Alexander Michaelides is Professor of Finance at the Department of Public and Business Administration of University of Cyprus. He holds a B.A. in Economics from Harvard University and a PhD in Economics from Princeton University in 1997. He worked as Foreign Exchange Economist at Lehman Brothers International in London before joining University of Cyprus as a reader and assistant professor in 1998. In 2001 he moved at the Department of Economics of London School of Economics initially as a lecturer and then as a reader. He rejoined University of Cyprus at 2010.
He is specialized in Macro-finance with noticeable contributions in heterogeneous agent models, portfolio choice and asset pricing.
I will attempt to analyse the crisis faced by a small open economy (Cyprus) in the Eurozone, and argue that there are interesting questions for both policymakers and academics that arise from this case study. At this point in time, Cyprus is in the process of negotiating the terms of a memorandum of understanding with the Troika (the European Commission, the European Central Bank and the International Monetary Fund). Cyprus is expected to receive a credit line of approximately 17.5 billion euros (small in absolute amounts but large relative to Cyprus’ GDP (100%)). Around 10 billion euros (57%) will be earmarked for the recapitalisation of the banking system and 7.5 billion (43%) will be earmarked for the rollover of expiring debt and budget deficits until 2016. In exchange Cyprus is implementing austerity measures to be able to repay the additional government debt that could exceed 140% (relative to GDP) by the end of 2016.
This end result generates a number of questions. How did Cyprus reach this point? Could the current crisis have been avoided? What measures could have been taken to avoid this eventual outcome? Is entry to the Eurozone on 01/01/2008 responsible for this eventual outcome? Is exit from the Eurozone a possible solution? These are some of the questions that are being discussed openly in Cyprus. I will not attempt to answer these here but will discuss chronologically how economic events unfolded and ask the questions policy makers and academics should be interested in from this case study.
Cyprus entered the Eurozone on January 1st 2008 and the European Union on May 1st 2004. As in other southern European countries, the combination of lower interest rates through Eurozone entry and better guarantees of property rights through EU entry generated a rapid increase in external demand (first from the United Kingdom, then from Russia) for holiday residences. Locals also started borrowing more due to lower interest rates and a relaxation of down payment constraints locally. By 2010 the combination of household and corporate debt to GDP was, within the Eurozone, second only to Ireland: household debt to GDP was 159.2% and corporate debt to GDP was 144.5% (Lane, 2012 and author’s calculations).
An interesting (academic and policy) question arises from this development. What level of private debt to GDP is “dangerous” for financial stability in a country? When land restrictions are tight, either due to stringent planning permission laws or simply the lack of space, tangible assets to GDP tend to have high values. Kiyotaki, Michaelides and Nikolov (2011) make the point that, in a calibrated general equilibrium model, a fall in interest rates leads to higher house price changes in countries with tighter land constraints. We expect Japan and the UK to have a higher ratio of tangible asset value to GDP, and we expect housing prices to be higher in coastal cities relative to cities where land is plentiful (for example, Glaeser, Gyourko and Saks (2005)). Along with high values come also high debts. Given this natural variation in debt levels across countries, at which point does private debt to GDP become dangerous for financial stability?
There was also a change in government in Cyprus in February 2008. A more leftist government took over, with a much stronger preference for redistributive policies. Just as external demand for tourism and holiday residences was dropping due to the world economic crisis, the government expanded social transfers dramatically. The government debt to GDP was 48% in the end of 2008 and finished the third quarter of 2012 at 84% (including a 10% increase due to a bank bailout in 2012). A 3% budget to GDP surplus in 2008 became approximately a 6% deficit every year from 2009 to 2012, driven mostly by higher social transfers.
At the same time, Cyprus had over time attracted substantial foreign deposits due to its low tax regime and relatively good value-for-money professional services. The banking sector had grown as a result and this trend became more pronounced after EU entry as foreign firms could enjoy a low tax rate within an EU jurisdiction. A natural place for banks to expand for diversification reasons was the Greek economy due to the common language and the substantial number of Cypriots living and working there. Banking sector assets managed to grow to the level of eight times GDP, since encouragement towards “financial integration” in a common currency area meant expanding heavily in Greece. As of September 2012, the three largest Cypriot banks had given out 132% gross loans to GDP and had a 77% deposit to GDP ratio. Thus, the expansion in Greece was financed partly through Cypriot deposits illustrating how global banks make decisions that can affect the host or originator country (Cetorelli and Goldberg, 2012 and Houston, Chen and Yue (2012)). As the probability of Greece exiting the euro rose after 2009, the bank exposure that had been built over the previous 15 years started to negatively affect the state of the Cypriot banking sector.
Downgrades of the Cypriot sovereign debt started in 2010 citing repeatedly bad public finances, low competitiveness and the large size of the banking sector (with the implied contingent liabilities for the sovereign). Short term, foreign debt became more important in 2009-2010 as the lure of lower foreign interest rates was a temptation too big to resist in the face of falling tax revenues and higher government expenditures. Once Cyprus was shut out of the international debt markets after May 2011, rollover risk of existing short term debt became an additional, major source of headache for the Cypriot minister of finance.
