Cyprus financial crisis: the framework for an economic recovery within the eurozone

Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at a discussion organised by the Hellenic American Bankers Association and the Cyprus-US Chamber of Commerce

New York, 11 December 2012


Ladies and gentlemen,

I would first like to thank the organisers of this event for their kind invitation to address the Hellenic banking and business communities in the US. Today I will touch upon the financial and economic challenges currently facing Cyprus as well as the way forward to come out of the current crisis.


Many developed economies in the world, including Europe, are still struggling to overcome the economic woes originating from the financial crisis. Four major weaknesses continue to feed into each other and conspire against any robust economic recovery. First, continued deleveraging by banks, firms and households is holding back normal credit flows and consumer and investment demand. Second, unemployment remains high, a condition that is both cause and effect of the lack of economic recovery. Third, fiscal austerity responses to deal with rising public debt are further depressing economic activity, which in turn is making a return to debt sustainability all the more challenging. And fourth, bank exposure to sovereign debt and the weak economy are perpetuating financial sector fragility, which in turn is spurring continued deleveraging. Developed countries, especially in Europe, continue to struggle to break through this vicious circle. According to the latest ECB projections for the euro area, GDP growth is expected to range between -0,6% and -0,4% in 2012, -0,9% and 0,3% in 2013 and 0,2% and 2,2% in 2014. Its projected path is expected to be severely affected by weak domestic demand, unfavourable financing conditions, the fiscal consolidation measures and the impact of the debt crisis on consumer and investor confidence.

Similarly, in the case of Cyprus consumer and business confidence remain at very low levels, while a further contraction in economic activity is expected until 2014. More specifically, according to the latest CBC projections, which take into account the measures agreed with the Troika, real GDP is expected to record a contraction of 2,4% in 2012, while a further contraction is expected in 2013 and 2014 due to the impact of the fiscal consolidation measures set out in the Memorandum of Understanding (MoU). 

How did we get here?

The draft MoU acknowledges that the Cypriot banking sector has been severely affected by the broader European economic and sovereign crisis, in particular through its exposure to Greece. It also states, however, that many of its problems are home grown and relate to overexpansion in the property market as a consequence of banks’ poor risk management practices and gaps in the supervisory framework that have led to significant under-provisioning.

It is important to note that banks could and should have done more to limit their exposure to Greece and their overseas expansion that is unrelated to core business. They should also have done a lot more to manage domestic loan portfolios. In particular, they should have done more to contain their exposure to the local property market.

When one invests over 100% of one’s capital in a single financial instrument – even if that instrument is considered low risk – it is indicative of poor risk management. When, however, markets consider that product highly risky, the same practice is usually considered risk loving, in other words gambling. When bankers do the same with investors’ money – because their bonuses are linked to short-term income while the losses are underwritten by the taxpayer – the same behaviour is more than just poor risk management – it is ‘casino banking’. Boards that fail to contain such behaviour by bank executives are boards that fail to exercise proper oversight. The Greek PSI alone cost Cypriot banks nearly 25% of the country’s GDP, because of excessive concentration of Greek debt in the balance sheets of the two largest Cypriot banks.  

The Cypriot taxpayer is now facing a bank bailout package that could be as high as €10 billion, which is equivalent to over 50% of Cyprus’s GDP. As a proportion of GDP it is one of the largest bank bailouts ever, second only to the 1997 bank bail out in Indonesia. 

Public finances have also deteriorated rapidly in the last few years, although even after injecting €1,8 billion of public money into one of our banks last June, the country’s public debt, currently 83,3% of GDP, remains below that of the euro area average. What has weighed heavily on public finances have been the successive downgrades by rating agencies, which have long recognised the contingent liability the large banking sector – imposed on the public finances, in light of its exposure to Greece that amounted to over 140% of Cyprus’s GDP. Weakening domestic macroeconomic conditions have also contributed to the deterioration in public finances and the significant consolidation efforts made in the last year or so have not managed to correct the excessive government deficit. 

The result of all this is that the two largest Cypriot banks were forced to request state aid. At the same time, the government finances which had been under pressure due to the relatively short maturities of the debt, have suffered interrelated mounting strains as the difficulties of banks effectively cut off the access of the Cyprus sovereign to international financial markets.

As a result, in June 2012 the Cyprus Government applied for financial assistance from the Eurogroup and the IMF. In exchange for financial assistance the Troika of institutions, namely the European Commission , the European Central Bank and the IMF, required Cyprus to embark on an economic adjustment programme aimed at restoring the health of the financial sector, continuing the on-going process of fiscal consolidation and to implement structural reforms that support competitiveness and sustainable and balanced growth. The adjustment programme is in the final stages of being concluded with the Troika. And it is the recovery of the Cyprus economy from the financial crisis in the framework of the economic adjustment programme that I wish to address next.

