1

Beware of German gifts near their elections: How Cyprus got here and why it is currently
more out than in the Eurozone
By Alexander Apostolides,
Lecturer, European University of Cyprus1
Key points:

The situation in Cyprus arose due to banking overreach, insufficient regulation,

excessive government deficits, poor debt management and collateral damage from
previous Eurogroup bailouts
The amount needed is small in absolute values, but large relative to the size of the
economy. The Troika was unwilling to fund more than 10bn Euros.
Extreme delay from the departing Christofias government and persistence from the
Troika led to the bailing-in depositors to cover the gap. An attempt to spread the pain
by suggesting a shares-for-deposits swap for all Cypriot depositors, (bailing-in even
insured depositors) was defeated in the Cypriot parliament.
In subsequent negotiations, insured depositors were unharmed: uninsured depositors
in the largest two Systemically Important Financial Institutions, Laiki Bank and Bank
of Cyprus were affected
Local debt default and forced rollover are part of the bailout, but as it currently stands,
holders of external debt are to be paid in full. The exception is the Russian Federal
Republic: the Troika has demanded that Cyprus negotiate a restructuring of that direct
government loan.
As a result of the above actions, Cyprus is left facing an unprecedented economic
depression; the link between weak financial institutions and a weak state has not been
broken, making a second bailout very likely.
Cyprus has capital controls, deteriorating financial situation and needs to defend itself
against local and domestic lawsuits that might overturn decisions. Cyprus is still
dangling precariously from the Euro exit cliff.

1. What happened in March 2013?

Cyprus has dominated news across the world since the early morning of the 16th of March,
when the Eurogroup and the recently inaugurated President of Cyprus, Nicos Anastasiades
agreed to a rescue deal that would include the bail-in of uninsured and insured depositors in
all Cypriot financial institutions2. The bailout Cyprus needed (for government debt expiration,
projected government deficits and supporting the financial system) was calculated then as
1bn The Troika, comprising of the European Commission (EC), the International
Monetary Fund (IMF), and the European Central Bank (ECB), was only willing to fund
10bn.

Corresponding Address: 6 Diogenes Street, 2404 Engomi, Nicosia, Cyprus. a.apostolides@euc.ac.cy

P Spiegel, ypriot bank deposits tapped as part of 1bn eurozone bailout Financial Times (2013), 16th of
March

2
The reasons for the large gap between the yprus needs and the Troikas desire were
twofold yprus needed bn for the recapitalization of the financial sector, which Germany
was not willing to pay; and the IMF would not participate in a programme that would push
the debt of Cyprus into what it argued were unsustainable (i.e. Greek) levels. The Eurogroup
demanded that out of the bn, junior bondholders of the banks would lose 12bn, but the
remaining bn could only be raised by bailing-in depositors. The final deal in the early
morning of the 16th of March led to all depositors in Cypriot financial institutions being
affected and not only those in the banks that needed urgent recapitalization. Those who had
deposits over the insured 1, would have % of their deposits converted into shares
of the financial institutions which would receive their deposits to recapitalize. Surprisingly,
insured depositors were also affected, having 6.75% of their deposits similarly affected.
The decision to bail-in even insured depositors was immediately regretted by the Eurogroup,
and the resulting rejection of the bailout from the Cypriot Parliament saved the Eurozone of a
lot of blushes3. While the Cyprus government scrambled to find alternative solutions, the
Eurogroup made clear that a decision not including a bail-in of depositors would not be
accepted4. Cyprus had became a hot issue in the upcoming German elections, and it was
deemed politically necessary to introduce a bail-in of depositors for the deal to go through the
German (and other) parliaments.

The banks in Cyprus remained closed while a new bailout deal was being hatched and a
flurry of foreign media correspondents descended on the island. Cyprus modern economy
quickly descended into cash-only exchange as all bank accounts remained frozen and no
one was allowed to take more than 3 a day from the ATMs: the Eurozone had its first
Corralito moment.
On March 25th, a new deal was reached, and three days later the banks opened after a twelve
day banking holiday, a world record5. Bank runs did not occur but the banking system was
operating under strict capital controls, which are still largely in place at the time of writing.

Stockwatch (2013) 30th of April

http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=173400
4
One alternative that was ignored was debt restructuring that would include external debt: M. Gulati and L.
Buchheit, Walking back from yprus Vox Columns (2013) http://www.voxeu.org/article/walking-back-cyprus
However the German Minister warned that unless there was a bail-in there would be no bailout: A. Breidthardt
& J 'onnell Insight - How Europe stumbled into scheme to punish yprus savers Reuters (2013) 18th
March.
5
On average bank holidays occur at only 10% of the IMF database on financial crises. They last on average 5
days aeven and Valencia, Systemic Banking rises An Update IMF Working Papers (2012) 12/163
3

3
The new deal indicated how severe was the damage caused by the bank closure and the
uncertainty; the bailout needs jumped to 2 - 23bn, an increase of 20.1 - 33.5% of
Cypriot GDP 6 . Despite the fact that such an increase means that Cyprus will miss the
budgetary and other targets set by the troika, the agreed second bailout agreement remained
effectively unchanged, with just the way depositors in Cyprus would be bailed-in being
different, as well as the new Eurogroup demand that all the Greek branches of Cypriot banks
should be sold.
The way the Eurogroup decision on the 25th of March chose to cover the bank recapitalization
needs has doomed Cyprus into a deep depression 7 . The European commission argues at
Cyprus will have a cumulative fall of nominal GDP of just 15% over three years; the IMF
suggests that the GDP will fall by more than 12% just this year. The Economics Research
Centre of the University of Cyprus suggests that even a cumulative fall of real GDP of over
30% in four years is probable8.
Tragically, the deepening recession in Cyprus that stems directly from the 25th of March
agreement is set to make a mockery of the projected debt sustainability assessment of the
European Commission. Debt sustainability was the basis of Troikas demands for Cyprus to
avoid reaching levels of high debt that would make repayment of the official sector loan
difficult9. Yet despite predicting a recession of -12% in 2013, the budget deficit target for the
year is -2.4%10. This is impossible. Even if the fiscal multiplier of government purchases is at
par (which is very unlikely) Cyprus would require a reduction of the government deficit by
20% in the seven remaining months of the year to achieve the debt sustainability target; this
is impossible, especially since the bailout took place prior to the end of the tax season.

