Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at the Cyprus International Business Association
Limassol, 25 September 2012
Cyprus has served as a centre for commerce and business since antiquity. The island’s geographical location and its skilful, hospitable and hard-working people have always been fundamental to its prominent position as a financial hub at the crossroads of three continents. Unsurprisingly, 12 conquerors ruled the island from the ninth century BC onwards and enjoyed the ensuing privileges. From the Phoenicians who settled at the island around 850 BC until the British colonial rule which ended in 1960, the island was considered a valuable conquest.
It might sound peculiar talking about the attractiveness of Cyprus at this undoubtedly difficult juncture due to the challenging economic conditions that Cyprus is faced with and which have forced the Government to apply for an EFSF/ESM programme. The ongoing euro area crisis led to a manifestation of the risks emanating from the large expansion of our banks abroad, most notably in Greece, and resulted insignificant capital shortfalls. There is no doubt, however, that the crisis has also brought to the fore underlying structural weaknesses, which to some extent were masked by the island’s good economic performance in the last two decades.
As an economist who, before taking on my current role as Governor of the CBC on 3 May 2012, researched and published in the fields of banking and financial crises for nearly two decades, the current crisis does not find me unprepared. Although history teaches us that every crisis is different, one can still draw many useful lessons from previous crises. One such lesson is that crises come and go. Another one is that a crisis is usually a rare opportunity to fix long standing problems, including structural weaknesses. This is why I can actually say that I am cautiously optimistic about the future of the Cypriot economy, as I am also about the future of the euro area.
In the remainder of this talk I would like to set out the reasons for my optimism.
Let me first start with a very brief overview of the main achievements of the Cypriot economy since the island gained its independence in 1960. Back then, the traditional rural economy was predominantly focused on agriculture and mining. The economy gradually developed into a services oriented economy, exhibiting a remarkable economic performance and resilience to external shocks. Even after the Turkish invasion in 1974, which destroyed over two-thirds of the island’s productive capacity, the economy recovered swiftly and in 2004 it achieved its strategic goal of becoming an EU member state, eventually joining the euro area in January 2008.
Cyprus is now widely recognised as a prominent international business and financial services centre. Our country enjoys a number of comparative advantages, which render it an ideal base for the conduct of international business. Its strategic location as Europe’s Middle Eastern outpost, the highly qualified and multilingual labour force and the advanced telecommunications network and infrastructure provide solid foundations for a business friendly environment. The provision of efficient professional services such as legal, accounting and banking services support the formation and management of all types of business activities. The highly favourable tax regime, including a corporate tax rate of 10%, 45 double taxation agreements, international trusts, and competitive ship registration fees and taxes ensures that businesses can reap the benefit of their operations worldwide. Moreover, Cyprus is an island that provides the opportunity for leisure activities all year round, combining a long heritage of arts and culture, pleasant weather conditions and, most importantly, safety and security.
I would like to elaborate on some of the aforementioned reasons for investing in Cyprus.
The accession of Cyprus to the EU on 1 May 2004 significantly expanded the potential for new business opportunities in a stable environment governed by EU laws and regulations. The adoption of the euro on 1 January 2008 further fostered the prospects for doing business through enhanced access to EU markets while reinforcing the institutional context for preserving a macroeconomic environment conducive to business. As anticipated, the island’s accession to the EU and the adoption of the euro in 2008 promoted the role of Cyprus as a financial services hub and the island is now a well-established investment gateway to the European Union, Eastern Europe and other markets.
Cyprus has a young, multilingual and well-educated workforce. The number of university graduates per capita is one of the highest in the EU and the Government is committed to further promoting the island as an educational centre. Since 2004 Cyprus has consistently allocated over 6% of GDP to education. In 2011, 33,6% of the island’s population aged between 15 and 64 held a Bachelor’s, Masters, or PhD degree. The respective figure for the EU27 was 23,6%.
A cutting edge and reliable telecommunications network provides companies based in Cyprus with excellent and efficient connectivity worldwide. Furthermore, advanced public infrastructure, including two recently inaugurated international airports, and convenient modern road network and port facilities have been instrumental in building Cyprus’s status as an international business and financial services centre in the region. More than 35 airlines operate scheduled flights from and to Larnaca International Airport and Paphos International Airport.
Cyprus is also a major international shipping centre, ranking among the top 10 maritime nations globally. The Cyprus flag has more than 1.000 registered vessels or about 21 million gross tonnage. More than 140 ship owning and ship management related companies maintain offices in and conduct international activities from Cyprus. These companies collectively control a fleet of about 2.400 ships with 48 million gross tonnage.
Notwithstanding the declining trend registered since 2001, tourism still remains an important contributor to our GDP. The Cyprus Tourism Organisation’s Strategic Plan for Tourism aims at the sustainable enrichment and upgrading of the ‘sun and sea’ tourist product, the promotion of new specialised products such as wellness, medical and sports tourism, conference tourism and incentives travel. Concurrently, a number of important infrastructure projects, ranging from the construction of golf courses to the development of marinas, are being implemented, aiming at adding value to Cyprus as a tourist destination.