Economic adjustment programme

The programme aims at addressing short- and medium-term financial, fiscal and structural challenges facing Cyprus. The key objectives are:

·  To restore the soundness of the Cypriot banking sector by thoroughly restructuring, resolving and downsizing financial institutions, strengthening supervision and addressing expected capital shortfalls;

·  To continue the on-going process of fiscal consolidation in order to correct the excessive general government deficit, and maintain fiscal consolidation in the medium term and to improve the efficiency of public spending;

·  To implement structural reforms to support competitiveness and sustainable and balanced growth.

Banking sector reforms

The banking sector will be thoroughly reformed and restructured in depth. The objective is for the sector to become smaller, sounder and more resilient. I will now focus on some of the main banking sector reforms included in the economic adjustment programme.

Due diligence review

The Central Bank of Cyprus (CBC) in consultation with the Troika has assigned an external consulting firm to conduct a due diligence review of the credit portfolios of a sample of banks and cooperative credit institutions(coops), which on aggregate represent the largest part of the sector. The review includes both an accounting review and an assessment of the economic value of banks' assets. The preliminary results were submitted to the project’s Steering Committee last weekend. The final report is expected to be made available by mid-January 2013.

The exercise will form the basis for a bank-by-bank stress test, using a baseline and adverse macroeconomic scenario. This stress test will build on the top-down exercise used to determine the overall size of the capital back-stop facility along with the capital needs of each participating institution. The aim is to establish the specific capital needs of each bank or coop with a view to recapitalisation or resolution, if necessary.

Restoring adequate capital buffers

All banking groups will be required to increase their minimum Core Tier 1 capital ratio from the present level of 8% to 9% by end-2013. Following the due diligence review, those institutions deemed to be undercapitalised will be required to present quarterly capital and funding plans to the CBC, explaining how they intend to fulfil the new capital requirements. Capital should, to the largest extent possible, be raised from private sources including internal measures, asset disposals and liability management exercises.

Maintaining liquidity in the banking sector

Enhanced liquidity monitoring will include the establishment and submission of quarterly medium-term funding plans by banks borrowing from central banks to the CBC. The plans should realistically reflect the anticipated deleveraging in the banking sector and reduce dependency on central bank funding, while avoiding asset fire sales and a credit crunch.

The lack of concentration limits in the liquidity framework allowed a concentrated exposure of Cypriot banks to Greek sovereign debt. To avoid similar outcomes in the future, the CBC will update and strengthen the prudential liquidity regulations for banks.

Regulation and supervision of banks and coops

The regulatory and supervisory framework for banks and coops will be enhanced, inter alia, by:

·  Increased efforts to maximise bank recovery rates for non-performing loans, while minimising the incentives for strategic defaults by borrowers;

·  Better monitoring and management of non-performing loans in order to safeguard the banks' capital buffers as well as tightening of prudential regulation regarding the classification of loans as non-performing;

·  The establishment of a central credit register listing all borrowers and beneficial owners, from both commercial banks and coops, to enable these institutions to check new loan applications against the register;

·  A review of the current regulatory framework with respect to loan origination processes, asset impairment and provisioning, and the treatment of collateral in provisioning;

·  Enactment of legislation to strengthen corporate governance in banks and coops, including strengthening of independence of boards and enhanced disclosure;

·  The introduction of supervisory mandatory structured intervention based on capitalisation levels for banks and coops.

In addition to the above, a number of other measures will apply specifically to the coop sector:

·  The regulation and supervision of coops will be aligned to that of commercial banks.

·  Their supervision will be conducted independently of considerations for the development of the coop sector as a whole.

·  The supervision of coops will be conducted along the lines of best practice in the euro area. In particular, a two-tier system will exist with the CBC being the ultimate supervisor and the Co-operative Central Bank conducting the day-to day supervision of the coops. It is no secret that we have been particularly inspired by the Rabobank model in the Netherlands which delivers good governance and supervision while respecting the local character of coops.

·  The accounts of coops above a certain threshold will be subject to an independent annual audit by an external and internationally recognised auditing firm.

Bank restructuring and resolution

Credit institutions deemed viable based on their restructuring plans can, if other measures do not suffice, ask for recapitalisation aid from the state or for a transfer of assets to an asset management company (AMC), pending formal approval under EU state-aid rules. The credit institutions benefiting from capital injections and/or transfer of assets will be subject to specific management rules and restrictions, and to a restructuring process. Banks that are deemed non-viable will be subject to the new resolution framework. 