More worryingly, the key issue that made the Cypriot bailout so difficult was that the island
was facing both a banking crisis and a government debt crisis; the Eurogroup decision does
P Spiegel, Reexamining the ypriot bailout numbers Again Financial Times (2013) 25th April.
Eurogroup, Eurogroup Statement on Cyprus on the 25th of March (2013)
http://www.consilium.europa.eu/uedocs/cms_Data/docs/pressdata/en/ecofin/136487.pdf
Leaked IMF MoU (Final): Memorandum of Understanding on Specific Economic Policy Conditionality (2013)
http://static.cyprus.com/troika_memo_final.pdf
8
University of yprus, Economic Research entre, April 213 Economic Outlook (2013)
http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdf
9
As leaked to the financial times: European Commission, Directorate General of Economic and Financial
Affairs Assessment of the Public Debt Sustainability of Cyprus, 9th April (2013)
http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf
10

Politis (2013) http://www.politis-news.com/cgibin/hweb?A=234663&-V=articles

6

4
not resolve the dangerous feedback loop between these two issues11. The state is not allowed
to borrow from the official sector to help the banks; yet the deepening depression will lead to
banks and cooperatives needing more support as bad loan provisions are revised upward. At
the same time the increased unemployment and a decrease in revenues will mean the state
will need to borrow more, but the local financial institutions will not be able to help12. As a
result Cyprus will need a second bailout, as the Troika is the only agent which can break the
link between weak government and weak state.
The 25th of March deal requested Cyprus to resolve the issue of the largest two banks in the
island, Laiki Bank (formerly Marfin Popular (Laiki) Bank) and Bank of Cyprus (BOC). Both
banks failed their recapitalization targets and now they would need to be recapitalised
without aid from the Troika. It was decided not to close down either bank but instead to
restructure them aikis insured depositors would be transferred to Bank of yprus, along
with all the performing assets. The uninsured depositors were bailed-in 100%, and they
would become the shareholders of bad aiki, which would have all the non-performing
assets. In the process Laiki shareholders and junior bondholders were wiped out. The BOC
would also bail-in uninsured depositors, although at a yet unknown proportion and then take
the insured depositors and good assets of Laiki bank. The BOC board resisted and the bank
was taken over by the Central Bank of Cyprus (CBC), who sacked the board. The CBC
initially cancelled all shareholders, only to reverse the decision after the local courts put a halt
in the proceedings, questioning the legality of cancelling existing property rights. The CBC
responded to the court by creating four categories of shares, placing the new bailed-in
shareholders in the first category, with junior bondholders and existing shareholders in lower
categories. Hundreds of lawsuits are already in place against Laiki, BOC, the CBC and the
Cyprus government due to the way the restructuring was handled.

This was new: in every single Eurozone bailout prior to Cyprus, a rescue fund was allocated
to enable banks to recapitalise through resources provided by the official sector, as it was
understood that there was a risk that a government debt crisis could become a financial sector
crisis that would undermine debt sustainability efforts, yet German elections due in
September ensured that the Cyprus bailout would be a very different proposition. The

SA Zenios, The yprus debt A perfect crisis and the way forward The Wharton Financial Institutions
Center, Working Papers (2013) #13-09
12
The Economist, Through a lass, arkly (213) 2 th of April

11

5
litigation that the chosen method of bank restructuring will generate will ensure uncertainty
in the Cypriot financial industry for years to come.
The bank branches of all Cypriot banks, irrespective if they were in trouble or not, were to be
sold to Piraeus bank in Greece by the order of the CBC at the request of the Troika. The deal
was awful for the Cyprus government but the Troika insisted that Cyprus should be isolated,
cutting off the only channel of contagion to the rest of the Eurozone13. Yet this decision
ensured that excluded depositors in Greece avoided the bail-in of Laiki and BOC, while
Cyprus would still have to pay both the losses in Greece as well as assume the liquidity
assistance given to Greece, thus increasing the haircut of depositors in Cyprus.
How bad was the deal for Cyprus? The CBC received 2 million from Piraeus bank
(effectively given by the Greek Bank Rescue Fund, set up by the Troika). For that amount,
yprus sold 1bn of assets and gave away 1bn of deposits 14 . It was stuck with
recapitalizing the Greek branches prior to the sale: just for Laiki bank in Greece that was
estimated at 2bn. In addition up to bn in liquidity assistance given to fund withdrawals
of Greek depositors from Greek branches of Cypriot banks also became liabilities of the
Cypriot branches. Thus with less assets, Cyprus was forced to cover the Greek funding and
liquidity gap that was created. Laiki bank refused to sign and the CBC governor ignored them
and just signed on their behalf 15. Lawsuits relating to the sale of the Greek branches are
expected.
Perhaps the most controversial decision in regards to the banking central was the handling of
the liquidity assistance provided by the ECB through the CBC. Through the Emergency
Liquidity Assistance (ELA) procedure the ECB, through its local subsidiary (in this case the
B) injected bn of liquidity in aiki bank, as aiki was facing substantial
withdrawals 16 . Laiki provided discounted assets as guarantees for the ELA: this liquidity
assistance remained a liability with priority of repayment for Laiki and an asset for the CBC
ixon, yprus bank resolution a bad joke Reuters (2013) 2nd of April http://blogs.reuters.com/hugodixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/
14
Piraeus Bank, Press announcement (in Greek); Piraeus Bank has taken the Greek banking business of Bank of
Cyprus, Cyprus Popular (Laiki) Bank and Hellenic Bank (2013) 26th March
http://www.piraeusbankgroup.com/el/~/media/0B74D7B60CF54BE7A57C8AB42720866D.ashx
15
H. Dixon, yprus bank resolution a bad joke Reuters (2013) 2nd of April http://blogs.reuters.com/hugodixon/2013/04/03/cyprus-bank-resolution-a-bad-joke/
16
The EA directive European Union, irective 2E of the European parliament and of the council of
6th of ay Official Journal of the European Union (2009) L146/37
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2009:146:0037:0043:EN:PDF
13

6
balance sheet; the ECB is not technically part of the process, although it is the provider of the
given liquidity. Yet the CBC, with the blessing of the ECB, kept providing liquidity to Laiki
bank, even though it became clear in 2012 that the bank was becoming insolvent. Laiki
owned bn by June17, and the current central bank governor (Panikos Demetriades) seems to
have refused to shut down the bank for political reasons, meekly stating that he warned the
departing Christophias government.

Why did the CBC governor not press the issue? There is the suggestion that his appointment
by the previous Christophias government (on the 3rd of May, 2012) was conditional to Laiki
bank remaining open until after the elections, scheduled in February 2013. The fact that Laiki
Bank became insolvent but was still provided liquidity became an issue in the Eurogoup
negations of the 15th of March; the Eurogroup warned President Anstasiades that failure to
agree on a bail-in of depositors would mean the stopping of liquidity of the ECB/CBC to
Laiki bank. This has led to public conflict between the new government of President
Anastasiades and the acting CBC governor.
The ELA given to Laiki has complicated attempts to restart the Cypriot financial sector.
Some argue that ECBhas placed its own interest above the local legal framework, damaging
the Cypriot economy further, through the actions of its local subsidiary, the CBC 18. This is
because the CBC accepted discounted assets of Laiki and provided over 9.9bn of ELA to
Laiki, even though it was clear by the level of withdrawals that the bank was by then
insolvent. But, when Laiki was restructured the CBC did not claim the assets that were
pledged to the liquidity provided, but liability of the ELA was transferred (with dubious
legality) to the new Bank of Cyprus19. A question of conflict of interest clearly arises here:
the CBC (and by proxy the ECB) did not want to become owner of the assets that guaranteed
the ELA, but by transferring the liability to Bank of Cyprus, it has effectively reduced the
recovery value of the bailed-in depositors. There have been calls for the investigation of the
CBCs role in providing liquidity to Laiki and to legal avenues being explored to force the
CBC to liquidate the ELA by taking the pledged assets20.

