ESTIMATING THE IMPACT OF THE TROIKAS SOLUTION ON CYPRUS: ASSESSMENTS AND A SUPERIOR ALTERNATIVE SCENARIO

Section I: Introduction The present predicament of the Cypriot economy traces its roots to the structural shortcomings of the European Union (EU)1. Lacking adequate institutional support, the European Unions economic formation left the blocs smaller economies vulnerable to shocks. In well-documented cases the Troika has prescribed solutions that have exacerbated existing problems while creating additional ones. Under such circumstances alternative paths to relieve economic pressures are warranted. A package of policies that takes into account Cyprus current advantages in services as well as its endowment of hydrocarbon resources should be crafted and carefully considered. Our investigation examines the necessary steps and benefits that arise from utilizing an alternative program in Cyprus2. Implementing this plan mimics the successes of other economies under similar schemes. In the case of Cyprus, our analysis yields promising results for the short, medium, and long term future. We also briefly outline the steps needed to ensure the viability of such a program and briefly describe how they can be fulfilled. Section II: Scope of Study The following analysis presents an evaluation of the Troikas current proposal to Cyprus and compares it to an alternative scenario which we believe provides a better alternative for Cyprus. We begin by explaining the structural flaws of the Euro and how those defects have contributed in bringing Cyprus to its present predicament. We outline the repercussions of the policies prescribed by the Troika and compare these outcomes to the projections from the alternative dollarization scenario on key macroeconomic indicators. We conclude with alternatives related to financing the current funding of banks as well as restructuring its banking system. Section III: Present Realities of the Eurozone The EUs basic institutions have produced an economic system rife with dysfunction. Designed without the support of a common Treasury and lacking a banking union, the EU does not meet the criteria of an Optimal Currency Area (OCA). In addition, the European Central Bank (ECB) has no mandate to act as a lender of last resort, which is a necessary element of a central bank. The EUs banking policies from 2002-07 allowed for the misallocation of capital through the convergence of interest rates between the EUs weaker and stronger members. This led to an overextension of credit and a divergence between the external and internal equilibriums of weaker economies with
1

This statement does not imply that we should ignore reasons such as political expediencies, corruption, questionable loans and bond purchases, structural rigidities, etc. 2 Such a plan is based on some presuppositions such as the successful sale of natgas bonds and/or a loan. If the latter cannot materialize, then the alternative would be the reversion to monetary sovereignty. It should be noted that the results shown under the dollarization plan do not differ significantly for the short and medium term from the monetary sovereignty solution.

their respective fundamentals. Adopting the Euro led to asymmetries between the value of the currency and the consumption patterns, and between banking dynamics and growth potential of smaller countries. Cyprus is not the only country experiencing substantial pain due to the structural deficiencies of the Eurozone. Previous proposals by the Troika to address imbalances and excessive debt in weaker countries have not produced the results advertised, and have often left the affected economies in a more perilous state. Section IV: The Present Situation in Cyprus The Cypriot economy currently finds itself in a position of both internal and external imbalances, demonstrated below in Figure 1-A (internal) and Figure-1B (external). The Troikas proposed policies focus exclusively on the external imbalances at the expense of the economys internal wellbeing. Implementation of this narrow plan by the Troika will devastate the Cypriot economy and will exacerbate the current predicament. Simply stated: If a family is starving, it is better to look after its own survival rather than being primarily concerned with payoff of its external debt. Rather, Cyprus should reorient the focus of its policies towards an emphasis on addressing internal disparities, demonstrated in Figure-1A. There are three pathways out of a state of internal imbalance characterized by high unemployment as shown in Figure-1A below: growth, currency depreciation, or a combination of the two.