On July 11th 2011 the economy took an unexpected turn for the worse. A cargo of ammunition, that had been confiscated in 2009 under the international arms embargo against Syria, exploded killing 13 people. The cargo was being stored in between a nautical base and the main electricity-producing plant of the country. Immediately, power cuts started affecting negatively the economy and the mood of the country, and full power generation was not restored until 18 months later.
In the midst of public anger, the government had to also deal with the worsening situation in Greece that was negatively impacting the local economy through trade links and the banking system. In October 2011 another fatal blow took place, and it emanated from the unintended consequences of the Greek PSI. Through the 79% haircut in net present value of Greek government bonds, 4 billion euros (the equivalent of 25% of Cypriot GDP) in bank capital was wiped out. An interesting policy question with regards to regulation arises here as some banks could be criticized more than others in how they accumulated this position. On one hand, according to Basel requirements government bonds get a zero risk weight. On the other, could banks have been taking on “zero risk” investments with substantial yield differentials relative to German Bunds as the “greatest” carry trade ever? (Acharya and Steffen, 2012).
The continuous downgrades of sovereign debt from the three main rating agencies further exacerbated the problems of the banking sector, and by implication, the real economy. Higher funding costs were passed on to businesses and consumers, whereas there was more pressure on banks to increase their capital buffers, a manifestation of what Goodhart (2009) calls “procyclical regulation”. During a boom, any improvement in the credit grades of assets held by a bank, given the constant capital ratio requirements, implies that banks can increase lending. The reverse happens in a recession, so that an economy enters a vicious circle between a credit crunch and further sovereign debt downgrades due to the recession.
This argument would surface again in October 2012 (definitely a recession period in Cyprus) when the Troika would require that banks increase their core tier I capital ratio from 8% to 10% within one year. I imagine that the motivation behind this requirement was that it would make banks more careful, attract private investors and reduce the uncertainty arising from evaluating uncertain loan portfolios. But then the question naturally arises: is that requirement the correct policy response during a crisis? Should these capital buffers not vary over the cycle, so that they rise in booms and fall in recessions? And if that should be the case, what should those capital requirements be? The issues are discussed in Kashyap and Stein (2004), Hanson, Kashyap and Stein (2011) and Repullo and Saurina (2011) but quantitative models providing answers to these questions are still not available.
As the Cypriot economic crisis is on-going, and the agreement with the Troika has not been signed, all the questions above become important topics of research and discussion, both for European policy makers and academics. What levels of private and government debt are dangerous for financial stability? How should public debt be forgiven to limit collateral damage? Should all government bonds get a zero risk weight when computing capital needs? How does one regulate/ monitor cross-border banking activities? How can banking regulation become less procyclical? How does one alleviate the sovereign debt – bank balance sheet vicious circle? What are the appropriate monetary policy instruments in such an environment? What are the government’s policy options in such an environment? All these questions need further research to be addressed in an intellectually satisfying and policy-relevant way.
Acharya, Viral and Sascha Steffen, 2012, “The “Greatest” Carry Trade Ever? Understanding Eurozone Bank Risks”, working paper
Cetorelli, Nicola and Linda Goldberg, 2012, “Banking Globalization and Monetary Transmission,” Journal of Finance, 67, 5, pp. 1811- 1843
Glaeser, Edward, joseph Gyourko and Raven Saks, 2005, “Why is Manhattan So Expensive? Regulation and the Rise in House Prices,” The Journal of Law and Economics, 48, 331-369.
Goodhart, Charles, 2009, “Procyclicality and Financial Regulation” Estabilidad Financiera, (16), Bank of Spain.
Hanson, Samuel, Anil Kashyap and Jeremy Stein, 2011, “A Macroprudential Approach to Financial Regulation,” Journal of Economic Perspectives, 25 (1), pp. 3-28.
Houston, Joel, Chen Lin and Yue Ma, 2012, “Regulatory Arbitrage and International Bank Flows”, Journal of Finance, 67, 5, pp. 1845-1893.
Kashyap, A., and J. Stein, 2004: “Cyclical Implications of Basel II Capital Standards,” Federal Reserve Bank of Chicago, Economic Perspectives, 1st Quarter, 18-31.
Kiyotaki, Nobuhiro, Alexander Michaelides and Kalin Nikolov, 2011, “Winners and Losers in Housing Markets,” Journal of Money, Credit and Banking, Vol. 43, 2-3, pp. 255-296.
Lane, Philip. 2012. “The European Sovereign Debt Crisis,” Journal of Economic Perspectives, 26(3), pp. 49-68.
Repullo, Rafael and Jesus Saurina. 2011 “The Countercyclical Capital Buffer of Basel III: A Critical Assessment” CEMFI Working Paper No. 1102.
Repullo, R., J. Saurina, and C. Trucharte, 2010, “Mitigating the Pro-cyclicality of Basel II,” Economic Policy, 64, 659-702.