The tax regime is a decisive factor in assessing the location of foreign investment. The Cypriot tax regime serves this purpose well, with a corporate tax rate of only 10%, one of the lowest in the EU, and an extensive network of double tax agreements, ensuring that the same income is not taxed in more than one country. Further double tax agreements are being negotiated with other countries and are in the final stage of being concluded. It should be emphasised at this point that negotiations with the troika on the conclusion of an EFSF/ESM economic adjustment programme for Cyprus will not have any impact on the tax regime governing international business activities in Cyprus whatsoever. In fact, not only the favourable tax regime but also all the other arguments for investing in Cyprus will continue to hold after the agreement on the economic adjustment programme.
The attractiveness of our country for direct investment is proof of the confidence in the Cyprus economy with a strong record in FDI and further FDI potential. Between 2007 and 2011, inward FDI amounted to a total of €6.656 million. As at 31 December 2011, the top four countries contributing to the inward FDI stock were the USA, Greece, UK and Russia. In 2011 the top four FDI sectors were wholesale and retail trade, professional, scientific and technical activities, financial and insurance activities and real estate activities.
In the field of energy, explorations in the Exclusive Economic Zone of Cyprus have established the existence of significant reserves of natural gas with a commensurate prospective financial impact on the island’s economy and welfare. A second round of licensing for the offshore exploration of hydrocarbons has been recently concluded in which a total of 15 applicants (companies or consortiums) expressed their interest. A decision by the Council of Ministers is expected within six months from the date of submission of applications. At the same time, the Government is strongly committed, inter alia, to encouraging the development of renewable energy technologies.
Let me now turn to the challenges facing the Cypriot economy today, especially the banking sector, and explain why I am confident that these problems will be overcome in the very near future.
As you know, the two largest Cypriot banks have requested state aid partly due to the capital shortfalls emanating directly from the Greek PSI. The banks were able to absorb a significant portion of these losses because, prior to the Greek PSI, they had substantial capital buffers. These, however, were not sufficient to absorb all the losses. In addition, the quality of both banks’ assets has been affected by their substantial exposure to Greece, and the deterioration of the property market in Cyprus. These adverse developments have put additional pressure on bank balance sheets, reflected in rising non-performing loans. It should be noted, however, that both banks continue to be profitable from their operations and their latest results show a more determined effort to clean up their balance sheets through a sharp increase in provisions, and to contain their operating expenses. The Central Bank of Cyprus (CBC), in its supervisory role, is taking important steps to strengthen corporate governance and risk management within both banks. The two banks have new leaderships with whom we are working very closely in order to ensure that the banking sector emerges stronger from the current crisis.
We have also appointed a leading international company to carry out an independent investigation into the circumstances that led the two banks to apply for state aid. This investigation will provide clarity and comprehension regarding the current financial stress in the Republic and will guide remediation to strengthen the stability of the banking sector.
The Government’s application for financial support from the EFSF/ESM and the IMF primarily aims to recapitalise the banking system. Recapitalisation is of course an opportunity to also restructure the banking system, and I can assure you that this opportunity will not be missed. We need, for example, to further strengthen corporate governance in the banking system and to tighten supervision not only of banks but also of credit co-operatives. Much more emphasis should also be placed on the macro-prudential aspect of supervision to identify, monitor and assess risks to financial stability and implement policies to strengthen the resilience of the financial system and decrease the build-up of systemic risks. Moreover, we need our banks to focus on core business, which may involve, among other things, withdrawing from some retail operations overseas while at the same time improving their services to their international clients on the island. We want the domestic banking system to become more healthy, more resilient and more competitive. I can assure you that the reforms that are currently taking place or are in the pipeline will aim to achieve all these things.
These are significant developments that will contribute not only towards maintaining financial stability in Cyprus but also towards restoring confidence and lowering the costs of doing business on the island. I am therefore confident that the Cypriot banking system will emerge substantially stronger from the current crisis and, as a result, so will the country’s economy.
In the next few years I expect to see shrinkage in the overall size of the Cypriot banking system relative to the size of the economy and I also expect to see the domestic banking sector becoming more competitive, not least because of new entrants in the market. A smaller, leaner and more competitive banking system will naturally have room for large and small players, and for different types of ownership, i.e. domestic, foreign, shareholder-based or mutual. Such diversity in any system is a source of resilience. Moreover, a more competitive banking sector will result in a lower cost of capital for non-financial corporations, which will help stimulate private investment and growth. The CBC’s aim is to maintain a healthy, stable and robust banking sector that can underpin sustainable growth.
There will also be much talked about reforms that will aim to consolidate public finances and strengthen competitiveness. These reforms are to be negotiated and agreed between the government, the troika and other stakeholders. Our aim, as the CBC, is to bring the talks to a successful conclusion by the end of October 2012. We will play our part in the negotiations with the troika.