Inbusiness (2013) 15th April

J Ewing, Blaming Europes entral Bank The New York Times (2013) 29th April
19
Xiouros,
Emergency iquidity Assistance

Stockwatch http://blog.stockwatch.com.cy/?p=1754
20
C. Xiouros, Handling of the Emergency Liquidity Assistance of Laiki Bank in the Bailout Package of Cyprus
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2254499
17

18

7
By placing the ELA burden in the newly restructured Bank of Cyprus the CBC ensured that
both capital controls needed to be introduced, and that the new bank would be capitalised but
illiquid. The new Bank of Cyprus will be capitalised fully as it received good assets the
insured deposits of Laiki bank, and it bails-in its uninsured depositors. Yet this bank might
not be able to lend as the ELA has priority in repayments21. In addition it was feared that as
over half of the deposits of the new BOC are foreign and are expected to flee in the first
opportunity, capital controls for the whole economy had to be imposed to prevent further
liquidity shortages for the new BOC, as it would reach the limit allowed under ECB rules.

The author has never seen a messier or more confusing bailout. It is clear that the deal on the
25th of March might be a better deal for the Eurogroup as it avoided spooking European
insured depositors, but it was a catastrophe for the financial sector of Cyprus. It is one thing
to bail-in the depositors of a small bank; it is quite another to do it simultaneously to the two
largest banks of a country that held 37.9% of all Cypriot deposits in February 2013 22. In
Cyprus, you simply cannot avoid doing business with Laiki and/or Bank of Cyprus: they are
by far the largest banks on the island if one takes any measurement and were the most
accommodating in terms of international business due to their global presence. The Cypriot
banking system was mostly funded by depositors being bn or 1% of liabilities in June
2012. Out of those just 40% were by Cypriot residents, with 34% being non-residents using
Cyprus as a business centre, 19% from Greece and 7% from other countries (Russia citizens
directly provided only 2% of deposits)23.
So why was the bail-in of depositors as a method of financing bank recapitalisation chosen?
The bail-in was considered as ideal by some in the Troika as Cypriot banks were
overwhelmingly dependent on deposits (there was very limited unsecured debt)

24

. The

German press and government also backed it, arguing that if Troika funds were used to help
out the banking sector, it would effectively help rich Russians who deposited their money in

SA Zenios,

Stockwatch
http://blog.stockwatch.com.cy/?p=1734
22
Source entral Bank of yprus, arket Shares of Banks, ebruary (213)
http://www.centralbank.gov.cy/nqcontent.cfm?a_id=11912
23
Ibid p.9
24
J otterill, A stupid idea whose time had come Financial Times Alphaville (2013) 16th March
http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/
21

8
Cyprus due to the high interest rate25. The claim of Russian presence / high interest rates has
a grain of truth, but they are essentially misleading as to who suffered the real damage of the
bail-in.
The outflow Russian depositors prior to March 15th was significant as the German and other
northern European statesmen made no secret of the fact that a bail-in of uninsured depositors
would be part of the Cyprus bailout deal26. Although the interest rates for saving accounts in
Cyprus were higher than in Germany, inflation was also higher, averaging at 2.7% in the last
three years, meaning that some of the interest rate differential could be explained away; in
any case, the bail-in was on all uninsured accounts, even non-interest bearing business
accounts 27 . As a result the majority of those affected are business accounts of Cypriot
companies and not saving accounts, taking away all working capital of most large Cypriot
businesses. The decision to bail-in the uninsured depositors of these two banks has wiped out
the liquidity from the Cypriot economy. Firms following sound financial planning during a
recession (cut costs and accumulate a cash reserve) suddenly found their whole reserve
amount over 1, turned into illiquid shares. While this was mainly expected for Laiki
Bank, it was largely unexpected for the case of bank of Cyprus, which had only missed its
recapitalisation needs in ay 213 by just 23 million28. Thus most large firms and
pension funds in Cyprus were caught out; the resulting liquidity tightening means that the
local market has crashed. The business confidence index has reached a historical low, with
consumers stopping all but non-essential consumption29.
It is my opinion, proponents of the bail-in did not understand how complicated it is in
practice and how difficult it was for Cyprus to resolve the banking sector quickly and

P. Schuseil, The yprus Bailout ontroversy in erman edia and Politics Bruegel (2013) 22nd of March
http://www.bruegel.org/nc/blog/detail/article/1049-the-cyprus-bailout-controversy-in-german-media-andpolitics/ and erman views on Aid for yprus Bruegel (2013)
http://www.bruegel.org/nc/blog/detail/article/985-german-views-on-aid-for-cyprus/ 16th of January
26
Jr Thomas, In yprus Bailout, Questions in Whether epositors Should Shoulder the Bill New York
Times (2013) 10th of January T Barber yprus must pay the price for joining the Euro Financial Times,
Global Insight (2012) 9th of ctober and Walker Inside erkels Bet on the Euros future Wall Street
Journal (2013) 23rd of April
27
Statistical Service of the Republic of yprus, Inflation, 1-2012, 8th of January update (213)
http://www.mof.gov.cy/mof/cystat/statistics.nsf/economy_finance_14main_en/economy_finance_14main_en?O
penForm&sub=4&sel=2
28
A liades, Truth and ies (in reek) Politis (2013)) 3rd April p.9
29
University of yprus, Economic Research entre, April 213 Research in the Economic Attitudes (In
Greek) (2013)
http://www.ucy.ac.cy/data/ecorece/EconomicOutlook_Apr13.pdfhttp://www.ucy.ac.cy/data/ecorece/erevnes%20
oikonomikis%20sigkirias_04_2013.pdf
25