Real Exchange Rate

Depreciation

Real Exchange Rate

Depreciation

Growth

Austerity

GDP

GDP

Figure-1A

Figure-1B

Section V: A Summary of the Effects of the Troika Plan3 The Troikas plan can be summarized as follows: First, shrink the banking sector (and consequently the whole service sector) of the economy to the point of being unrecognizable. Conservative estimates show that the sector may shrink between 50-60%. At the same time, the Troika plan would recapitalize the banks by breaking a cardinal rule of banking, i.e., through confiscations and bail-in procedures. Second, implement austerity measures that will bring external balance in the countrys international position. Third, squeeze liquidity and reduce credit in the economy. Fourth, proceed with sales of state assets among which would be gold reserves (needless to state that such gold sales would be catastrophic since the country will be selling a valuable asset that is no other partys liability). Our estimations of how the Troikas proposed policies will affect Cyprus are presented in Table-14. The results exhibited portray a grim situation. The Troika plan will cause a cumulative economic contraction of almost 50% in three years, along with unemployment rates close to 40%. These results risk economic, political and social chaos5.
Summary of Estimates -- Troika Plan 2010 GDP Growth Rate GDP Unemployment Rate Deficit Deficit/GDP Inflation Rate FDI Inflows Current Account Balance Credit Growth Rate 1.31% 15,106 6.23% -920 -6.09% 2.56% 1,886 -1,712 6.22% 2011* 0.53% 15,186 7.91% -1,132 -7.46% 3.48% 2,530 -849 11.46% 2012* -2.43% 14,818 11.88% -1,703 -11.49% 3.09% 3,566 -2,092 5.70% 2013E -23.68% 11,308 22.28% -4,140 -36.61% 0.92% 746 97 -15.98% 2014E -19.56% 9,096 31.39% -3,394 -37.31% 1.25% -920 1,982 -50.42% 2015E -15.44% 7,692 39.23% -2,874 -37.37% 1.46% -1,821 3,198 -82.69%

Millions of Millions of

Millions of Millions of

Table-1 From the table above we should also emphasize that besides the devastation in GDP growth and unemployment, foreign direct investments (FDIs) turn negative and the projected capital outflows will undermine the real economy. Section VI: Emergency Liquidity Assistance The Emergency Liquidity Assistance (ELA) extended to Cyprus was provided under terms which may violate Article 123 (1) of the Treaty on the Functioning of the European Union and the Council Regulation (EC) no. 3603/93 by providing ELA to a bank which was insolvent and based on collateral that was inadequate. The procedure by which the ELA was extended did not conform with the rules and regulations of the National Central Bank. The ELA was imposed on the Bank of Cyprus without the consent of the Board of Directors and may exceed the authority of the state, as the terms and conditions may violate the Constitution of Cyprus. The resulting change in priorities
3

It should be noted that efforts to improve the models specifications will continue. At this point such efforts do not point to any significant changes in the results. 4 The results are robust and the model used is a dualistic model of the Cypriot economy where service and non service sectors growth are main explanatory variables. The models explanatory power exceeds 90%. 5 It should be noted that this is the medium scenario of our estimates.

between and among depositors, bondholders, and shareholders of the Bank of Cyprus raises significant questions about the validity of the obligation to repay the debt to the extent such debt was advanced against inadequate collateral and/or such debt corresponds to liabilities of Laiki bank in excess of specific assets of Laiki pledged to secure such debt. If the ELA is proved to be unenforceable (an ultra vires act may justify repayment failure), the whole Cypriot debt picture changes. Moreover, Cypriot loans to Greece in excess of 23 billion complicate the whole banking structure of Cyprus and Greece and may create a systemic threat to the Eurozone. At this point it needs to be stated that a prerequisite for the implementation of any alternative plan is the need for the Cypriot government to request the repatriation of 10 billion from countries that benefited from Cypriot funds. Specifically, we consider it as a necessary condition for any successful alternative that about 5 billion be repatriated back to Cyprus from the Cypriot deposits that enriched the balance sheets of branches outside Cyprus. In addition, another 5 billion from Laiki Banks ELA be repatriated since they went to Laikis branches outside Cyprus enhancing their viability but now threatening the solvency of the Bank of Cyprus (BoC). Section VII: A Superior Alternative Before we present the results of an alternative scenario lets present a roadmap of how we envision this alternative to play out: Government demands the repatriation of 10 billion as outlined above. The banking sector balances revert back to their March 15th, 2013 status, i.e. no haircuts in deposits. This is crucial since the service sector feeds the non-service sector. If the service sector is allowed to collapse then the whole economy will collapse. It is the service sector that has created high value added growth which has become the locomotive of growth in the last 15+ years6. Laiki Bank is not dissolved. Rather the good bank/bad bank model (which has been used so successfully in other countries like US, UK, Sweden, Germany, etc.) is implemented. The good bank will split later into commercial and energy bank. In the meantime is capitalized with government Treasury credits which in turn are based on natgas future income. The bad bank absorbs the bad assets, which through market procedures are restructured and once this procedure is completed the bad bank is dissolved. ELA is treated as unenforceable and an ultra vires act is being declared while investigations are proceeding as to the validity of the repayment obligation. A negotiated settlement for an orderly Eurozone exit over a period of 12 months is being negotiated. The EU has incentives doing that because the stability of the Eurozone will be threatened with the steps outlined above. During that amicable divorce period the ECB and/or the EU commit to finance the funding needs of the country. It is our opinion that this might be the optimal solution. If the EU does not desire to negotiate an orderly exit and a settlement, then alternative financing options for the funding gap should be pursued, as outlined in the following section.

