Cyprus: Let’s See What Happens When We Turn the Dial

The rather eccentric New Zealand economist William Phillips made a hydraulic computer in 1949 out of, among other things, old bits of WW2 Lancaster bombers. The contraption—more formerly called the Monetary National Income Analogue Computer (MONIAC)—was built to mimic the British economy. If you ever find yourself in London’s Science Museum (or to be exact the museum’s history of computing gallery), you can see one of these machines (here):


Coloured water represents money and this flows around the hydraulic computer, just as money does within an economy. Moreover, by adjusting various valves, levers, taps and pumps, you can see what happens when various changes are made to tax, government spending, investment, savings and so on. At a time when electronic computers were still at an embryonic stage of development, the MONIAC was at the cutting edge for conducting “what if” experiments with the economy. A 1950s student could ask his or her teacher: “what happens to the economy if we turn this dial all the way to the left?”

But, of course, nowadays we don’t need simulations. Take Cyprus. In this country’s case, we are performing a real time, live experiment. We are taking the Cypriot economy and saying “Let’s see what happens when we turn this dial all the way to the left and cut off credit completely?”

I must admit I am rather stunned. It seems that since 2007 we have been continually taking theoretical ideas out of my battered old first economics textbook, Paul Samuelson’s Economics, and running them real time. I thought that Ben Bernanke’s operation of monetary policy at the interest rate zero bound has been pretty novel (this stuff was supposed to stay in the text books and not happen in the real world). But now, with Cyprus, we are going to see how an economy finds a new equilibrium with a draconian contraction in credit and a fixed exchange rate: wow, rather them than me.

However, as with all good experiments, we should first have a quick look at the initial conditions. The Statistical Service of Cyprus (CYSTAT) has a good publication called National Accounts 1995-2010.  As you can see, economic growth has been concentrated solely in the services sector for many years (click for larger image).

Cyprus Distribution of GDP jpeg

And from Cyprus in Figures, this chart goes back either further in time to show employment trends between broad sectors since 1960  (click for larger image):

Cyprus Employment by Broad Sectors jpeg

And a more detailed breakdown of GDP by activity:

Distribution of GDP jpeg

At first glance, the 8.8% share accounted for by the ‘finance and insurance activities’ does not look too troubling. However, it is very difficult to disentangle the extent to which offshore financial services have penetrated the rest of the economy. How much of ‘professional, scientific and technical activities’ relates to lawyers and accountants processing overseas investments in and out? And how much of ‘real estate activities’ relates to the Russian diaspora in Cyprus? You could speculate on the mix in almost any sub-category within services.

Further, to what degree is the non-resident community within Cyprus purely related to financial services and what will they do if their bank deposits are frozen or written off? According to CYSTAT’s figures, the population of Cyprus in 2011 was 840,000, of which 667,000 were Cypriot (79%). Of the rest, the two largest groups were Greeks (29,000) and Brits (24,000). From all the news reports, one would have expected the Russians to be near the top of the non-resident table as well, but behind the Brits come Romanians (just under 24,000) and Bulgarians (18,000). Next are Filipinos at 9,000 and then Russians at 8,000. Of course, Russians come in many hues; if we lump together all the former Soviet Union countries, including the Baltic states, we get a total of 18,000.

Next, let’s add the Romanians, Bulgarians and FSU countries together to produce a grand total of 60,000, or 7% of the population. The reason for doing this is because these countries occupy a special position in the balance sheets of Cypriot banks, but, before we look at that issue, let’s just study a couple more macro charts. As of 2011, Cypriot GDP was roughly €18 billion (click for larger image).

Cyprus GDP by Expenditure jpeg

Further, the country has been running a trade deficit of over €4 billion, or roughly 25% of GDP, and another €0.5 to  €1 billion goes out the country every year in net income payments. These outflows has been balanced by around a €3 to €4 billion inflow on the services account and something less than €1 billion on the capital account.

Cyprus Trade Stats jpegCritically, energy imports alone are above €1 billion and exceed total merchandise exports. The country had the opportunity, during the good years, to aggressively expand renewables and also promote natural gas in place of oil for electricity production. It did little, and thus now has almost no energy resilience with which to face the crisis.

