29. Cyprus is on the verge of undertaking a comprehensive financial reform. The two cornerstones of the reform are (i) a liberalization of interest rates and (ii) an opening of the capital account. The reform is intended to prepare the country for a membership in the EU, and to tap new sources of economic growth which would result from a better allocation of savings.

Abstract

29. Cyprus is on the verge of undertaking a comprehensive financial reform. The two cornerstones of the reform are (i) a liberalization of interest rates and (ii) an opening of the capital account. The reform is intended to prepare the country for a membership in the EU, and to tap new sources of economic growth which would result from a better allocation of savings.

III. Financial Reform in Cyprus—Lessons from Scandinavia18

29. Cyprus is on the verge of undertaking a comprehensive financial reform. The two cornerstones of the reform are (i) a liberalization of interest rates and (ii) an opening of the capital account. The reform is intended to prepare the country for a membership in the EU, and to tap new sources of economic growth which would result from a better allocation of savings.

30. In contrast to the liberalization of trade, financial reform is often regarded with some scepticism. Latin American countries experienced formidable crises in the late 1970s, which were preceded by financial reform. These crises have highlighted the need to establish a stable macroeconomic environment before financial markets are deregulated.19

31. However, sound macroeconomic policies are not a guarantee for success. At least equally important are the underlying microeconomic conditions of the financial system. Quite recently, a number of countries with excellent macroeconomic records saw their financial reforms turn into costly banking crises because of neglecting microeconomic fundamentals. The Asian crisis is a case in point. This paper first gives an outline of the present financial system in Cyprus, with special emphasis on microeconomic conditions. It then presents a case study of the financial reforms in Scandinavia during the mid-1980s, and the difficulties experienced there. Interestingly, the starting conditions of the Scandinavian reforms closely resemble the situation in Cyprus today. Therefore, these examples might contain some useful lessons.

A. The Present Financial System of Cyprus

32. The existing financial system of Cyprus can best be described as three-tiered: it comprises a formal, highly regulated domestic banking sector, an informal cooperative sector, and offshore banks. Measured in terms of assets, formal banks are slightly larger than offshore banks, and about three times as large as the informal cooperative sector (Figure 12).20 The three tiers of the financial system operate under very different legal and regulatory conditions, which determine their microeconomics. Each sector shall be discussed briefly.

Figure 12.
Figure 12.

The Size of the Three Segments of the Financial System (In £C million) in 1997.

Assets of domestic and offshore banks, total deposits of cooperatives.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: Central Bank of Cyprus (CBC).

The formal domestic banking sector

The formal banking sector is highly regulated. By law, banks cannot charge more than 9 percent interest on loans. In addition, the CBC can prescribe maximum deposit and lending rates below the 9 percent ceiling. Figure 13 shows that nominal deposit and lending rates have been broadly unchanged over a long period of time. As a consequence, real interest rates were determined almost entirely by inflation (Figure 14). The law on the interest rate ceiling has been in place since 1944. It was drafted under British rule to protect farmers against widespread usury by money lenders. Another reaction to usury was the creation of agricultural cooperatives, which will be discussed shortly.

Figure 13.
Figure 13.

Nominal Interest Rates in Cyprus.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Figure 14.
Figure 14.

Real Interest Rates in Cyprus.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

33. At a macroeconomic level, an interest rate ceiling can create procyclical output effects. When inflation is high, real interest rates are low. This increases aggregate demand, adding to the overheating pressures. Two examples are the years of 1984 and 1992, when inflation peaked at (the still modest level of) 6 and 6.5 percent, respectively. With real interest rates down to 2 percent, real GDP growth was unusually high, reaching 9 percent in 1984 and 10 percent in 1992. The opposite effect during recessions has been less pronounced. As long as inflation remains above zero, the ceiling sets an upper bound to real interest rates. During the past 20 years, real interest rates have never surpassed 7.5 percent. A decrease in inflation rarely resulted in a sharp slowdown of output.