There is also an additional reason that makes me optimistic about the future of the Cypriot banking sector and the economy as a whole. Recent decisions and actions at the EU level with the aim of tackling the crisis demonstrate strong eagerness on behalf of the EU leaders and institutions and are therefore reinforcing our efforts to overhaul the banking system in Cyprus. It is reassuring to see that the ECB is determined to act to safeguard the monetary union from market distortions which threaten its viability. In my few months on the ECB Governing Council, I have witnessed increased determination by the ECB to safeguard the future of the currency union. Recent examples of policies aimed at enhancing economic and financial stability include the enhancement of collateral requirements, the new Outright Market Transactions (OMT) programme as well as the significant progress made in creating a banking union in the EU.
As regards the setting-up of an EU banking union, in June of this year the European Council committed itself to the establishment of a single supervisory mechanism (SSM) for euro area banks. This decision was based on the fact that the EU banking sector has grown significantly and has become increasingly interconnected. Many banks have developed cross-border activities and have outgrown their national markets. The recent financial crisis has clearly revealed how quickly and powerfully problems in the banking system of one country can spread to another. This is especially the case in a monetary union. Coordination of national banking supervision is no longer an option for the euro area. A move to an integrated supervisory system is necessary.
The Commission proposals for a SSM for banks in the euro area published on 12 September 2012 are a significant first step in creating a banking union. In the new single mechanism, ultimate responsibility for specific supervisory tasks related to the stability of all euro area banks will lie with the ECB. National supervisors will continue to play an important role in day-to-day supervision and in preparing and implementing ECB decisions.
This new system, with the ECB at the core and involving national supervisors, will help restore confidence in the supervision of all banks in the euro area. Banking supervision needs to become more effective in all European countries and we have to make sure that single market rules are applied in a consistent manner. A mechanism has been proposed to separate banking supervision from monetary policy within the ECB as well as make the ECB accountable to the European Parliament for supervisory decisions, while maintaining its strong independence. Thus, the European Parliament will also have a crucial role to play in ensuring democratic oversight. This will also pave the way for any decisions to use European backstops to recapitalise banks.
The ECB will cooperate with the European Banking Authority (EBA) within the framework of the European System of Financial Supervision. The role of the EBA will be similar to today: it will continue developing the single rulebook applicable to all 27 member states and make sure that supervisory practices are consistent across the whole EU.
As the Vice-president of the Commission, Olli Rehn, has stated, the timetable for implementing of the Commission proposals on the SSM by the end of 2012 is ambitious but feasible. In my view, every effort should be made to move ahead as quickly as possible based on a phasing-in approach, as put forward in the proposals, due to the urgency of the matter, especially as the set-up of the SSM has been made a precondition for the possible direct recapitalisation of banks by the ESM.
Although past losses may need to be borne by the Cypriot taxpayer, the future capital needs of banks that are systemically important in a banking union would ideally be covered by the ESM.
Overall, a European banking union is envisaged to be one of the main drivers towards much deeper European economic integration. The Cypriot authorities fully support this endeavour which, apart from the setting up of the SSM, also includes the establishment of European deposit insurance and resolution schemes. The various components that integrate the concept of a banking union constitute a solid and consistent framework that will foster financial integration and be supportive of EMU. Their implementation will partly address the current crisis by helping to sever the link between sovereigns and banks and reverse the on-going fragmentation of markets along national borders.
For countries like Cyprus with large banking systems, the banking union is particularly important since it will decouple sovereign risk from banking risk.
Given these positive developments in the euro area, I believe that with appropriate planning and with the assistance of our European partners, the banking sector and the Cyprus economy as a whole will recover and will come out stronger and capable of achieving more sustainable economic growth.
Last but not least, Cyprus is a small and very open economy with a large number of trading partners. This is both a source of vulnerability in bad times – when other economies are in recession - as it is also a source of strength in better times – when our trading partners are booming. Once the recovery begins elsewhere, a relatively small increase in demand for the products and services we produce will make a big difference to our economy. In light of improved competitiveness that the programme will no doubt deliver, Cyprus will be in a strong position to benefit from such a development.
In conclusion, Cyprus’s medium and long-term prospects remain very good. Besides excellent human capital, institutions and infrastructure, the recent discovery of natural gas resources, and the associated investments that are envisaged, has substantially improved the medium and longer-term growth potential of our economy. The conclusion and implementation of an EFSF/ESM economic adjustment programme should not be seen as a development hampering investment opportunities. Potential investors have nothing to fear in that regard. Instead, the EFSF/ESM programme should be regarded as a catalyst that will reinforce macroeconomic and financial stability in Cyprus thereby further promoting the position of the island as an international business and financial centre.
In my capacity as Governor of the CBC I will do my best to set the conditions for safeguarding the stability and soundness of the banking sector in Cyprus. When my term ends, I would like to deliver a more competitive, more resilient and more innovative banking system.