Statement by Mr. Menno Snel, Executive Director for Cyprus and Mr. Ektoras Kanaris, Advisor to the Executive Director, May 15, 2013

Cyprus experienced significant internal and external imbalances owing to the European financial crisis. The oversized and weak banking sector continued to be a threat to the sovereign. Greek debt restructuring, together with loan losses of both Cyprus and Greece, resulted in the two largest banks being declared insolvent. However, the authorities have taken unprecedented steps to address the country’s banking problems. Temporary administrative controls have been taken to preserve financial stability, while the Extended Fund Facility (EFF) arrangement has been aimed to stabilize the financial system and achieve fiscal sustainability.


Cyprus experienced significant internal and external imbalances owing to the European financial crisis. The oversized and weak banking sector continued to be a threat to the sovereign. Greek debt restructuring, together with loan losses of both Cyprus and Greece, resulted in the two largest banks being declared insolvent. However, the authorities have taken unprecedented steps to address the country’s banking problems. Temporary administrative controls have been taken to preserve financial stability, while the Extended Fund Facility (EFF) arrangement has been aimed to stabilize the financial system and achieve fiscal sustainability.


On March 25 2013, after exactly nine months of protracted discussions since its request for assistance, Cyprus reached a political agreement with its international partners on the key elements of a macroeconomic adjustment programme. Cyprus’s request for assistance on June 25, 2012 was triggered by increasing pressure in financial markets, against the background of rising concerns about the sustainability of its public finances and the increasingly fragile position of the two largest banks.

In the months and years leading to this point, several events and circumstances contributed to the deterioration of the Cypriot economy. Although Cyprus had weathered the beginnings of the European crisis relatively well, reluctance to correct long standing imbalances, the lax fiscal policies and the banking sector’s large exposure to Greece had started taking the toll on the country’s ability to refinance its debt at rates compatible with long term fiscal sustainability. These imbalances became increasingly more evident in 2011 as rating agencies launched a series of downgrades and investors increasingly focused on the large exposure of the country’s banks to Greece. By mid-2011, Cyprus lost access to long-term sovereign debt markets.

While these imbalances were reasonably manageable at the time, the events that followed accelerated and magnified the island’s problems. On July 11, 2011 a catastrophic explosion of a huge cache of confiscated munitions stored at a military base caused significant loss of life and destroyed the next-door Vassilikos power plant, which supplied half the island’s power. The fallout included rolling blackouts in the summer months, with adverse effects on output and government revenues, deepening the sense of economic uncertainty. After the explosion, the economy was thrown into recession.

Three months later, on October 26, 2011 at the EU council in Brussels, the decisions taken on the Greek PSI resulted in an effective loss of about 80% of the value of the debt that the private sector held. Cyprus’s two largest banks had significant exposures, costing them overnight more than €4.5 billion (around 25% of GDP) and a substantial amount of capital.

Failing to request assistance at that point, when the island’s lending partners may have been more sympathetic, Cyprus’s fate had taken a path of inevitability. Following these events, a new wave of consecutive downgradings rendered the sovereign debt non-investment grade and made government securities ineligible as collateral for borrowing from the euro system. In parallel, the banking sector was increasingly cut off from international market funding and major financial institutions recorded substantial capital shortfalls. The situation in the banking sector worsened dramatically in early-2013. The delays in concluding an assistance package, unfavorable statements and rumors in the press regarding deposit haircuts and the consequent fall in confidence led to accelerated and substantial deposit outflows.

Against the background of these severe economic and financial disturbances, on March 16 and 25, 2013, an agreement was forged on the key elements of a programme, which included the restructuring and substantial downsizing of the banking sector, the reinforcement of efforts on fiscal consolidation, and initiation of structural reforms. Arguably, the most important and extraordinary element of the programme was that the recapitalisation of banks would be almost exclusively generated from the banks’ retail deposits. Deposits up to €100,000 were to remain unaffected. Amidst financial turmoil and public outcry, a bank holiday of 10 days was imposed, followed by an introduction of capital controls and restrictions on deposit withdrawals – a course of action considered necessary to prevent what was probably an imminent collapse of the banking system. At the same time, the separation of the Greek operations of Cypriot banks was a required feature that immediately downsized the banking sector by a significant amount. It was also pursued in an effort to eliminate any potential spillovers operating in either direction. In that context, Greek deposits in Cypriot banks were unaffected.

On April 2, 2013, an agreement at the technical level was reached in respect of a comprehensive policy package to be implemented in a 3-year macroeconomic adjustment programme whose key objectives, measures and outcomes are specified in the MEFP between the IMF and the Republic of Cyprus.

The programme

The authorities’ concern, even dissatisfaction, regarding the chosen type of the unconventional financing method of “bailing-in” depositors and particularly the extent to which this took place, is no secret. However, a variety of reasons, some of which are explained in the staff paper, necessitated the use of this alternative. Furthermore, the delays in concluding an agreement between all parties involved, worsened the situation and magnified the size of the financing need that is now seeked out from the uninsured depositors, which the authorities accept some responsibility for. Even so, they would have hoped that the negotiations were dealt with a more sensitive and fair manner for the benefit of Cyprus, the euro area, the EU and for the programme in general.