Depositors could be offered the option of exchanging a smaller portion of their deposits for real assets that have been used for the collateralization of non-performing loans.

In the worst case scenario that the funding gaps cannot be bridged within the interim 12-18 months period then a form7 of a local currency should be issued that will assist in the liquidity needs of the nation. In such a case a debt repayment moratorium should be negotiated. Rejecting the Troikas solution8 poses two broad issues for Cyprus: 1) how to finance pressing funding gaps, and 2) whether to remain a part of the Eurozone. Beginning with the second decision and given the mentioned shortcomings of the EUs institutional framework, we have investigated the viability of leaving the Eurozone. Withdrawing from the Euro presents two immediate concerns, namely: providing adequate liquidity in the financial system and assuring financial stability. Our preliminary results indicate that issuing new currency or adopting another currency per se as an anchor to the new currency, produce results that are not that different from each other. Therefore, the results shown below could be assumed that reflect both options. However, it should be noted that further study is needed and is already underway and the compass for the study is the need to maintain financial stability. The latter is required in order to avoid currency attacks, capital flights, balance of payment issues, and destruction of growth prospects. If financial stability is threatened then we recommend the adoption of another reserve currency as the new currency or to peg the new national currency to the dollar9 or a basket of currencies. Returning to the alternative estimates we should note the following: They contain an inherent devaluation, which advances exports and reduces imports. It also encourages FDIs (foreign direct investments), and other capital flows. In addition, it reduces deflationary pressures (which could entrap the economy into stagnation), while under the proposed mechanism it also improves liquidity. As an example we will assume that the US dollar is adopted. All deposits will be converted into US dollars at current exchange rate. All loans, contracts (including wage and salary agreements), and prices will convert to dollars at a 1:1 ratio. This approach (which implies a devaluation of approximately 30%) sustains the existing competitive advantages of the Cypriot economy (services) while it bridges the transition to the emerging competitive advantages in the hydrocarbon sector denominated in U.S. dollars. Improved competitiveness and improvements in financial liquidity also come with the application of this plan.

7 8

Such as IOUs for domestic purposes. th, If the Troikas solution is rejected then the banking balances should revert to the March 15 2013 status. 9 Especially given the emerging hydrocarbon competitive advantage which uses dollars as the currency of choice.

Section VIII: A Summary of the Effects of the Alternative Plan10 The table below clearly shows the following: The blow to the economy will be much less under the alternative scenario than adopting the Troikas suggestions. Moreover, adopting the Troikas solution will not allow the survival of the banking sector and thus of the competitive advantages of the Cypriot economy.
GDP Growth Rate GDP Unemployment Rate Deficit Deficit/GDP Inflation Rate FDI Inflows Current Account Balance Credit Growth Rate 2010 1.31% 15,106 6.23% -920 -6.09% 2.56% 1,886 -1,712 6.22% Summary of Estimates -- Dollarization Plan 2011* 2012* 2013E 0.53% -2.43% -7.92% 15,186 14,818 13,644 7.91% 11.88% 17.61% -1,315 -2,461 -4,307 -8.66% -16.61% -31.57% 3.48% 3.09% 3.81% 2,906 3,022 3,571 -849 -2,092 -1,522 11.46% 14.82% 14.37% 2014E -5.86% 12,844 17.25% -3,920 -30.52% 5.86% 3,699 -633 13.93% 2015E -4.04% 12,325 16.36% -3,481 -28.24% 7.74% 3,857 -611 12.93%

