Economic Challenges and Priorities for Cyprus

7 March 2013 | Philip Ammerman

The two-round Cypriot presidential election in February provided Nikos Anastasiades of the DISY Party with a convincing majority for his election as President. The election has widely been heralded as a success by domestic and international media, ending a period of instability brought about by the former President, Dimitris Christofias, whom many commentators blame both for the Mari disaster as well as for a less-than-optimal handling of Cyprus’ bail-out request to the European Union.

It is important to note amidst this euphoria that in concrete terms, little has changed with the election of the new President. An important issue is that the composition of Parliament has not changed, and that the new government will be forced to work with the Parliament that existed before the elections. This Parliament comprises 6 parties, which is a high number given the low population of Cyprus, and engenders a certain extent of political fragmentation.

The objective of this article is to examine the economic challenges and opportunities facing the new government in the first 12 months of its administration. It does so non-politically and non-ideologically, based on economic priorities and not political considerations.

There are four major economic challenges and opportunities facing the government:

Negotiating the bail-out package
Restructuring the public sector
Effective regulation and restructuring of the banking sector
Promoting sustainable foreign and domestic investment

Each priority is explored in further detail below.

Negotiating the Bail-out Package

Cyprus is in the unenviable position of requesting a bail-out assumed to amount to EUR 17.5 billion, or about 100% of GDP. This bail-out request has been contaminated by three different issues which have arisen:

The Christofias administration waited for too long and negotiated badly with the Troika in formulating the request. This led to the embarrassing situation where Jean-Claude Juncker, then head of the Eurozone’s finance ministers, requested that Cyprus clarify its intentions in September 2012. This exasperation with Cyprus’ intransigence was widely reported. By any standards, the Christofias administration blundered badly here, sending mixed signals and engaging in embarrassing public demagoguery over issues such as privatisations.
The key point of the bail-out is the amount necessary for bank recapitalisation. The two main Cypriot banks have lost money on non-performing loans in Greece and Cyprus, as well as the write-down of Greek government bonds. The methodology of assessing their capital needs, however, has been badly handled. Two external organisations, PIMCO and BlackRock, both received a mandate to conduct a capital assessment audit. The PIMCO audit was based on a worse-case scenario, and confirmed the estimate of EUR 10 billion. BlackRock was brought in afterwards to try to lower the estimate. Media reports indicate that the PIMCO terms of reference were based on a worse case scenario for political reasons; the Blackrock valuation was done on more favourable terms.
The bail-out is being (mis-)used for political reasons by various political parties in Germany, notably the Social Democratic Party, who have invented the idea of Russian money laundering in Cyprus. While there is some merit to this case, it overlooks the fact that Russian-Cypriot transaction are determined by a legal double tax treaty and comply with OECD regulations. It also overlooks the fact that far larger Russian capital deposits are found in the UK, Switzerland or Luxembourg, and have not until now been portrayed as the result of criminal activity.

This last point in particular has led to absurd scenarios for different bail-outs, including one in which depositors in Cypriot banks would be “bailed in” or receive a “haircut” on their deposits. Quite apart from the fact that this is illegal and amounts to state expropriation, it is obviously not a cure which inspires confidence in the Cypriot banking system. In fact, it would weaken the entire Eurozone banking system, and is one of the stupidest means of balancing bank assets and liabilities to comply with reserve requirements that this consultant has ever heard of.

Restructuring the Public Sector

The key challenge beyond securing the bail-out is restructuring the public sector. Although the initial austerity packages passed by Parliament include temporary measures (e.g. salary reductions, headcount reduction through attrition, etc.) there is no meaningful structural reform envisioned.

The contrast with Germany in the 1990s is instructive. When the reunification of East and West Germany took place in 1990, the German government began a systematic review of all public sector functions. This was based on a detailed mapping and strategic review of organisations, workflows, and staffing, and led to the streamlining, merger and closure of hundreds of repetitive or obsolete government units.

This approach has still not been planned in Cyprus. As a result, key questions relating to public and semi-governmental sector productivity and operations remain unanswered. Yet the growth of the public sector since 2000 is precisely the key factor that has undermined the competitiveness of the Cypriot economy, and has derailed the public sector budget.

It is imperative that the government undertakes strategic public sector reform, not temporary measures or “band-aids” which offer some form of temporary budgetary relief but do nothing for fundamental competitiveness.

Effective Banking Sector Regulation and Restructuring

A key challenge affecting Cyprus today is the sustainable regulation of the banking sector. The credit policies which fuelled the real estate and lending boom of the past 8 years remain largely in place, as are the staff which implemented them. Today, there is a “paper-based” consensus on what healthy lending standards are, but it is very clear that few Cypriot banks are actually implementing these.

This is a strategic weakness for Cyprus. Banking sector credit policies were at the heart of the stock market boom and bust in the late 1990s and the subsequent real estate boom and bust at the present time. Bank due diligence and “know your client” policies remain effective on paper but untested in reality, and have rightly or wrongly reinforced international allegations that Cyprus is a money laundering centre.