34. To stabilize aggregate demand, the CBC had to rely on instruments other than the interest rate. In the monetary framework that was in place until December 1995, liquidity requirements were the most prominent tool, sometimes supplemented by direct credit controls. Liquidity requirements have traditionally been high in Cyprus, averaging 27 percent of deposits. The CBC increased them in periods of high inflation and decreased them during recessions. However, as their remuneration was below the lending rate, liquidity requirements were similar to a tax on banking, and created economic distortions. In 1996, the CBC started to lower liquidity requirements gradually and introduced open-market operations. As long as the interest ceiling remains in place, however, open-market operations will only function properly in periods of high liquidity, when interest rates are low.

35. Since 1992, Cyprus has pegged its exchange rate to the ECU. Nevertheless, tight capital controls have allowed the CBC to retain a certain degree of freedom in monetary policy. Domestic interest rates do not correlate closely to rates in Western Europe.

36. The rather closed capital account has limited banks to using domestic deposits for the funding of their loans. This holds despite the fact that Cypriot banks have accumulated a large amount of deposits in foreign currency. At the end of 1997, these deposits reached a volume of 47 percent of GDP. However, the CBC has made it difficult to channel foreign currency into the economy, as every loan needs the central bank’s approval. In 1997, an equivalent of only 1.2 percent of GDP in foreign currency loans was allowed to leak through the capital account barrier. However, once the capital account is liberalized, deposits in foreign currency are apt to become an important source for the funding of loans.

37. On a microeconomic level, the interest rate ceiling has truncated the market for loans. As banks cannot charge more than 9 percent interest, they tend to select low-risk borrowers. Riskier projects are rarely funded, although their expected return might be higher. The interest rate ceiling denies banks a share in the extra returns. However, the extra risk would force them to increase their loan-loss provisions, which would raise costs. Credit demand is therefore rationed, making banking “relationship-oriented.” Banks and their customers cultivate long-standing relations to overcome the information problem inherent in financial intermediation. As banks become more familiar with their clients, they attain an accurate knowledge of business and default risks. Long-standing relations substitute for comprehensive project assessments and for a close monitoring of loans. It is interesting to note that the sectoral distribution of loans in Cyprus has a strong bias toward low-risk borrowers (see table below). The highest percentage goes to personal loans, whose rate of default is traditionally very low. The next largest items are trade, typically a low-risk business, and construction, which uses real estate as collateral. Tourism, the most important sector in terms of output in Cyprus, appears only in the fifth position.

Distribution of Loans, 1997

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Sources: Central Bank of Cyprus and Ministry of Finance.

38. The interest rate ceiling favors debt financing of firms. With low real interest rates, borrowing is inexpensive, and corporations have an incentive to be highly leveraged. A proxy for the extent of leverage is the ratio of private sector credit to GDP, which is shown in Figure 15. Cyprus has a ratio of 1.25, significantly higher than other European and Mediterranean countries. Furthermore, this ratio has been increasing steadily over the last two decades (Figure 16).

Figure 15.
Figure 15.

Credit to the Private Sector in Percent of GDP: A proxy for economy-wide leverage.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.
Figure 16.
Figure 16.

Credit to the Private Sector.

Credit to the private sector has been increasing strongly in Cyprus, compared to an average of the five other countries in Figure 15.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.

39. According to estimates by the Bank of Cyprus, the aggregate debt-to-equity ratio of Cypriot firms may be as high as 6. Although these data may be particularly difficult to compare, the ratio in Cyprus would be substantially above the average for industrialized countries (0.25 in the United Kingdom and 0.2 in the United States), and even higher than the ratio of 4 measured in South Korea before the recent crisis (1996).

40. Banks too have an incentive to favor borrowing over equity. With few risks in their portfolio, they do not expect large loan losses. Therefore, a small amount of equity can easily fulfill the function of a shock absorber. A small equity position also allows banks to generate a larger return to shareholders from a given profit. Figure 17 shows that the risk-adjusted capital adequacy ratio of Cypriot banks is comparatively low, and it has been decreasing in recent years. For cooperatives, the ratio seems to be lower still.

Figure 17.
Figure 17.

Risk-adjusted Capital Adequacy Ratios in Percent, Data for 1995, Cyprus Banks 1997, and Cooperatives 1996.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

(*) Ratio of accumulated reserves to deposits, for lack of comparable information. The risk-adjusted measure might be somewhat higher.Source: OECD (1997) and Moody’s (1997).