9
effectively. The CBC needs to take over and administer two banks that are far larger than
itself: this created manpower shortages and delays. In addition both the Eurozone and the
Cyprus government have demanded exemptions to the bail-ins, creating further delays. The
Eurozone has demanded that all inter-bank loans should be exempt, while the government,
fearing that the bail-in will also cause a pension crisis, has asked for exceptions for the
affected pension funds. The list of exemptions has now widened to include charities,
educational institutions and local government, but at the time of writing the list has been
removed from the central bank website; there is still uncertainty if any exemptions will be
granted, but the size of the exemptions will determine the amount the depositors are bailedin30. It has also proven difficult to distinguish who is uninsured: for example, is the joint bank
account of a family of three to count as insured for 300,000 or for 100,000?
The resulting confusion has created delays and increased local and international litigation
claims creating ever greater uncertainty. The letter by the Governor of the Central bank to the
Acting Executive Officer of Laiki, dated 11th of February 2013, clearly states that the
Governor considered bailing-in depositors illegal under the constitution of Cyprus and the
European onvention of uman Rights, calling it legally unfounded; the same governor
would now have to defend such bail-ins in local and foreign courts.
The delay in the resolution of the bail-ins and the existence of capital controls is destroying
any chance of effective resolution of the banking crisis. As there are strict limits to what one
can do with their deposits in Cyprus, the Cyprus banking sector loses its credibility and utility,
damaging even healthy institutions. This creates a catch-22 the longer capital controls are
in place the more depositors become flighty and consumption plummets; the resulting
deterioration on the Cypriot economy delays the final resolution of BOC and Laiki, as more
provisions against bad loans need to be undertaken. At the time of writing just 10% of the
uninsured Bank of Cyprus depositors has been released to the clients; a 37.5% has been
converted to shares, and the remaining 52.5% is held frozen by the Central Bank until
September, when hopefully the final bail-in percentage will be announced. Yet as it seems
likely that capital controls will remain in place at least until then, the situation of the financial
industry will deteriorate further, leading to much more severe bail-ins for the uninsured

Stockwatch (2013) 10th April

http://www.stockwatch.com.cy/nqcontent.cfm?a_name=news_view&ann_id=171716

30

10
depositors. Controls have begun to have very negative effect in the remaining competitive
industry of Cyprus, that of business services.

The banking sectors problems are still unresolved and the resulting uncertainty it generates
has led to a sudden stop of lending and borrowing. Unless that link between a weak
financial sector and a weak government is broken, depositors worry that a second bail-in
might take place as the economic outlook deteriorates, prompting them to make the rational
decision of taking their money out of the country. This fact, combined by the lack of
unlimited liquidity by the ECB, requires the existence of capital controls, which further
damage the economy. In addition the Cypriot capital controls, although granted an exemption
by the ECB and the IMF, may still be in breach of Bilateral Investment Treaties entered into
by Cyprus, providing further litigation against the republic and the restructured banks.
The final bailout amount and its breakdown is still fuzzy and confusing, indicating how
messy the Cyprus bailout is in practice. The European Commission suggests a breakdown of
what the government of Cyprus needs to provide for itself as 1bn raised from the
depositor bail-in m from increases in taxation m from the sale of all the gold of
the B, 1bn from privatisations, 1bn on local debt rollover and 1m from lower
interest through the debt restructuring of the direct loan by the Russian Federation 31. The
numbers and their estimations vary depending on different versions of the document, with
other recent documents suggesting a smaller depositor bail-in might be necessary 32 . The
Troika will provide Cyprus 10bn, out of which 2 will go to support the cooperative sector
and other banks, 3bn is given for the fiscal needs of the state over the period 2013-2016,
and 1bn will go to pay in full maturing foreign loans of the Republic of Cyprus.
The most surprising issue in this whole mess is the decisions relating to the countrys
sovereign debt. All private sector participants, even bank depositors, will be affected, but the
foreign law sovereign bondholders are to be paid on time and in full. The IMF had instructed
the previous government to pass legal instruments allowing the arbitrary restructuring of
locally issued debt. The new government will now use that privilege to roll over 1bn of debt,

31

European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt
sustainability of Cyprus, 9th April (2013) http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9April2013.pdf p.10
32
P Spiegel, Reexamining the ypriot bailout numbers Again Financial Times (2013) 25th March
http://blogs.ft.com/brusselsblog/2013/04/reexamining-the-cypriot-bailout-numbers-again/

11
and will reduce the debt it has with the B by swapping it with land worth of 1bn 33. The
direct loan with the Russian Federation, whose terms have never been made public and
whose maturity is due in 2016 will also be restructured, becoming a five year loan with
repayment starting in 2018, and providing a lower interest rate.

The irony is that although Greece PSI was meant to be an exemption, both Public Sector
Involvement and Official Sector Involvement aspects exist in the Cyprus bailout; it is just not
affecting the foreign bondholders or European Union governments. It is incredible that
foreign debt holders are to be immune from pressures to restructure their bonds, despite the
Cyprus bailout requesting such a restructuring from local lenders and a foreign government34.
What makes it even more astounding is that the timing of payouts to bondholders seriously
restricts the viability of the Cypriot bailout plan. At a time when Cyprus is already failing to
meet its deficit targets, the first tranche of 2bn of Troika financing will be receive in May.
Yet 1bn will go towards paying in full Euro edium Term otes expiring in the 3rd of
June, leaving only million for financial and banking needs until the first half of the year
Because of this there are growing calls for foreign law bondholders to be pushed into the
same restructuring that is being offered to the local institutions and the Russian government35.
Questions of fairness of paying in full strategic investors who knew the risks of Cypriot
Government bonds while bailing-in Cypriot grandmothers are being asked, while the amount
of litigation the Cypriot bail-in and capital controls have created make the threat of further
litigation on foreign debt not so prohibitive36.
The above was an attempt to explain the complicated situation that arose during the last two
months in Cyprus. Yet we need to understand how Cyprus ended up in this mess and what are
the challenges moving forward?

33

European Commission, Directorate General of Economic and Financial Affairs Assessment of the public debt
sustainability of Cyprus, 9th April (2013)
http://blogs.r.ftdata.co.uk/brusselsblog/files/2013/04/DSA-9-April2013.pdf p.12
34
J otterill, The Buchheit bat-signal, a few days on Financial Times Alphaville (2013) 21st of March
http://ftalphaville.ft.com/2013/03/21/1430252/the-buchheit-bat-signal-a-few-days-on/ ; J. Cotterill A stupid
idea whose time had come Financial Times Alphaville (2013) 16th March
http://ftalphaville.ft.com/2013/03/16/1425732/a-stupid-idea-whose-time-had-come/
35
Public Debt Office, Cyprus, Outstanding Securities in the Foreign Market as of 31 st of December (2012)
http://www.mof.gov.cy/mof/pdmo/pdmo.nsf/All/0F88002C3BEA16C1C225784800373547/$file/Outstanding%
20securities%20in%20the%20foreign%20market%2012_12_31.pdf
36
M Zachariades, Fairness and Sustainability for Cyprus" Econbrowser (2013)
http://www.econbrowser.com/archives/2013/04/guest_contribut_36.html yprus Academics Initiative, The
yprus debt crisis apital lows and ebt Restructuring Stockwatch (2013)