Millions of Millions of

Millions of Millions of

Table-2 It is obvious that the alternative scheme softens the blow that the economy will endure. The contraction of the economy and a rise in unemployment are not as pronounced, while other variables also improve. In the context of Figure-1A the alternative proposal recalibrates Cyprus resources towards internal equilibrium. For example, use of the dollar provides improved competitiveness, maintains Cyprus competitive advantage in services, and provides protection against speculative attacks. In relation to Figure-1B the alternative plan devalues the currency by approximately 30%, lowers wages, costs and domestic contracts, and brings Cyprus foreign engagement closer to balance. Reforms to liberalize the Cypriot economy and improve its efficiency are still encouraged, as is maintaining EU membership. Section IX: Financing Funding Gaps Over the Next 18-24 Months If Cyprus chooses to reject the terms and conditions offered by the Troika the banking balances should revert to their status of March 15th. This involves the restoration of Laiki bank (CPB) as well as the account balances in both CPB and the Bank of Cyprus (BoC). CPB should then be divided into a good bank and bad bank replicating the successful models of other countries in similar circumstances. The balance sheet of the good bank should be supplemented with government bonds backed by assets and then split into a commercial and energy bank. The bad bank will undertake the non-performing assets (loans) and efforts will be made to negotiate settlements with
10

Again, this is the middle scenario under sensitivity analysis. The full report will outline the results of all three scenarios.

borrowers, to sell the loans, or take possession (unless it is the main home for the borrower) of the assets used to collateralize the loans, and create a fund of those assets that can be supplemented with government guarantees (based on natgas income streams). During the interim period the government will need to finance notable funding gaps. Here are the estimates of the funding gaps: Fiscal Needs External Debt/Bonds12 Bank recapitalization13 Total One Year 1.3 billion 2.8 billion 2.9 billion 7 billion Three Years 3.4 billion11 4.6 billion 4.8 billion 12.8 billion

Therefore, for the next 18-24 months about 7.5B should be identified to finance the countrys needs. The proposed source of funding is the collateralization and securitization of assets (natgas reserves, real estate, etc.) and/or a loan against those assets. Efforts are being initiated toward that solution as well as for a strategic partner for the two banks, especially if Laiki is partially converted into an energy bank. We reiterate that the government should initiate a process of local currency and debt settlement, as well as enact a moratorium of interest payments, in case that financing the funding gaps prove to be unsuccessful. Opening credit swap lines with various central banks should be pursued to secure requisite access to U.S. dollars for the support of a dollarization scheme. Section X: Conclusion The institutional deficiencies of the Eurozone created underlying fractures between the Unions core and peripheral economies. The rupturing experienced in the wake of the financial crisis pushed multiple small economies to implement drastic measures at the encouragement of the Troika. These policy prescriptions have not produced the promised results, and have often caused further deterioration of the effected economies. Political and social stability has also been jeopardized. Implementing the Troikas policies in Cyprus would have devastating effects, and will worsen the economy while removing the competitive advantage in services. It may also endanger the value and sovereignty of its hydrocarbon assets. Cyprus should focus its future path on addressing internal disparities while preparing for long term growth. Applying an alternative program would maintain the economys competitive advantage while softening the consequences from the countrys current weakness. This program would improve competitiveness and provide financial stability to allow Cyprus to prepare for a long term competitive advantage in hydrocarbons. In closing, and as noted above, the total financing needs for the country (government, debt repayment, and banks recapitalization) are estimated at 7 billion over the next 15 months. If an
11

Some savings will be observed due to fiscal discipline and the alternative scheme that devalues wages and salaries. 12 Domestic debt is assumed to be rolled over 13 Assumes that ELA is non-enforceable and both Laiki and BoC operate as outlined above.

amicable settlement with the EU proves to be impossible, then the proposed funding could come from immediate internal funding and other external sources. Immediate internal sources could include an one-off compulsory contribution of 3-5% of all deposits as well as the issuance of special internal IOUs that could accommodate liquidity needs. Such a plan could raise up to 3 billion in one day which represents almost 43% of the total funding needs of the country for one full year. That would buy the time needed to issue the asset-backed bonds. External funding sources could include the collateralization and securitization of assets (e.g. natgas reserves, real estate) and a bridge loan. Interested parties for the bridge loan facility are ready to come to Cyprus in the next two weeks. Further efforts toward other external funding sources are being initiated too.