Cyprus Energy Balance jpeg

Against this background, let us just focus on the island’s premier bank, The Bank of Cyprus. As it stands, the deal just announced states that 37.5% of deposits over €100,000 will be turned into bank equity and 22.5% will be frozen in non-interest-bearing accounts. As to how much of Bank of Cyprus’ deposits are ring-fenced within the €100,000 guaranteed limit, no information is given. Nonetheless, if we hop over to Bank of Cyprus’ web site we can have a look at their financial statements and make some educated guesses. Prepare to be amazed.

The latest financial statements for the 9 months to September 2012 show a balance sheet of €36.0 billion, down from €42 billion at the end of 2011. Therefore, this one bank, albeit the biggest, has a balance sheet twice the size of the Cypriot economy! Tellingly, over the 21 months from December 2011 to September 2012, customer deposits shrank by €6 billion but loans and advances to customers fell by less than €2 billion. The smart money was getting out fast.

As of September 2012, the bank officially had €2.3 billion of equity to protect the depositors, but the quality of the loan portfolio already looked terrible. Over 30% was suffering from credit quality problems of some kind (note provisions of €2 billion had already been made, click for larger image):

Credit Quality jpeg

And when we turn to a breakdown of the loan book, we see the main problem with the Bank of Cyprus is not dubious lending to Russians, but rather its massive exposure to the comatose economy of Greece (click for larger image):

Concentration Analysis of Loans jpeg

Unfortunately, we now know that the contraction of credit within Cyprus will lead to a negative feedback loop pushing a large part of the domestic loan portfolio into default. An investor presentation from last year shows us that International Banking Unit (IBU) deposits stood at €7 billion, down 22% year on year. So those Romanians, Bulgarians and FSU Russians we met earlier in the post will now likely experience the loss of a large proportion of the IBU deposits.

Extraordinarily, local deposits were actually up year-on-year: did individuals think they were flying to quality? And of the non-IBU deposits, can we guess at the split between corporations, small- and medium-sized enterprises (SMEs) and individuals? For the loan book, large corporations account for half of lending. If this is mimicked in the deposit book, perhaps €5 billion of Cypriot money could be subject to painful haircuts.

Domestic Deposits jpeg

Outside of Cyprus, it is not the Russians or oligarchs of other nationalities that will be hit but rather the Greeks (find the presentation here, click for larger image):

Analysis of Customer Deposits copy

Overall, Cyprus is now suffering from an almost complete cessation of credit provision by private banks. At such a time, a central bank would normally step in as the lender of the last resort. However, the Central Bank of Cyprus is locked into the euro and so can’t print money; instead, it has to rely on the forbearance of the European monetary authorities, who have shown little sympathy with Cyprus to date.

What will happen? I have no idea: I have never seen anything quite like this before. Watch and learn as the dial is turned all the way. And for all those Brits out there. remember that hyper-specialisation in finance and services within a globalised economy is an economic model not that dissimilar to that of the U.K.

Finally, Cyprus is, of course, not a real time economic experiment: there are actual living, breathing people involved. I am not a a natural basher of all things EU, but in this case no-one appears to have given any thought to the consequences of policy actions. At the very least, the EU needs to establish some kind of emergency credit facility—otherwise the Cypriot economy will just collapse.

2 responses to “Cyprus: Let’s See What Happens When We Turn the Dial

  1. This is a remarkable post; the media has gotten it wrong from the start, and even in those features written by professionals I have not seen anything like this level of detail. Although my own blog focuses on Russia, the meltdown in Cyprus has been a peripheral issue of discussion, and a reader cited this article as a reference. It not only contains a tremendous amount of very compelling detail and analysis, it is written in a very readable style. Great work.

    Another reader linked some bank documents which illustrate who got their money out first; perhaps we should not be surprised, but at least one entity is linked to the new Cypriot president. Here it is, for your reading pleasure; the site is in Greek, which you can translate if you like, but the pages list the companies in English, along with how much they took out and what currency they directed it be turned into, as well as the date of the transfer.

    The firm linked with the president is A. Loutsios & Sons.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s