41. The fact that interest rates are regulated, did not lead to a complete suppression of market forces. Instead, banks engaged in a vigorous nonprice competition for deposits. To be as close as possible to the source of funds, Cypriot banks have installed an extensive network of branches. Figure 18 shows the number of bank branches per 1,000 inhabitants in different countries. Cyprus indeed appears to be greatly “overbanked.” Also, the intense use of electronics, and the quality and range of products offered are not typical for a country with the income level of Cyprus. Similar observations have been made in highly regulated industries all around the world, such as utilities or air transport. Industries with a predictable rate of return tend to use a high proportion of capital. This tendency increases average costs and can create a competitive disadvantage if the regulations are removed.21

Figure 18.
Figure 18.

Bank Branch Density in Different Countries.

Data for Cyprus include credit cooperatives.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Sources: OECD (1997), Moody’s (1997), and Cypriot authorities.

42. The formal banking sector in Cyprus is highly concentrated. In total, there are nine competitors, four domestic and five foreign-owned banks. The domestic banks are larger and control about 85 percent of the market. Since 1974, there has been no entry, but two banks have disappeared in mergers. Concentration and an extensive branch network—the “overbanking” described above—deter new competitors, who have to incur large setup costs. The table below shows that the present, sheltered conditions allow Cypriot banks to earn high profits and a high return on capital. These profits strongly exceed the average in the other five countries and are unlikely to persist in a more competitive environment.

Profitability Indicators

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Note: Capital includes equity, reserves, and subordinate capital. Data are for 1995, except for Cyprus: those refer to 1997 and are an average of the three largest commercial banks.Sources: CBC and OECD (1997), Bank Profitability.

43. The CBC is the central regulatory agency for commercial banks. It supervises them and controls entry into the banking market. The regulatory framework seems to have functioned well in the past, as no single bank has failed. However, prudential standards are not uniform throughout the financial system, and cooperatives follow distinctly different guidelines. This is a serious weakness that shall be discussed shortly.

The informal cooperative sector

44. The first cooperatives in Cyprus were founded around 1910, to take care of the financing needs of agriculture. At this time, farmers depended on unscrupulous money lenders, which charged interest rates of up to 30 percent in real terms.22 A “Central Cooperative Bank” was established to intermediate liquidity among local cooperative societies. The cooperative movement has grown rapidly over the years and commands strong popular support: 80 percent of all Cypriots belong to a cooperative.

45. Traditional cooperatives are owned and managed by their members. After the Turkish invasion of 1974, a new type of cooperative emerged, the so-called “secondary” or “industrial” cooperative. Members of an industrial cooperative are not individuals but other cooperatives which pool their funds to finance large projects. With this new type of organization, the character of the cooperative movement has changed. Industrial cooperatives financed large projects in industry and construction and were guided by a clear profit-maximizing motive. They aggressively entered the genuine banking business, and increasingly lost their association with agriculture.

46. The rapid expansion of cooperatives was also a result of legal privileges (Figure 19). Cooperatives are not subject to the monetary directives of the CBC. They do not have to fulfill liquidity requirements, and do not have to pay income and corporate taxes. Cooperatives have their own supervisory body, which operates along prudential standards that are less stringent than the CBC’s. This adds up to a sizeable competitive advantage over commercial banks.

Figure 19.
Figure 19.

The Share of Cooperatives in Total Deposits in Percent.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: CBC.

47. The Central Cooperative Bank was shaken by two episodes of financial crisis. The first one occurred around 1980. Cooperatives had been heavily involved in financing an investment boom in the late 1970s, a result of reconstruction efforts after the Turkish invasion. Loans were often granted without the necessary feasibility studies. Being new to the business, the cooperatives lacked knowledge about the risks in industrial investment. A large number of loans turned out to be nonperforming, and the Central Cooperative Bank slid into a full-fledged solvency crisis. The government recapitalized the Central Cooperative Bank, injecting more than £C 22 million over three years (3 percent of 1980 GDP). Public assistance was needed again in the late 1980s when the government provided £C 67 million to cover new loan losses (3 percent of 1989 GDP).

