By W.A. Wijewardena –

Dr. W.A. Wijewardena

Cyprus Financial Crisis: Where there is hot money, there is finger-burning too

Parallels between Sri Lanka and Cyprus

In many respects, Cyprus and Sri Lanka have parallels. Both are former British colonies which gained independence in mid 20^th century, 12 years apart from each other. Both had been embroiled in a costly ethnic war for decades. Both are islands located on convenient naval routes – Cyprus in the Mediterranean and Sri Lanka in the Indian Ocean – offering enormous economic prospects. Both have no natural resources except a hint of some off-shore natural gas deposits in Cyprus and identified oil and gas deposits in off-shore Sri Lanka. In both countries, it is yet to establish whether these deposits are commercially viable. Both have skewed economies with a huge services sector, a light industrial sector and a relatively small agricultural sector. In the case of Cyprus, services produce 82 percent of its wealth and agriculture only 2 per cent. The relevant ratios for Sri Lanka have been 60 per cent and 12 per cent for the latest data. In the services sector, Cyprus has developed three hubs – naval, aviation and banking – to boost the services income in the balance of payments or BOP and thereby meet the huge trade deficit. Sri Lanka is also planning to develop five hubs which include these three as well for the same reason, namely, financing the huge trade deficit through a diversification of foreign earnings. In the recent past, Cyprus has tapped cheap hot money in the international markets – money that moves around in search of higher interest incomes but does not stay in a country permanently – mainly from Russia to fill the gap in the BOP. Sri Lanka too has tapped such hot money into its government securities market mainly from USA as reported in the media to fill the gap in the BOP and thereby build its foreign reserves.

Essential differences

But there are two important differences between the two countries, one relating to their ability to issue money and the other relating to the level of economic prosperity.

With regard to the first difference, Cyprus has given up the right to issue its own currency by joining the Euro Zone and becoming a part of the European Central Banking system. Thus, it uses Euros produced elsewhere as its currency. By giving up this right, Cyprus has sought the protection of the wider Euro Club. But Sri Lanka has its own central bank which can produce its own currency and therefore does not have to depend on an external source to supply it to the market. But that self-sufficiency and independence have been attained by sacrificing the protection which it would have got from an outside party in a crisis situation.

Cyprus is in the rich country club

Regarding the economic prosperity, nearly 800,000 Cypriots produce an output of about $ 24 billion annually earning on average about $ 25,000 per citizen. Thus, Cyprus is in the rich country club. In contrast, Sri Lanka’s 20 million people produce an output of about $ 59 billion and their average per head income is about $ 2900 or one eighth of the income of their counterparts in Cyprus. Accordingly, Sri Lanka is still in the lower middle income country category struggling very hard today to push itself up to the upper middle income country category.

The Cypriot financial crisis

Cyprus has been faced with a financial crisis since 2011 and it culminated to a peak level by the first quarter of 2013. The crisis is so grave today, its President has announced that within the next few days, the country will either make it or break it. Hence, the examination of the Cypriot financial crisis – its root cause, its direction and its resolution – will be an eye-opening exercise for a country like Sri Lanka which is also exposed to similar external sector risks.

Exploiting Russian Hot Money

Why has Cyprus tapped the Russian hot money which is widely believed to be ill gotten and therefore banned under the global anti-money laundering laws? The reason has been the desperation. It is like a drowning man clinging to a floating piece of straw to save himself. Cyprus has developed itself as a major tourist centre in the Mediterranean and to maintain the rich tourists visiting the country, it has to import practically everything from abroad. Thus, its imports have been pretty much higher than its exports resulting in a persistent and rising gap between its imports and exports, known as the trade gap. The latest data indicate that the trade gap is as big as 12 per cent of the country’s GDP. This gap has to be filled by the earnings out of services. By developing the naval, aviation and banking hubs and promoting tourism in the country, Cyprus has been able to earn a sizeable amount as services income but it has amounted to only 9 per cent of GDP. The net incomes in the form of wages, interest, rents and profits from abroad and the remittances have not been able to fully offset the still remaining gap in the trade and the services accounts. Thus, Cyprus has a deficit in the current account of BOP in the region of about 2 per cent of GDP and it has been a recurring feature.

Sri Lanka is worse off than Cyprus

In comparison, Sri Lanka’s situation is a little worse than that of Cyprus. Like Cypriots, Sri Lankans too have to import practically everything necessary to maintain the tourists visiting the country. Cyprus has an annual tourist flow of about two and a half million compared to Sri Lanka’s one million. Sri Lankan authorities too are planning to increase the tourist traffic to about two and a half million tourists per annum within the next five year period. When that target is realised, Sri Lanka will find itself in a more dangerous situation since its already high trade deficit at about 16 per cent of GDP is to jump up further to meet the demand coming from tourists. In the absence of viable business plans, Sri Lanka’s current naval and aviation hubs are still not money earners and therefore do not support to fill the gap in the services account. Hence, it has a huge deficit in the trade and the services accounts of BOP which is not fully offset by the remittances sent by the Sri Lankans working abroad. This has led to a sizeable deficit in the current account of Sri Lanka’s BOP amounting to about six per cent of GDP. To fix this ailment, Sri Lanka is required to go for a massive economic restructuring and reform programme, but the authorities appear to be, like Cypriots, relying on hot money coming from abroad to fill the gap and live for another day through these palliatives.