The Cypriot authorities will introduce legislation establishing a comprehensive framework for the recovery and resolution of credit institutions. The CBC will become the single resolution authority for banks and coops. The new resolution legal framework will allow the CBC to mandate the sale of some or all of the assets and liabilities of an institution, the establishment of a bridge institution, the setting-up of an AMC and the enforcement of a write-down or conversion of capital instruments into common equity, also in the context of a recapitalisation with state aid.

Segregation of non-performing assets

In order to resolve bad assets effectively and to reduce the financial sector's exposure to non-performing and non-core assets, the Cypriot authorities could consider the setting up of an AMC or other vehicles. These will be able to acquire loans and other claims, including foreign exposure from credit institutions in Cyprus that have received or will receive state aid. The objective of asset segregation will be to maximise the recovery value of assets, which will be wound down within a medium- to long-term perspective. As part of its funding strategy, an AMC or other vehicles will have the capacity to issue bonds that are guaranteed by the state. In exchange for the assets, the banks will receive a consideration which may take the form of a suitably small equity participation in an AMC or other vehicles, bonds issued by an AMC or other vehicles, cash and/or high quality securities.

Fiscal policies and reforms

Fiscal consolidation

Efforts aimed at consolidating the public finances have been pursued over the last 18 months, but have been countered by losses in the banking sector that have further strained government financial resources and essentially cut off Cyprus’s access to financing from international markets. The weakening of the public finances, also caused by rapidly increasing public sector wages and social benefits, has led to rising government debt, which is expected to climb to over 85 % of GDP by end-2012. The fast growth of public sector wages has also driven economy-wide labour costs higher, resulting in a loss of competitiveness.

Accordingly, the programme’s second pillar entails a comprehensive fiscal consolidation plan underpinned by structural reforms. Moreover, the Cyprus authorities view the placing of the government finances on a sustainable path as of overriding importance in order to stabilise the economy and to restore the confidence of companies, citizens and foreign investors in the longer-term prospects of Cyprus as a competitive, advanced and investor-friendly economy.

In this endeavour, the on-going process of fiscal consolidation is being intensified so as to lower significantly the general government deficit, and bring the budget close to balance by 2016. Indeed, the government is committed to achieving a primary fiscal surplus of 4% of GDP by 2016, which is needed to place debt on a sustained downward path. 

The programme is front-loaded in that out of a total fiscal adjustment effort of 7,25% of GDP over the period late 2012 to 2016, over 3% of GDP in budgetary measures need to be passed and implemented in the last weeks of this month and in 2013. 

Fiscal adjustment measures for December 2012 and 2013 are concentrated on the expenditure side and focus on substantial reductions in public sector wages and cut-backs in social benefits as well as reductions in transfers to semi-government organisations. Excises, VAT rates and property tax rates will be raised to contribute to the front-loaded adjustment. Measures to be implemented in 2014 and beyond comprise mainly of further reductions in public sector wages and social benefits and increases in indirect taxes.

Structural reforms

In the decade or more prior to the financial crisis, Cyprus experienced relatively rapid economic growth accompanied by the fast expansion of the public sector. If the public sector is to continue providing appropriate support for the sustainable and balanced growth of the Cyprus economy, fiscal and labour market-structural reforms are needed to improve competitiveness, to provide the fiscal space necessary to diversify the economy and to ensure the long-term sustainability of public finances. In this respect, reforms will be implemented in the following areas: 

Labour market

Competitiveness will be improved by reversing the considerable public sector wage increases of recent years and reforming the wage indexation mechanism that in turn wag will contribute to an improvement in competitiveness. 


Cyprus will build on recent pension reforms by, among other things, gradually increasing the mandatory retirement age and implementing an early retirement penalty. The impact of reform options such as benefit reductions, higher contribution rates, and further increases in statutory retirement ages are also being considered. And after consultation and agreement with programme partners a comprehensive reform with the aim of establishing the long-run viability of the system will be carried out, if needed.

Other fiscal-structural measures and reforms

Time does not permit detailed discussion of other fiscal-structural measures and reforms incorporated in the economic adjustment programme. These include: 

·  Steps to raise tax compliance and collections;

·  Reforms of the public administration to improve its functioning and cost-effectiveness;

·  Improving the efficiency of state-owned and semi-public enterprises.

Government debt

There is still some debate on how government borrowing under the economic adjustment programme will affect government debt sustainability and how the revenue from natural gas exploration and exploitation can contribute to lowering the government debt burden.