48. In reaction to the crises, the government placed the Central Cooperative Bank under the supervision of the CBC. However, all other cooperative societies were placed under a separate supervisory body, which reports to the Ministry of Commerce and Industry. This has created a split in banking supervision (mentioned above). The liquidity of cooperatives continued to deteriorate in recent years, as the ratio of loans to deposits increased from 85 percent in 1988 to 91 percent in 1997. By comparison, commercial banks record a ratio of around 65 percent (Figure 20).

Figure 20.
Figure 20.

Ratio of Loans to Deposits as a Measure of Illiquidity.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: CBC.

49. It could be argued that two characteristics of cooperatives provide for a certain safety in lending. First, cooperatives only lend to members, which are locally known individuals, especially in the case of smaller communities. And second, around 55 percent of all loans go into housing or construction, and are collateralized. Looking ahead, however, the commercial niche that cooperatives have exploited may disappear, since financial reform will lead to increased competition from banks. The small size of most institutions will then become a major disadvantage. There are currently 476 credit cooperatives, most of them tiny. More than half of the deposits are controlled by the two large cooperatives of Limassol and Strovolos (Nicosia). The fact that cooperatives are limited to doing business within their political district has so far impeded a process of consolidation.

50. The presence of a large cooperative sector complicated monetary policy. The CBC could not enforce its liquidity requirement on the cooperatives. If it wanted to restrict credit growth, it had to tighten liquidity more strongly in the formal banking sector. This put commercial banks at a disadvantage, and part of the demand for loans simply shifted into the cooperative sector. Controlling the monetary aggregates in this traditional way was thus very difficult. Figure 21 shows in fact a positive, not negative, correlation between liquidity requirements and money growth during 1983-95.23 Indirect instruments that affect the interest rate are more likely to level the playing field. Credit demand is sensitive to interest rates in both sectors. Therefore, lifting the 9 percent ceiling would allow the CBC to improve its control over monetary aggregates.

Figure 21.
Figure 21.

Correlation Between Liquidity Requirements and the Growth Rate of Broad Money (in percent).

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: CBC.

51. In recent years, the market share of cooperatives has stagnated at around 34 percent of domestic deposits (Figure 19). It seems that intermediation in the cooperative and formal banking sectors are not perceived as perfect substitutes. Most likely, this is the result of a certain product differentiation, as the two sectors do not completely overlap in their range of services.

The offshore sector

52. Cyprus has created a very attractive environment for offshore banking. Most importantly, there is no withholding tax on interest earnings and no capital gains tax. Offshore banks pay only a 4.25 percent profit tax. Their employees enjoy substantial privileges in income taxation compared to local workers. Finally, Cyprus has signed double taxation agreements with a large number of countries (25 at present), eliminating legal uncertainty for offshore banks and preserving their cost advantages.

53. Geography places Cyprus in a prime position to be an international financial center. It is close to the Middle East, the Gulf states, and Eastern and Western Europe. Cyprus can intermediate funds from Arab Gulf states and Western Europe into investments in transition economies and less developed Middle Eastern countries. It has good diplomatic relations with all countries in the region (except Turkey), and a modern telecommunications infrastructure.

54. The CBC regulates entry into the offshore market. Its policy is to select only reputable foreign banks which are subject to stringent supervision in their home countries. Measured in terms of assets, the offshore sector has reached about the same size as the formal domestic banking sector. At present, there are 18 offshore banking units and 65 so-called offshore financial companies, which are predominantly small financial consulting firms.

55. Whereas formal domestic banks face direct competition from the cooperatives, they did not face much competition from offshore banks in the past. Cyprus’ strict capital account regulations drew a sharp line between the domestic and the offshore banking sector. Offshore banks are allowed to deal with nonresidents only, and only in foreign currency. Domestic banks were in general not allowed to extend loans to foreigners, with the exception of export credits. The build-up of foreign currency deposits in recent years has so far not spilled over into the domestic market. Every foreign currency loan to a resident has to be approved by the CBC, and approvals have not been numerous.