Easy hot money promotes risky lending

When Cyprus attracted Russian hot money out of desperation, its banking system became over-liquid compelling it to increase its lending in a relaxed manner.  Thus, the total bank loans amounting to $ 110 billion by end 2012 were four and a half times the country’s GDP. Despite the denial by the Cypriot Central Bank that there is no money laundering involved, the UK based ‘The Independent’ had reported on 03 August 1994 that Russians arriving in Cyprus in private jets and carrying suitcases full of dollars have been depositing such money in Cypriot banks. According to an estimate made by the rating agency Moody’s, the total amount which Russians have deposited with Cypriot banks is in the region of some $ 31 billion, much more than the total GDP of the country (available here).  Much of such deposits have ended up as investments in Greek government bonds and when Greece, following its financial and economic collapse, had defaulted the payment of those bonds, the victims were the Cypriot banks. According to the statistics released by the Central Bank of Cyprus in December, 2012, the non-performing loans of Cypriot commercial banks and Coops had amounted to € 23 billion or 27 per cent of the total loan portfolio of these institutions (available here ). This is 125 per cent of Cyprus’ GDP. Naturally, the Cypriot banking system cannot continue its operations without an outside liquidity support in the first instance and recapitalisation of banks to make them solvent as a permanent solution.

The meltdown of the solidified services sector

Cyprus being a part of the Euro Zone had to depend on the European Central Bank or ECB to pump liquidity to its banking system. According to ECB policy, it can supply liquidity only to solvent banks and since Cypriot banks have become insolvent, ECB could not continue with its liquidity support to them. Without liquidity support, Cypriot banks have suffered from an acute cash shortage. Thus, Cyprus had all the ground conditions for a massive bank run by the third week of March, 2013. This had to be fixed quickly to save the country’s financial system, and consequentially its economy, from collapsing. All the hubs that had been developed in Cyprus to create wealth for the nation were running the risk of ending up in smoke like a Chinese paper lantern that has caught fire.

Troika’s offer: Sinners have to pay

To prevent another financial crisis in the Euro Zone, European Commission, European Central Bank and the International Monetary Fund, nicknamed Troika after the notorious Soviet era three judges to punish people, put forward a bailout plan. According to this plan, out of the liquidity support of € 16 billion, ECB and IMF will provide € 10 billion and the balance € 6 billion has to be supplied by Cyprus as its stake. However, the Troika did not want the Cypriot tax payers to shoulder the burden because it was inequitable to pass it on them. The underlying reasoning was that it is the stakeholders of the banks and not the general tax payers who should rescue the Cypriot banks. Accordingly, a major stakeholder, namely, the depositors, was selected as the single group that should bear the full burden of recapitalising the insolvent banking system in the country. The trick was to exchange a part of their deposits for equity in banks.

Compulsory levy on deposits

Thus, a proposal was placed before depositors that they should forego a part of their deposits in exchange for shares of the banks concerned and the future revenue from the yet to be commercially developed gas sector of the country. The formula suggested was that deposits of less than € 100,000 will be charged one off levy of 6.75 per cent and the deposits above that amount a levy of 9.9 per cent. The Cypriot Parliament was supposed to approve of this bailout plan but despite the pleading of the country’s President, the Parliament rejected it possibly in fear of the massive public wrath as demonstrated by wide-spread protests that had sprung up all throughout Cyprus. Thus, the Troika’s bailout plan has now failed.

Draconian restrictions on cash withdrawals

The Cypriot banks are now closed and when they are opened this week, there will be a panicky bank-run in the country leading to a collapse of both the economy and its financial system. This is not unusual in a services centred economy without a solid production base. Services are solid and contributory to wealth as long as the system functions well and there is cash to operate the same. But this solid services sector melts down when the system becomes malfunctioning and is hit by a cash shortage. To prevent it from happening, the Cypriot authorities have introduced some draconian cash restricting regulations on banks. These regulations include restricting cash withdrawal from banks, prohibition of premature withdrawal of time deposits, mandatory renewal of maturing time deposits, restricting the credit, debit and ATM card operations, mandatory conversion of demand deposits to time deposits and imposition of exchange controls on the transfer of funds out of Cyprus. These regulations are to come into effect from Tuesday, the 26^th of March, 2013.

Shock treatments should be withdrawn as quickly as possible

These types of regulations, known as shock treatments, are useful in bringing a market to order when it has got into a chaotic situation. The current situation in Cyprus fully justifies their introduction. Since these regulations make the Cypriot banking system virtually non-operational, they have to be withdrawn as soon as possible. To withdraw them, public confidence has to be established by recapitalising the banks, providing them with sufficient liquidity support and allowing them to operate as normal financial institutions. It is not foreseeable that these three ground conditions will be put in place in the near future. Hence, the possibility is that these draconian regulations are going to stay in Cyprus for some time and with them in force, the Cypriot banking system is as good as dead.

Russia’s self-interest is not sufficient to bailout Cyprus

Russia has a stake in the current financial crisis in Cyprus since a large number of influential people there stand to lose their funds deposited with the Cypriot banks. To capitalise on this self-interest, the Cypriot authorities have sought a funding facility from Russia. But it is unlikely that Russia will provide a sufficient liquidity facility to Cyprus in the magnitude of the offer by EU and IMF. Any peanut support by Russia will be quickly exhausted by the cash starving Cypriot banks like water being absorbed by a sinking well. Hence, Cyprus has no alternative but to go back to ECB and IMF and introduce a massive economic restructuring and reform programme involving tight austerity measures which are not palatable to Cypriots who had enjoyed while the going had been good and now have to pay for their past profligacy.

Cypriot lesson: Avoid Devil’s Alternative

Cyprus is now faced with the Devil’s Alternative, a term coined by the British novelist Frederick Forsyth in the novel by the same title: Whatever it does, it has to suffer. But it has left a valuable lesson for other nations. That is, do not substitute international hot money for the needed economic reforms. Hot money may keep a sinking nation afloat for the time being, but for permanent fixing of an ailing economy, it is the economic reforms that are most needed.

*W.A Wijewardena can be reached at waw1949@gmail.com