At end-2012 the government debt-to-GDP ratio is estimated to reach 86% of GDP, which includes €1,8 billion for the support of Cyprus Popular Bank. Assuming that the government net borrowing under the economic adjustment programme from the ESM and IMF amounts to €11,5 billion (€1,5 billion for financing government deficits and €10 billion for capitalising banks) over the programme period to end 2015, then the government debt -to -GDP ratio could reach over 140%.

There is of course the prospect that if funds from the ESM can be used to directly inject capital into banks and not be placed on the balance sheet of the government then the government debt-to-GDP ratio can be reduced pari passu. If, for example, €6,5 billion was directly injected as capital into Cyprus banks from the ESM during the programme period the government debt-to-GDP ratio would be lowered to around 100%. This prospect is, however, dependent on progress with the establishment of a banking union in the euro area. While differences among EU member states on certain aspects still remain, the topic is expected to dominate the discussions at an extraordinary ECOFIN Council to be held on 12 December, before the European Council meeting of 13-14 December, with a view of working out solutions on the main sticking points. Despite the difficulties, I am cautiously optimistic that a compromise on the banking union is in sight.

It is stated in the MoU that government revenue from natural gas exploration and exploitation in Cyprus offshore waters could be used to repay government debt. With estimated revenues of up to €300 million annually from exploration rights, royalties, etc. from 2013 onward and very large profits foreseen from natural gas production and exports from 2018 onward, there are good prospects that proceeds from natural gas exploration and exploitation will reduce the debt burden substantially over the longer run.

Natural gas

Over the last 18 months there have been very important natural gas discoveries in the offshore waters of Cyprus providing a large boost to the potential assets of the Republic. More specifically, the discoveries of substantial quantities of natural gas within Cyprus’s Exclusive Economic Zone reported by Noble Energy in December 2011 and the estimated potential in adjacent and Israeli fields have fundamentally changed the medium and long-term economic outlook for Cyprus. According to the initial evaluation of Block 12 by Noble Energy, a massive natural gas reserve of around 3 trillion cubic metres exists in this region.

The system chosen for licensing the exploitation of natural gas is a production sharing contract. Under this contract, the Cyprus remains the legal owner of the natural gas deposits and has a right to also receive part of the natural gas produced, thus reducing the country’s dependency on energy imports. A second round of licensing for exploration begun on 11 February 2012 and was completed on 23 September 2012. A total of five companies and ten consortia bid for exploration rights.

On 5 October, the government announced the formation of a state-owned hydrocarbon company to handle all aspects of natural gas, including its import, liquefaction, transport and export. It is expected that the company will be instrumental in attracting investors for the construction of a liquefied natural gas terminal to process the gas to be extracted from Cyprus’s offshore Block 12 and adjacent fields. It is estimated that the liquefaction plant will cost around €10 billion. Cyprus is expected to derive direct economic and financial benefits from the production and export of natural gas in around five to six years’ time, when onshore storage and condensing facilities for the natural gas have been completed. While the anticipated government revenues from natural gas are clearly uncertain, the Ministry of Commerce currently estimates them to be in the range of €18,5 billion - €29,5 billion for Block 12 alone, depending on the method of extraction.

Following agreement with the Troika a study on the financial aspects of the transition towards the exploitation, use and export of natural gas will be undertaken as a first step in the formulation of a comprehensive development plan for the Cyprus energy sector, including the costs and financing sources for infrastructure investments. Cyprus’s natural gas resources will be used to help with financing the necessary infrastructure for the development of the hydrocarbon industry, for investing in future generations, and for placing Cyprus’s public debt on a steady downward and sustainable path. In particular, natural gas revenues will allow Cyprus to meet its current and future debt service obligations in full, without recourse to further debt relief or rescheduling, while allowing the country to achieve an acceptable level of economic growth.

Concluding remarks

This is undoubtedly a difficult juncture for Cyprus. But it is encouraging that the agreement with the Troika has been expedited by substantial goodwill on all sides, i.e. government, political parties and other stakeholders. Everyone has shown understanding, willingness and flexibility for the purpose of adapting a programme of financial, fiscal and structural adjustment appropriate for the needs of the country.

I remain optimistic that the Cyprus economy and financial sector as a whole will recover and come out stronger from the current crisis. The economic adjustment programme should be seen as a catalyst that will reinforce macroeconomic and financial stability in the country. The effective implementation of the programme should restore the health and soundness of the financial sector, so as to allow credit flows to the real economy to resume and thus contribute to the revival of private sector activity. This will help to spur sustainable economic growth and employment creation. Secondly, public finances will be placed on a sustainable path that will provide the stability and fiscal space necessary for supporting reforms and the balanced growth of the economy. Finally, over the longer term the exploitation of natural gas discoveries should substantially boost growth prospects and help lower the debt burden of future generations.