B. Financial Liberalization in Scandinavia, 1983-92

56. Fifteen years ago, Scandinavian countries faced similar decisions to those facing Cyprus now. Sweden, Finland, and Norway saw the need to open up their financial sectors in order to align themselves more closely with the markets of the European Community, which they intended to eventually join. The cases of Sweden and Finland are especially illustrative, as the effects of financial liberalization can be studied in a very “pure” form, that is, almost in isolation from other shocks. As both countries started out with reasonably sound macro policies, the crucial role of microeconomics will become evident. The deregulations were completed in a brief period of time and hit the economies as a major shock. They triggered pronounced boom-and-bust cycles and expensive fiscal rescue operations. The mistakes that became apparent in hindsight may provide the most valuable lessons for Cyprus today.24

Banking in Scandinavia until 1983

57. The financial system in Scandinavia in the early 1980s bears striking resemblance to the Cypriot system today. Before 1983, both lending and deposit rates were set by the central banks (Figure 22). Although nominal interest rates were changed more frequently than in Cyprus, real interest rates remained quite low. In addition, interest payments were tax deductible. Borrowing offered an attractive way of reducing the notoriously high Scandinavian tax burden. As Figure 23 shows, real interest rates after taxes were strongly negative, sometimes in the order of -6 to -8 percent per year.25

Figure 22.
Figure 22.

Nominal Interest Rates in Finland.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.
Figure 23.
Figure 23.

After-Tax Real Interest Rates in Scandinavia.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: Drees and Pazarbaşioğlu (1998).

58. Both the administrative interest ceilings and the tax deductibility created a large excess demand for loans. The mechanism of rationing was the personal contact to banks and longstanding business relations were perceived as highly desirable. By knowing their borrowers intimately, banks did not need to devote a large amount of resources into risk assessment and monitoring. They were very conservative in granting loans, and selected low-risk projects, as the interest rate ceiling limited their potential return.

59. Entry into the banking business was regulated and difficult. In both countries the market was dominated by a small number of banks, by 14 banks in Sweden and by 7 banks in Finland. This stands in contrast to Denmark, which had more than 200 institutions in 1983 but about the same population as Finland. Banks competed for deposits by expanding their branch networks and offering a wider range of products.

60. Because of the small share of risky projects in banks’ portfolios, the rate of nonperforming loans was low. Tight prudential supervision was not perceived as a priority by the authorities. Compared to other countries, loan loss provisions were minimal. In 1983, they amounted to only 0.05 percent of assets in Sweden and 0.02 percent in Finland, compared with 0.60 percent in Germany and 1.03 percent in Italy.

61. Also, low interest rates created an incentive for firms to be highly leveraged. The economy-wide debt to equity ratios in 1980 were 4 for Finland and 5.5 for Sweden.26

62. During the early 1980s inflation accelerated, but the authorities were reluctant to adjust nominal interest rates. The ceilings became more and more binding, and accentuated the desire to bypass the regulations. An informal sector developed, with market-determined interest rates. Borrowers and lenders often interacted directly on this “grey market,” without the help of banks. The “grey market” expanded rapidly and began to frustrate monetary policy. Liquidity requirements could not be enforced in this part of the financial system. To be effective, the liquidity requirements had to be raised extra high in the formal banking sector, a fact that was rightly perceived as unfair discrimination. The only way to overcome this dilemma was for monetary policy to switch to an active management of interest rates. Interest rate increases would be felt in both sectors, formal and informal. The central banks therefore started to press hard for financial reform and demanded the abolition of the interest rate ceiling.

Deregulation

63. Within the relatively short period of two-three years, both Finland and Sweden completely liberalized their domestic financial systems. The liquidity ratios were abandoned in 1983. In 1985, interest rate ceilings were removed. The central banks resorted to indirect instruments of credit control, such as open-market operations. Importantly, exchange rates remained pegged in both countries. By 1989, the last foreign exchange restrictions were abolished.

The boom-and-bust cycle

64. After removing the interest rate ceiling, credit demand was no longer rationed. A large backlog of higher-risk projects flooded the market and promised ample profit opportunities. Banks responded to this stock adjustment in demand with an aggressive expansion of credit supply. They willingly incurred losses to attract as many depositors and borrowers as possible. Net interest income of banks declined during the liberalization period. In Finland, the competition for market shares was such that lending rates remained below the yield on public issues until the late 1980s.