12
2. How did Cyprus end up here? Entry in the Eurozone
The republic of Cyprus joined the European Union in 2004 and like all member states (with
the exception of the UK and Demark) it committed to join the Eurozone once the necessary
macroeconomic conditions were met37. Joining the European Union was considered a great
strategic success for a republic which has multi-communal rights enshrined in the constitution,
but is effectively without Turkish-Cypriot representation since 1963 and under partial
occupation since 1974. The Republic of Cyprus in the EU represents the whole island de jure,
but in reality more than 42.8% of the area is under Turkish military occupation, United
Nations Buffer Zone control, or British Sovereign Base Area command.
Cyprus was by far the most prosperous nation in terms of income of the ten new entrants in
the EU, having the best macroeconomic indicators relative to other fellow entrants. In fact
unlike other new entrants, Cyprus was and still is a (marginally) net contributor to the EU
budget. Between EU entry and the entry into the Eurozone 2008, Cyprus had fulfilled the
Maastricht criteria for entry, had an average yearly inflation of 2%, maintained a GDP growth
rate of 4.1% and had one of the lowest European unemployment rates at 4% 38.
The Eurobarometer survey of opinions on the Euro in 2007 indicated that Cypriots were most
suspicious of the Eurozone and only reluctantly left the Cypriot pound: only 40% on
respondents thought the Euro would have a positive impact for Cyprus, and just 33% of
Cypriots thought the adoption of the Euro was a positive experience for other countries39.
This was due to the relative success of the Cyprus Pound in being a stable currency. However
a rapid entry in the Eurozone was considered vital for Cyprus for two reasons:

to reduce the interest rate premium on government and private borrowing.

to enhance its competitive advantage in business services

Cyprus wanted to enter the Eurozone as soon as possible in order to reduce the interest rate of
its lending. The republic of Cyprus had to endure high interest rates due to the risk posed by
the presence of Turkish Troops on the island and the non-resolution of the communal
problem. This high government rate created a high base rate for the economy: private

37

European Commission, Adopting the Euro http://ec.europa.eu/economy_finance/euro/adoption/

Source: IMF World Economic Outlook Database, October edition (2012)
http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx
39
European Commission, Flash Eurobarometer Introduction of the Euro in the New Member States: Analytical
Report (2007) http://ec.europa.eu/public_opinion/flash/fl_214_en.pdf
38

13
borrowing was also at high interest levels. The gradual abolition of capital controls prior to
accession to the EU, combined with preparations for Eurozone entry led to a reduction of
borrowing costs, creating a windfall gain for the government and for Cypriots. From 2008
onwards, both the government and Cypriots used that windfall to increase their debt to
worryingly high levels

Why was Cyprus rapid entry in the Euro areas considered crucial in order to develop the
emerging business service sector? Even before EU entry, the Cypriot government had
promoted itself as an offshore international banking and business services centre and
considered that entry to the Eurozone would increase the islands attractiveness. One can
argue that before the decision to enter Europe, anti-money laundering controls were below
standard. Yet, as part of the negations for entry, successive Cypriot governments ensured
compliance with increasingly more stringent directives on issues of corruption and illegality:
it was a price worth paying in order to gain the advantages of EU entry.
Some suggested that Cyprus did improve its regulatory framework while at the same time
relaxing the supervision of money-laundering, which might be fair. It is worth noting
however that in terms of compliance Cyprus currently ranks as 7th out of the 17 Eurozone
countries according to Financial Action Task Force (FATF) of the Organisation for Economic
Cooperation and Development (OECD), with Germany being 14th. The issue of moneylaundering and tax avoidance became a contentious issue during the negations of the Cypriot
bailout, with the German press arguing that none of their contribution to the bailout should go
to support tax dodging depositors of Cypriot banks. Thus, as part of the Memorandum of
Understanding, a commitment was made for two anti money-laundering investigations: a
customer due diligence report by the European ommissions MONEYVAL40, which has
up to now given Cyprus a clean bill of health, and a separate report from a private firm. At
the time of writing the MONEYVAL investigation has been concluded but not released and a
contract has been signed with Deloitte to undertake the private investigation.
Meanwhile the effort to clean up its act in terms of money laundering had an effect: by 2000
Cyprus was removed from the blacklist of annual reviews by the FATF; this resulted to

40

MONEYVAL: acronym of Committee of Experts on the Evaluation of Anti-Money Laundering Measures and
the Financing of Terrorism

14
some loss of attractiveness for offshoring in Cyprus41. In an effort to maintain the islands
attractiveness as an offshore centre, Cyprus lowered its local corporate tax rate in 2003 to the
same level as the offshore rate (10%), enabling foreign firms to register as Cypriot. At that
moment Cyprus gave a great advantage for offshore business to the transferred into domestic
companies, creating the initial conditions that would lead to the crisis. It allowed essentially
offshore firms to become European firms with all the advantages that entailed, and enabled
them to continue to use Cyprus as a conduit of their tax efficiency, while being domiciled
inside the Eurozone from 2008 onwards.
The combination of the above policies led to unintended consequences: Cyprus in the
Eurozone did expand as a financial centre, but not in the way the policy makers envisaged.
The favourable double taxation treaty of Cyprus and Russia and other countries42, combined
with the low corporate tax rate for Cypriot firms led to the island becoming a conduit for
deposits to and from Europe. European, Russian and Ukrainian firms registered as domestic
companies in Cyprus and used it for tax efficiency purposes. Sometimes Cyprus companies
would funnel capital back from other offshore centres into Russia and other countries and
gain tax exemptions by registering it as foreign investment.

These practices were encouraged by Cypriot banking, accounting and law services, and over
time they managed to attract an ever greater number of European and non-European firms.
Firms would be established here and open accounts in Cypriot banks; at the same time they
would lend the money back to their international operations, making Cyprus more of a centre
for capital flows (in and out) to capitalise of tax efficiency and investment schemes. This
roundtripping of deposits explains in part how Cyprus is considered one of the largest
investors in Russia, and why external debt of domestic companies shot up But it must also
be understood that Cyprus is neither the main centre of Russian deposits within Europe
(Luxembourg and Switzerland hold far higher absolute numbers of Russian deposits), and nor
were such practices isolated to Russian firms and Cypriot banks, but also involved other EU
and non-EU companies and financial institutions.

F ullen, Economic Impact of embership, in J Ker-Lindsay, H Faustmann, F Mullen (eds.) An Island in

Europe: The EU and the Transformation of Cyprus (2011) p.72
42
The double taxation treaty has been updated in 2009 with an additional protocol. Cyprus ratified the Protocol
in September 2011 whilst Russia ratified it on February 15, 2012. The Protocol came into force on April 02,
2012. Source: Inland Revenue, Republic of Cyprus, Double Taxation Agreements (2012)
http://www.mof.gov.cy/mof/ird/ird.nsf/dmldtc_en/dmldtc_en

41

15
The central bank governor at the time of Euro entry, Athanasios Orphanides (2007-2012)
attempted to isolate the domestic market from these volatile, essentially foreign deposits that
were used for roundtipping. The CBC asked for MONEYVAL data of country of residency
and enforced stricter reserve ratios on such loans; as a result banks gave lower interest in such
roundtipping deposits, as they incurred a greater cost ence the foreign press was wrong
to justify the bail-in of Cypriot depositors as one of higher interest rates on savings, as at least
roundtipping deposits did not receive necessarily higher rates than what they would receive
in other Eurozone countries, but gained from low corporate tax rate, tax efficiency and other
efficient business services that Cyprus could provide.