Cypriot banks remain heavily unionised, overstaffed and overbranched in domestic operations, with limited opening hours and low productivity leading to high operating costs. The ratio of staff between the domestic and international operations (IBUs) remains skewed in favour of the former, while the latter comprises the strategic advantage of the sector.

Finally, the role of the Central Bank of Cyprus remains unclear, and conflicting statements and efforts in the past 12 months cast doubt on the ability of the Central Bank’s top management to handle the crisis.

This is a critical issue for the new government. Its efforts are complicated by the fact that the Central Bank is nominally independent, and that certain aspects of banking operations remain off-limits to public disclosure, such as non-performing loans or the true condition of the cooperative banking sector. Without effective regulation and operational restructuring of the domestic and international banking system, Cyprus’ competitiveness will continue to erode.

Promoting Foreign and Domestic Investment

Cyprus’ gross domestic product was until recently driven by consumption. With rising unemployment, wage cuts and lower public sector spending, consumption is falling and not expected to form a significant growth driver of the economy in the near future. Export potential is extremely limited. This means that corporate investment must form the driving force in the economy, which in turn means attracting and promoting foreign and domestic investment.

Cyprus’ efforts here are mixed. The government is heavily promoting two key sectors of the economy, oil and gas exploration and large integrated hotel resorts. Yet there are plentiful signs that each sector contains important risks and potential which may be more limited to real economy growth that expected.

Oil and Gas Sector

In the oil and gas sector, meaningful investment cannot take place until downstream gasification structures and a gas pipeline network for the domestic market are complete. This investment will likely total over EUR 15-17 billion if expanded to its full potential. Even if offshore production were to start tomorrow, successful exploitation and exports will not be possibly until the downstream infrastructure is complete.

The location of the planned LNG terminal at Vasiliko, adjacent to power generation and industrial facilities, risks concentrating vital infrastructure in a single strategic point, creating new vulnerabilities and raising the spectre of a disaster hundreds of times more serious than the Mari explosion.

Employment in this sector is likely to be limited as regards Cypriot staff: the multinationals that will own and operate the offshore production will use specialised foreign staff, some of which will be based in Cyprus, but many of whom will rotate on and off the island.

The key risk of the oil and gas sector is therefore one in which the average Cypriot sees little development impact from the oil and gas sector, except for higher inflation and a few grandiose public sector projects. This higher inflation will feed into all other sectors, making key segments such as exports or tourism much less competitive. Cyprus needs a strategy for this as soon as possible: there are few indications that such as strategy will be developed, or is even understood.

Real Estate / Hotel Sector

The recent inauguration of the Shacolas Group’s integrated resort at Limni can be construed as a vote of confidence in Cyprus, as can the Limassol Marina. Yet mega-projects like this will probably create far fewer jobs than initially forecast, particularly for Cypriots. Moreover, a quick glance at the Cyprus Investment Promotion Agency (CIPA) website indicates that most of the projects being promoted concern very similar real estate or hotel developments.

The question then arises to what extent such investments will really be viable. The Cyprus tourism sector is hit by high seasonality, very low year-round occupancy, high operating costs, and marginal profitability. To put it bluntly, most hotels in Cyprus lose money most of the time. When viewed on a longer-term cycle, even that marginally profitability tends to be affected by regional issues such as the wars in Iraq or Lebanon. None of these fundamental structural issues will be changed by a few major investments, many of which (such as the Limassol Marina) receive questionable long-term tax holidays and thus generate little direct income for the state.

Cyprus needs to address the fundamental issues in tourism competitiveness: there are no indications that this is being done in a systematic manner.

Other Sectors

Finally, the government needs to take urgent measures to promote international competitiveness for investments in other sectors. We can outline two immediate sectors where a material difference could be made.

Casino licensing: The government could take the final, inevitable step and tender five casino licenses for Cyprus: one each for Famagusta, Larnaca, Limassol, Nicosia and Paphos districts. This tender should be open to Cypriot and international operators, and include high standard hotel investments (either greenfield or based on existing properties). This is a strategic investment which would create a new tourism category and attract international tourists, and solve the problem of unlicensed casinos, or Cypriot gambling in the occupied northern Cyprus or abroad.
Free Trade Zones for Exports: The government should create free trade zones for export-oriented manufacturers or trading firms. This would create an immediate advantage for Cypriot exporters, which are currently hit by high taxes, high import and input costs and high export costs. Such a model can be based on the Jebel Ali Free Trade Zone in Dubai, or could be a “virtual” model, whereby existing Cypriot manufacturers are granted preferential tax rates or rebates on international sales.

The election of Nicos Anastasiades as President provides Cyprus with the opportunity to turn the page and begin work on a forward-looking economic policy which builds on Cyprus’ competitive advantages, and addresses key weaknesses. It is hoped that the government will be able to rise to the occasion and concentrate on the key economic priorities and issues affecting the country. Although Cyprus finds itself in a crisis, its long-term strategic and competitive advantages can still be developed and enhanced if the right policies are in place.

Philip Ammerman