65. The response of the government was inadequate in many ways. In a new “laissez-faire” attitude, the authorities reduced rather than intensified their efforts at banking supervision. In addition, the government announced a “no-bank-will-fail” policy to soothe the public, which was worried about radical changes. This encouraged banks to minimize their screening and monitoring of loans and induced them to take more risks. The large branch network of Scandinavian banks also encouraged risk-taking behavior. Individual branches were poorly supervised by their headquarters and acted in an autonomous way. Small subsidiaries granted loans generously, including loans for very risky projects. The Finnish savings banks were most notorious in this respect: Their ownership structure was such that management was not monitored by shareholders. Moreover, an individual savings bank did not bear the entire default risk of its loans, since losses were shared with other banks through a system of mutual insurance.

66. Evidence from many countries suggests that after financial liberalization loans grow faster than deposits. The Scandinavian countries confirm this rule. Figures 24 and 25 show the expansion of private sector credit as a percentage of GDP for Sweden and Finland. As deposits became insufficient to finance the rapid expansion of loans, banks increasingly borrowed abroad. This introduced a large dose of exchange rate risk into the system. Borrowing in foreign currency was stimulated by an exchange rate peg, which was perceived as durable. Banks extended foreign currency loans to nontradable sectors, and increasingly to more cyclical parts of the economy.

Figures 24 and 25.
Figures 24 and 25.

Private Sector Credit Relative to GDP.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.

67. A boom in asset prices reinforced the credit expansion. Sharp hikes in real estate prices increased the value of collateral, and booming share prices increased perceived wealth. This led to a fall in the savings rate. Both investment and consumption grew at a faster rate than output, and large current account deficits appeared in Sweden and Finland (Figures 26 and 27). Monetary policy initially accommodated the credit boom, perhaps in fear of an excessive increase in real interest rates. This fueled domestic inflation and led to a continuous real appreciation of the currency. The loss of external competitiveness was an early warning sign for the difficulties to come (Figures 28 and 29).

Figures 26 and 27.
Figures 26 and 27.

Current Account in Percent of GDP.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.
Figures 28 and 29.
Figures 28 and 29.

Real Effective Exchange Rates.

Citation: IMF Staff Country Reports 1998, 098; 10.5089/9781451809794.002.A003

Source: International Financial Statistics.

68. Around 1990, seemingly minor factors triggered a severe banking crisis in Finland and Sweden. A tax reform in Sweden reduced the financial incentive to borrow. Together with tighter monetary policy, it led to a sharp increase in real after-tax interest rates. Finland was hit by a drop in world paper prices, and, more severely, by the collapse of trade with the former socialist COMECON countries. Now the dangers of a highly leveraged economy became apparent. The increase in debt servicing costs in Sweden and the drop in revenues in Finland caused a wave of bankruptcies. This wave was reinforced, as both countries decided to devalue and float their currencies in order to contain the current account deficits. The devaluation led to a large increase in the value of foreign debt and to more bankruptcies.

69. Banks registered a surge in loan losses. Nonperforming loans increased to 11 percent of GDP in Sweden (1993) and 9 percent in Finland (1992). The largest default rates were registered in the construction sector, after the real estate bubble burst and land prices collapsed. As providers of nontradables, construction firms could not repay loans in foreign exchange after the devaluation.

70. Because banks themselves were highly leveraged, they were ill prepared for the increase in bad loans. Their small equity base was swiftly eroded, and several of the largest banks became insolvent. A full-fledged banking crisis threatened to pull the entire economy down into a depression. The government decided to intervene, taking over a number of large banks. Using tax money, the government conducted an expensive exercise in restructuring the financial system. This was the price for neglecting prudential supervision in the early stages of deregulation. The direct fiscal impact of the bank support operations amounted to 5.2 percent of GDP in Sweden and 10 percent of GDP in Finland.

C. Conclusions

71. Successful financial deregulation requires a delicate mix of conditions. The Scandinavian experience highlights the following points:

  • First, stable and sound macroeconomic policies are needed to create basic confidence in the financial system. Scandinavia differed favorably from Latin American countries in this respect. Still, a serious crisis occurred. Macroeconomic stability alone is clearly not sufficient for a successful financial liberalization.