The PIMCO report commissioned by the CBC clearly indicates that by 2012 this went out of
hand: by 31st of March 2012 Cypriot banks had over 13bn worth of assets43, when the GDP
of yprus was just 1bn. The banking system became far greater than the nations ability
to monitor and support it in times of crises. This would be less of a problem if the banking
sector was under majority foreign ownership, as in the case of Luxembourg, and hence under
the supervision of a regulatory authority which has the capability and the backing of a much
larger and solvent state.

Some did warn about big, domestically owned banking institutions and the inability of the
government to support them in times of crisis, but most ignored the advice44. In fact, when
the second biggest bank, then called Marfin Popular (now Laiki) Bank announced in May
2009 that it would merge its Greek and Cypriot operations and move its headquarters to
Greece, (thus regulated by the Central Bank of Greece) due to claimed obstruction to its work
by the CBC governor, most financial commentators in Cyprus breathed a sigh of relief. Yet
the decision was reversed in September 2009 through direct political intervention by the then
President of the Republic of Cyprus, Demetris Christofias (2008-2013); as a result the bank
merged its Greek branches with the Cypriot operations while maintaining its headquarters in
Cyprus thus increasing rather than reducing the systemic risk to the Cypriot economy45.

43

PIMCO, Independent Due Diligence of the Banking System of Cyprus (2013) p.8
C Stephanou, The Banking System in yprus Time to Rethink the Business odel Cyprus Economic
Policy Review, (2011) Vol. 5, No. 2, pp. 123-130
45
Alvarez and Marshall, Investigation Report, Bank of Cyprus Marfin Popular Bank Group Review of Cross
Border Merger 26th March (2013) p.5 http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriotbanks-sought-state-help/20130404
44

16
The stage was set for a serious banking crisis: it took the actions of the communist led
government during the period 2008-2013, the actions of the two largest banks of Cyprus,
Marfin (Laiki) bank and BOC and the decisions of the Eurogroup to make Cyprus the most
intractable bailout case within the Eurozone.
3. Marfin Laiki Bank; Cypriot Bank Expansion in Greece
When the republic of Cyprus became independent in 1960, it already had a competitive
domestic banking infrastructure. Bank of Cyprus (BOC) was based in Nicosia (the capital)
but was already a national bank and the biggest bank on the island. Following was the
Limassol Cyprus Popular (in Greek: Laiki) Bank based in the second port city, Limassol.
Other financial institutions (most notably the cooperative sector) and foreign banks existed,
but the aforementioned banks dominated the domestic financial landscape.

Competition was mainly based on expansion in larger foreign markets. Both banks had
established branches in Greece prior to the entry into the European Union due to the strong
cultural links of Cyprus with Greece. The rapid inflow of deposits explained above led to a
rapid expansion of their operations in Greece, as well as in new ventures in Serbia, Romania,
Russia and Ukraine. In an attempt to outgrow its far larger competitor (the BOC), Laiki Bank
decided in 2006 to merge with two smaller Greek banks. Greek lawyer Andreas Vgenopoulos
was placed in effective control, despite not having significant ownership. In doing so the
Cyprus Popular bank undertook a Faustian contract, which doomed itself and the small
Cypriot economy.

Cyprus Popular (Laiki) Bank, was merged with smaller Marfin Bank and Egnatia Bank to
form Marfin Popular Bank (MPB). The Greek branches of these banks were merged as
Marfin Egnatia Bank (MEB) a subsidiary which with 95% ownership by MPB. The merger
was a disaster for Laiki bank. MEB was one of the worst performing Greek banks, running
into trouble very early in the Greek financial crisis: by 2012 over 40.1% of its Greek
loanbook was non-performing46. Up to million was given in loans to third parties to buy
shares in Marfin Investment Group, a company also controlled by Andreas Vgenopoulos;
many of these loans were structured as bullet loans, with the principal and sometimes the

A Antoniou,

Inbusiness (2013) 15th of April

http://www.sigmalive.com/inbusiness/news/business/40289
46

17
interest all paid in the end of the loan period47. The decision to turn MEB into a branch of
MPB in 2009 while keeping the main company under the regulatory supervision of Cyprus
ensured a direct transfer of exporting the poor performance of MEB in Greece to the Cypriot
state, who would have to act as the lender of last resort. What is shocking is that the merger
and the convergence of MEB into a branch was not finalized until the 31st of March, 2011.
By that date, it must have been clear that MEB was moribund, and that the Greek Private
Sector Involvement (PSI) of Greek Government Debt was on the cards, as the
Merkel/Sarkozy auville moment suggested it as far back as Octomber 2010.
It is not clear why the branching conversion of MEB by MPB was not stopped by the Cypriot
Central Bank Governor. When the merger and branching was finally approved in 2011, the
MPB was holding 3bn of Greek Sovereign debt, for which the CBC requested an increase of
capital of 1.5bn. Yet despite increasing evidence that there would be a mandatory private
sector involvement of the Greek Government Bondholders, the MPB maintained the high
levels in Greek government bonds it had purchased. By July 2011 the Cyprus Government
was also aware of the voluntary private sector involvement as agreed by the EU consilium,
and yet no efforts were made to force MPB to realise the losses of Greek Government
Bonds 48 . The eventual losses of Laiki Bank and Bank of Cyprus to the Greek PSI were
3bn, putting the death knell on any possibility of Cyprus being able to initiate a selfrecovery.

The MPB was not the only Cypriot bank which acted recklessly in hoarding Greek
Government Bonds as the Greek PSI was crystallizing. A leaked Alvarez and Marshall report
indicates that the then CFO and future CEO of Bank of Cyprus, Giannis Kypri, informed the
market that the bank sold 1bn reek overnment Bonds, with only 1bn left in the bank
portfolio 49 . Yet on the same day the BOC began repurchasing Greek Government bonds
reaching close to 2bn by June 21 The report highlights that in BOC (and it is assumed
that similar things were taking place in MPB Laiki) kept trying to hide the emerging losses in
Greece through speculation in Greek Government Bonds; up to 30% of pre tax profits were
Alvarez and Marshall, Investigation Report, Bank of Cyprus Margin Popular Bank Group Review of Cross
Border Merger 26th March (2013) http://www.cyprus-mail.com/cyprus/new-leaked-reports-why-cypriot-bankssought-state-help/20130404
48
Council of the European Union, Statement by the Heads of State of the Euro Area and Euro Institutions, (2011)
21 July http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/123978.pdf
49
Alvarez and Marshall, Investigation Report, Bank of Cyprus Holdings of Greek Government Bonds, 26th
March (2013)
47

