cyprus parliament on the 30th of April, 213 And yet we havent seen the end nor the final resolution of the Cypriot crisis. Capital controls are in place, effectively discriminating between Euros in Cyprus vis-a-vis the rest of the Eurozone, leading to increased desire for capital flight. Cyprus is in effect more out of the Eurozone than in. Although such capital restrictions have been relaxed it is hard to see when they can be lifted since the majority of Cypriot deposits are foreign owned and they will not be willing to stay in the Cypriot banking system for long.

Meanwhile the banking crisis that the bail-in of depositors sought to resolve has remained an open wound. What is preventing its closure is the precedent of the bail-in, the delayed resolution of the Bank of Cyprus, the insistence of the ECB/CBC in offloading the ELA liability to Bank of Cyprus and the lack of direct support by the Troika to the banking sector. Unless the vicious cycle between a weak government that is unable to borrow and the weak financial sector that needs capital is addressed, Cyprus will not be able to enter a roadmap for recovery.

And yet the whole operation can be seen as a success by the European peers: the embarrassment of bailing-in insured depositors was prevented, German sensitivities prior to elections were addressed, and contagion effects were limited through the sale of the Cypriot branches in Greece. Cyprus can now stay in the Eurozone and suffer an economic calamity comparable to the war and occupation of 1974, or it can exit the Eurozone with even worse outcome but with limited impact to the rest of the Euroarea, bar the realisation of small losses for the official sector.

The damage for Cyprus meanwhile has been huge. The elimination of most working capital from business through the bail-in is closing even healthy industries that had their working capital turned into illiquid shares. There is an intense lack of liquidity as banks and cooperatives reign in on all lending and accumulate resources as the bad loan provision rates rise. Meanwhile the closure of banks for a record period and the lack of liquidity led to the Cypriot economy reverting to a partial cash-only basis, slowing down the velocity of money and hence placing a further drag on GDP. As a result of the above the real economy has crashed: unemployment figures, already at prior to the bailout 12.7%, are expected to rise to over 20%. The capital controls are threatening the future of the already wounded business services sector, and tourism lacks the ability to borrow in order to invest in further capacity.

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Whose fault is it? It is clear that the previous government of President Christofias must take a large part of the blame: the combination of excessive spending and the failure to receive support for the Cypriot banking sector during Greek PSI negotiations doomed Cyprus into a double calamity. The Cypriot banking sector and its regulatory authorities must be blamed for letting the banking sector to get so out of hand, and for mistakes in regulation and the subsequent restructuring processes. The new government of President Anastasiades also made mistakes, although its share of the blame is limited, considering it was only in power

for 15 days prior to the first Eurogroup meeting. Yet a great part of the blame must be handed to the Troika and the Eurgroup as well. The demands of each member of the troika to safeguard their own interests (IMF debt sustainability; ECB ELA, European Commission containing contagion) has led to several demands being made on Cyprus which are collectively disastrous. The insistence of the Eurogroup in placing politics, such as the German election needs, above practical issues led to a badly botched bail-in of depositors and a world record closure of the Cypriot Banking System. As Morski states for the Eurogroup No human agency has achieved so much economic destruction in such a short time without the use of weapons54.

What next for Cyprus? The Cyprus crisis was a banking crisis that also because a government debt crisis due to the mismanagement of president Christofias. Capital controls are in place and the bailout was only passed by one vote, with voices clamouring for exit from the euro and default becoming increasingly loud. The bailing-in of pension funds in Laiki and Bank of Cyprus might just turn the crisis into a pension crisis as well.

What Cyprus needs is understanding and solidarity from the rest of the Eurogroup. In order for Cyprus to find its feet, Europe must appreciate that direct support of the banking sector will be needed. Also since Cyprus is small, the amounts Cyprus needs to find its feet are minor relative to the EU whole: Cyprus should be allowed to become from a net contributor to a net recipient of EU funds as the per capita GDP of Cypriots will fall dramatically.

Both European Commission President Barroso and Oli Rehn have issued statements confirming additional funds to stimulate economic growth in Cyprus, but the amounts are far

54 P. Morski Cyprus: The Operation Was a Success. Shame the Patient Died. (2013) 25th of March

http://pawelmorski.com/2013/03/23/cyprus-the-operation-succeeded-shame-the-patient-died/

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less than the current needs of Cyprus55. Cyprus should also be allowed to restructure Cypriot foreign debt, something the government of Cyprus requested, and was denied on the 25th of March. Restructuring existing foreign debt is one of the few ways Cyprus can gain some breathing space. Cypriot EMTN bonds should be restructured on a longer time horizon; while loans by the EFSF, the European Investment Bank, the Council of Europe development Bank and the French Treasury should be restructured on similar terms as those of the Russian Federation loan.

55 JM Barroso, Letter from Commission President Barroso to President Anastasiades of Cyprus (2013)

MEMO/13/339 on the 16th of April. Rehn, Statement on Cyprus in the European Parliament (2013) SPEECH/13/325 on the 17th of April