  • Financial reform brings deep changes in microeconomic incentives and the behavior of firms. A history of smooth banking holds no guarantees for the future. The level of credit risk is likely to increase because new segments of demand enter the market. These market participants had previously been rationed. In Scandinavia, even banks with a record for conservatism turned into aggressive lenders after liberalization to protect their market shares.

  • Banks need to recognize the importance of more thorough risk assessment and monitoring. As the examples of Sweden and Finland show, this might require a break with old habits and seemingly successful business practices. To have a buffer against higher risks, banks must increase their capital base.

  • Prudential supervision must be intensified during liberalization. Furthermore, no bailout guarantee should be given to banks because such guarantee might encourage excessive risk-taking. Scandinavian regulators failed on both accounts, with the consequence of costly rescue operations.

  • Monetary policy faces the challenge of containing a possible credit boom. To avoid asset price bubbles and other inflationary phenomena, monetary policy should not be accommodating during the period of reforms.

  • The opening of the capital account should proceed with caution. It is critical that supervision be extended to foreign exchange operations of banks. Borrowing from abroad introduces exchange rate risk into the system, in addition to the domestic default risk. By lending foreign currency to nontradable sectors, Scandinavian banks greatly increased the vulnerability of the economy to external shocks. As the credit bubble burst and the currencies were devalued, widespread bankruptcies occurred which intensified the downturn of the economy.

References

  • Bank of Cyprus, October 1997, Anatomy of the Cypriot Microeconomy.

  • Drees, B., and C. Pazarbaşioğlu, 1998, The Nordic Banking Crisis: Pitfalls in Financial Liberalization? IMF Occasional Paper No. 161 (Washington: International Monetary Fund).

    • Search Google Scholar
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  • International Monetary Fund, International Financial Statistics (Washington, various issues).

  • Moody’s, 1997, “Banking System Outlook—Cyprus,” Moody’s Investors Service.

  • OECD, Banking Profitability, various issues.

  • Phylaktis, K., 1995, The Banking System of Cyprus (London: Macmillan).

  • Stephanou, C., 1996, The Appropriate Sequencing and Speed of Financial Liberalization Reforms in Cyprus, Harvard University: mimeo.

  • Train, K., 1991, Optimal Regulation: The Economic Theory of Natural Monopoly (Cambridge: MIT Press).

  • Villanueva, D., A. Mirakhor, 1990, “Strategies for Financial Reforms,” Staff Papers, International Monetary Fund, Vol. 37, pp. 509-536.

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STATISTICAL APPENDIX

Table 1.

Cyprus: Aggregate Demand

(At constant 1990 prices)

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Source: Ministry of Finance.
Table 2.

Cyprus: Aggregate Demand

(At current prices)

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Source: Ministry of Finance.
Table 3.

Cyprus: Contributions to Growth of Real GDP 1/

(In percent)

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Source: Ministry of Finance.

Bulk items include aircraft purchases for Cyprus Airways valued at £C 48.4 million and £C 17.4 million in 1992 and 1993 respectively. Totals may not equal the sum of individual components due to rounding.

Table 4.

Cyprus: Composition of Gross Fixed Capital Formation

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Source: Ministry of Finance.
Table 5.

Cyprus: Origin of Gross Domestic Product

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Source: Ministry of Finance.
Table 6.

Cyprus: Origin of Gross Domestic Product

(At current prices)

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Source: Ministry of Finance.
Table 7.

Cyprus: Gross Manufacturing Output by Major Industries

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Source: Central Bank of Cyprus.

Including cottage industries.

Table 8.

Cyprus: Tourist Arrivals and Receipts

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Source: Cyprus Tourism Organization.

Excluding Israel.

Table 9.

Cyprus: Labor Force and Employment by Sector

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Source: Ministry of Finance.

Includes employees of British military authorities and the national guard.

In percent of the population ages 15–64 in government-controlled area.

Table 10.

Cyprus: Wage and Productivity Indicators

(Percentage change over previous year)

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Source: Ministry of Finance.

Including basic wages or salaries, cost of living and other allowances, bonuses, gratuities, and payments in kind. Data exclude overtime payments and are gross of income tax and social security deductions.

Total gross weekly earnings, including overtime.

Based on average earnings.

Deflated by the GDP deflator.

Deflated by the manufacturing deflator.