18
coming from Greek government bond related activity in the BOC prior to the Greek PSI. The
risks were there, but it seems banks preferred not to divest Greek Government Bonds, as that
would mean they could avoid the crystallisation of losses50.
This is a case of clear moral hazard. By 2010 the combined investments of MPB and BOC in
Greek Government Bonds were higher than the ability of the increasingly cash strapped
Cyprus government to absorb them. Thus banks in Cyprus knew that if Greek bond PSI did
take place, their losses would be severe enough to force the Republic of Cyprus to seek a
bailout. Thus any Greek PSI would either be vetoed by Cyprus, or Cyprus would hold out
until support for the Cypriot banks or for the Cypriot government was guaranteed. This
spurious strategy allowed them to invest in increasingly high risk Greek government bonds.
But why did the Cyprus Government not request for a bailout when the Eurogroup decision
for the Greek PSI was confirmed in EU consilium meetings in July/October 2011 and
finalized in February 2012?
4. The Disastrous Government of President Christofias
There is no doubt that an emerging crisis was brewing over the island of Cyprus since 2008.
Yet the above issues were then still manageable with correct leadership: At best Cyprus could
have introduced measures to combat the emerging banking crisis right away and avoid a
bailout; at worst the Cyprus government could have just borrowed for its stricken financial
sector at the same time as Spain.
Sadly the republic of Cyprus elected a president in February 2008 with no real understanding
of the issues who was also ideologically averse to the idea of the European Union. Demetris
Christofias was the general secretary of the AKEL party. The party, which used to be aligned
with hard line communist values, still has anti-Europe, anti-NATO, and anti-IMF views,
which President Christofias has expressed frequently during his time in office.
If the banks are to blame for questionable morality, the government of Demetris Christofias is
to blame for stubbornly refusing to accept the limitations of government in a weakening
economy. The Christofias government can be summarised as one of unrestrained largesse:

Alvarez and Marshall, Investigation Report, Bank of Cyprus Holdings of Greek Government Bonds, 26th
March (2013)

50

19
too much government spending, too much short term borrowing, too much solidarity to
Greece, and too much delay in seeking a bailout.
President Christofias in 2008 received an economy which was by then unaffected by the
Lehman brothers crisis but it was beginning to have collateral damage from the emerging
Greek crisis. The initial conditions were ideal: a low debt to GDP (48.9%) ratio and small
government surplus for two years (cumulative +4.4% of GDP)51 meant that the government
could have supported the banking sector initially through borrowing in external markets.
However, in the first year of his presidency the economy went into a recession (-1.8% of
GDP), while the Christofias government went on a reckless spending spree. Despite
government revenues falling by -8.5%, the Christofias government increased expenditure by
7.8% mainly in untargeted and ineffective social benefits and in exercising the patronage that
previous Presidents had also exercised by bulking out the government employment. This
yawning gap between revenue and expenditure kept getting larger despite the weak recovery
of the economy, as the government kept increasing expenditure faster than revenue
throughout its five years in office; by 2011 the debt to GDP of Cyprus rose to 71% of GDP.
Even in July 2011 when the need for reigning in government revenue was understood by the
then minister of Finance, Charilaos Stavrakis, President Christofias delayed and then
cancelled the implementation of mild austerity measures52. This eliminated the ability of the
government to borrow to help the banks, leading to a series of credit rating downgrades: these
were largely ignored by the then minister of Finance, Charilaos Stavrakis, which railed about
unfair treatment by the credit rating agencies.
There was resistance to this untargeted expansionary fiscal policy by the then CBC governor
Orphanides, which led to public spats. The government in turn sought to reduce the
governors power by placing pro-government members in the CBC board and removing the
management of public debt from the CBC, establishing a public debt office in the Ministry of
finance in August 2010. This enabled the Christofias government to continue borrowing in
increasingly short term foreign and local loans and bonds, while ignoring the slide in credit
rating of Cypriot Debt by rating agencies: S & P downgraded Cyprus from A in March
2011 to CCC in 2013. The increase in cost of borrowing due to being downgraded led to
ever more short term borrowing. This dangerously skewed debt repayment of the Cyprus debt
51

Source: IMF World Economic Outlook Database, October edition (2012)

http://www.imf.org/external/pubs/ft/weo/2012/02/weodata/index.aspx
52
Political row puts Cyprus austerity plans in doubt Financial Mirror (2011) 25th of July

20
in an unsustainable way: over 71% of the total public debt needed to be repaid in the period
2013-2016 with median expiration dates of Cypriot debt calculated in September 2011 as 2/3
years, the shortest in the Eurozone53.

This short term borrowing was both domestic but most worryingly foreign, through the use of
Euro Medium Term Notes (EMTN); over 3bn mainly short term ET were issued. The
role of the EMTN in the upcoming crisis of the Cypriot government is important as it placed
a deadline for which further delays would lead to default. By borrowing short the Cyprus
government ensured that Cyprus could not delay the inevitable forever as there was a 1bn
repayment scheduled on the 3rd of June, 2013. This hard deadline meant the the new
government of President Anastasiades had no time to negotiate away the insistence for a bank
depositor bail-in he had to accept what he was offered or face default within the first 100
days of his presidency.
In 2011 several incidences occurred that should have convinced the government to enter into
a bailout; instead the Christofias government kept delaying what was becoming increasingly
inevitable, with disastrous results for Cyprus: problems were compounded but not resolved.
By May 2011 credit rating agencies eventually downgraded Cyprus to junk status, raising
borrowing costs and reducing the available liquidity for the Cypriot banks. Then on the 11th
of July, confiscated explosives heading Syria were negligently left in the sun for two years,
and as a result they exploded, taking thirteen lives and destroying the main power station of
the island. The Vassiliko station was supplying 3% of the islands electricity capacity; an
independent commission found the President and his office at fault. The destruction of
Vassiliko led to higher than expected government expenditures, as well as very high
electricity prices, causing first a stagnation in GDP in 211 and then a double dip recession
in 2012. Meanwhile Greece and then Spain applied for support from the European
Commission, which was an opportunity to tie the Cyprus issue with one of a much greater
sovereign state, especially since the Greek PSI caused billions of losses to Cypriot banks; yet
Cyprus did not ask for a bailout in 2011. In August 2011 the finance minister resigned over
the obstruction by the President in his plans to introduce austerity. Finance ministers came
and went, but no one could change the mind of the President. By December 2011 the
government announced it had secured a direct loan by the Russian Federation to the tune of
Votsis,
5th September

53

, Cyprus Cooperative Central Bank (2011)

21
2bn the terms of the loan were kept secret. Rather than using the amount to recapitalize
the banks and introduce fiscal retrenchment, the Russian federation loan was spent for
general government expenditure.

Meanwhile Troika and Eurogroup meetings were confirming that the owners of Greek
Government Bonds would take increasingly ever larger losses through the implemented PSI;
yet the Cypriot government did not attempt to ensure that the losses of the Cypriot banks
would be accommodated. It is of great mystery why did the Cypriot government not speak
out or ensure aid to Cypriot banks while the PSI negotiations were taking place, as the
resulting deal led to a 3bn loss for the ypriot banking system The acceptance of the
Eurogroup decision over the Greek PSI by President Christofias without securing support for
Cypriot banks ensured that Cyprus would face in 2013 not just a public deficit crisis which he
created, but also a banking crisis that he failed to stop.
Time essentially run out and the Christofias government asked for a bailout officially on the
25th of June 2012. Negotiations dragged on however until the 4th of December, despite all
opposition parties requesting greater fiscal restraint and swift negotiation with the Troika
representatives. Despite President Christofias first accepting the bailout, he once again had a
change of heart; by borrowing from provident funds and pension funds of government and
semi government organisations, by providing 1bn of share capital to aiki and accepting
ELA for the Cypriot banking system, he managed to finish his term of office without signing
or implementing the Cyprus bailout programme.
As a result of President hristofias recalcitrance, the next president faced a perfect storm of
problems. State coffers are empty while short term loans are due; reforms that were due to be
implemented over a five year period need to take place within the first 100 days; any room
for negotiation was removed, and the ability to secure the banking system, as well as
negotiate away from a depositor bail-in, has evaporated. He and his government are the
principal reason the Cyprus issue has been so complicated, and why the Troika could use
yprus a a guinea pig of future templates of bailouts in the Eurozone
5. Conclusion: Where does Cyprus stand- more out that in?

22
The Cyprus bailout programme was passed by a very slim majority by the Cyprus parliament
on the 30th of April, 213 And yet we havent seen the end nor the final resolution of the
Cypriot crisis. Capital controls are in place, effectively discriminating between Euros in
Cyprus vis-a-vis the rest of the Eurozone, leading to increased desire for capital flight.
Cyprus is in effect more out of the Eurozone than in. Although such capital restrictions have
been relaxed it is hard to see when they can be lifted since the majority of Cypriot deposits
are foreign owned and they will not be willing to stay in the Cypriot banking system for long.

Meanwhile the banking crisis that the bail-in of depositors sought to resolve has remained an
open wound. What is preventing its closure is the precedent of the bail-in, the delayed
resolution of the Bank of Cyprus, the insistence of the ECB/CBC in offloading the ELA
liability to Bank of Cyprus and the lack of direct support by the Troika to the banking sector.
Unless the vicious cycle between a weak government that is unable to borrow and the weak
financial sector that needs capital is addressed, Cyprus will not be able to enter a roadmap for
recovery.

And yet the whole operation can be seen as a success by the European peers: the
embarrassment of bailing-in insured depositors was prevented, German sensitivities prior to
elections were addressed, and contagion effects were limited through the sale of the Cypriot
branches in Greece. Cyprus can now stay in the Eurozone and suffer an economic calamity
comparable to the war and occupation of 1974, or it can exit the Eurozone with even worse
outcome but with limited impact to the rest of the Euroarea, bar the realisation of small losses
for the official sector.

The damage for Cyprus meanwhile has been huge. The elimination of most working capital
from business through the bail-in is closing even healthy industries that had their working
capital turned into illiquid shares. There is an intense lack of liquidity as banks and
cooperatives reign in on all lending and accumulate resources as the bad loan provision rates
rise. Meanwhile the closure of banks for a record period and the lack of liquidity led to the
Cypriot economy reverting to a partial cash-only basis, slowing down the velocity of money
and hence placing a further drag on GDP. As a result of the above the real economy has
crashed: unemployment figures, already at prior to the bailout 12.7%, are expected to rise to
over 20%. The capital controls are threatening the future of the already wounded business
services sector, and tourism lacks the ability to borrow in order to invest in further capacity.

23

Whose fault is it? It is clear that the previous government of President Christofias must take a
large part of the blame: the combination of excessive spending and the failure to receive
support for the Cypriot banking sector during Greek PSI negotiations doomed Cyprus into a
double calamity. The Cypriot banking sector and its regulatory authorities must be blamed for
letting the banking sector to get so out of hand, and for mistakes in regulation and the
subsequent restructuring processes. The new government of President Anastasiades also
made mistakes, although its share of the blame is limited, considering it was only in power
for 15 days prior to the first Eurogroup meeting. Yet a great part of the blame must be handed
to the Troika and the Eurgroup as well. The demands of each member of the troika to
safeguard their own interests (IMF debt sustainability; ECB ELA, European
Commission containing contagion) has led to several demands being made on Cyprus
which are collectively disastrous. The insistence of the Eurogroup in placing politics, such as
the German election needs, above practical issues led to a badly botched bail-in of depositors
and a world record closure of the Cypriot Banking System. As Morski states for the
Eurogroup No human agency has achieved so much economic destruction in such a short
time without the use of weapons54.

What next for Cyprus? The Cyprus crisis was a banking crisis that also because a government
debt crisis due to the mismanagement of president Christofias. Capital controls are in place
and the bailout was only passed by one vote, with voices clamouring for exit from the euro
and default becoming increasingly loud. The bailing-in of pension funds in Laiki and Bank of
Cyprus might just turn the crisis into a pension crisis as well.

What Cyprus needs is understanding and solidarity from the rest of the Eurogroup. In order
for Cyprus to find its feet, Europe must appreciate that direct support of the banking sector
will be needed. Also since Cyprus is small, the amounts Cyprus needs to find its feet are
minor relative to the EU whole: Cyprus should be allowed to become from a net contributor
to a net recipient of EU funds as the per capita GDP of Cypriots will fall dramatically.

Both European Commission President Barroso and Oli Rehn have issued statements
confirming additional funds to stimulate economic growth in Cyprus, but the amounts are far
54

P. Morski Cyprus: The Operation Was a Success. Shame the Patient Died. (2013) 25th of March
http://pawelmorski.com/2013/03/23/cyprus-the-operation-succeeded-shame-the-patient-died/

24
less than the current needs of Cyprus55. Cyprus should also be allowed to restructure Cypriot
foreign debt, something the government of Cyprus requested, and was denied on the 25 th of
March. Restructuring existing foreign debt is one of the few ways Cyprus can gain some
breathing space. Cypriot EMTN bonds should be restructured on a longer time horizon; while
loans by the EFSF, the European Investment Bank, the Council of Europe development Bank
and the French Treasury should be restructured on similar terms as those of the Russian
Federation loan.

55

JM Barroso, Letter from Commission President Barroso to President Anastasiades of Cyprus (2013)
MEMO/13/339 on the 16th of April. Rehn, Statement on Cyprus in the European Parliament (2013)
SPEECH/13/325 on the 17th of April