Nevertheless, despite so harsh realities, the lingering problems and the demoralizing uncertainty overshadowing the island for the past year have finally been addressed. A macroeconomic adjustment programme has now been agreed that aims at restoring financial market confidence, re-establishing sound macroeconomic balances and enabling the economy to return to sustainable growth. To achieve these goals, the programme builds on three pillars:

  • (i) A financial sector policy that aims to restore financial stability and resume credit to support economic activity. Building on the restructuring and downsizing of its financial institutions, the recapitalization of the whole system will be completed, supervision will be further improved and private sector debt will be restructured. Furthermore, despite several independent positive evaluations with respect to the AML practices (FATF-MoneyVAL, Basel Institute of Governance AML index etc.), the authorities will further strengthen the AML framework to satisfy any remaining concerns for good. Similarly, the independent evaluation in banks by an external auditor and MoneyVal that was requested of Cyprus, has recently been completed. The results serve to further evidence that some perceptions abroad were highly exaggerated. At the same time it is acknowledged that there is room to improve and the recommendations made will be taken on board.

  • (ii) An ambitious fiscal consolidation strategy, building on the consolidation efforts initiated in 2012, in particular through measures to reduce current primary expenditure, enhance government revenues, improve the functioning of the public sector and maintain fiscal consolidation in the medium-term. The aim is to correct the government deficit while balancing short-run cyclical concerns and long-run sustainability objectives.

  • (iii) A broad structural reform agenda, with a view to improving competitiveness and sustainable and balanced growth, in line with country-specific recommendations addressed to Cyprus in 2012, and allowing for the unwinding of macroeconomic imbalances.

Policy developments

Fiscal sector

The Government is committed to working with its international partners in implementing a determined deficit reduction strategy. The strategy tries to balance the need for fiscal correction without hindering economic recovery. Accordingly, the authorities re-confirm their commitment to the fiscal adjustment targets set forth.

A key objective of the fiscal strategy is to achieve a continuous strengthening of the primary budget balance over the programme period, resulting in a primary surplus of 3% of GDP in 2017 and 4% of GDP in 2018. This constitutes an ambitious but feasible improvement in the primary balance of close to 4 p.p. of GDP over 2013-16 and close to 3 p.p. of GDP over 2017-18. The consolidation schedule is also considered appropriate in addressing the need to balance cyclical considerations and sustainability concerns.

Building on past peer experiences, the authorities are fully cognizant that programme ownership and implementation are key. Confirming their commitment, the majority of the fiscal adjustment measures for the programme had already been enacted by the parliament in December 2012 almost unanimously. These were identified as potential prior actions following the November 23, 2012 staff-level agreement and legislated well before signing the MEFP, without having any assurances at the time for imminent financing. The measures represented around 5% of GDP and included the bulk of fiscal measures for 2012-16 (outlined in the paper), as well as important steps in relation to fiscal-structural reforms. The range of fiscal-structural and structural reforms agreed and detailed in the staff paper include establishing a medium-term budgetary framework, undertaking pension system, health care and welfare system reform measures, enhancing revenue collection and tax administration and ensuring improvement to the public finance management and the functioning of the public sector.

Subsequent to the March 25, 2013 Eurogroup political agreement, new additional fiscal consolidation measures of around 2.2% of GDP for 2013 have been legislated and implemented, namely (i) an increase in the statutory corporate income tax to 12.5%, (ii) an increase in the interest income withholding tax to 30%, (iii) an increase in the bank levy to 0.15% and (iv) a revision of the property tax and of the social housing schemes.

With these, all the remaining prior actions pending at the time the staff paper was issued have now been completed.

Financial sector

The authorities are moving rapidly with the plans for a complete overhaul of the financial sector. Most importantly, on March 22, 2013, the Parliament adopted legislation establishing a comprehensive framework for the recovery and resolution of credit institutions. The new framework allowed the carve-out of the Greek operations of the largest Cypriot banks, the resolution of Cyprus Popular Bank and the transfer of selected assets, insured deposits, interbank liabilities and ELA to the Bank of Cyprus. The upfront actions have addressed immediate concerns while reducing the domestic banking sector from 550 to 350 percent of GDP. Furthermore, the recapitalization of the Bank of Cyprus was done mainly through the conversion of uninsured deposits into equity. The structure implies a minimum of a 37.5% conversion ratio with a maximum of 60% pending the completion of a new independent evaluation of the bank’s assets and liabilities. Once the recapitalisation is completed, Bank of Cyprus could then resume normal activity and will also regain its eligible counterparty status for the purpose of participation in regular Eurosystem monetary policy operations.

To preserve the liquidity of the Cypriot banking sector administrative measures on capital flows have also been imposed. However, as restrictions remain in place and depositor uncertainty remains, there is still way to go to rebuild confidence in the viability of the banking system and lay down the conditions for growth.

It must be reiterated that the capital restrictions are an undesirable but necessary constraint. However, as unwelcome as they are – particularly given that they are disrupting economic activity – premature lifting could undermine financial stability. The authorities intend to fully pursue their complete removal at the earliest opportunity. Early lifting would be facilitated by external support in terms of liquidity as well as supporting communication regarding the strength of the restructured banking system. Notwithstanding, after a series of gradual relaxations, the latest decree1 entails significant relaxations of the measures, further to those pointed out in Box 3.

Recapitalization of the Banking System

In consultation with program partners, PIMCO was commissioned to undertake an independent due diligence of Cypriot financial institutions. The due diligence which was completed in January 2013 covered 22 institutions representing approximately ¾ of the Cypriot banking system’s assets. These capital needs are the result of a comprehensive and conservative analysis following a bottom up evaluation of credit portfolios and foreclosed assets, and of the earnings capacity of the banks to absorb losses over the next three years under a base and an adverse scenario.

The final report identified an overall capital shortfall of €5,980 million in the Base Scenario (to reach a Core Tier 1 of 9% by the end of the programme) and €8,867 million in the Adverse Scenario (to reach a Core Tier 1 of 6% by the end of the programme). As regards to the solvency problems of the two largest banks pointed out in the paper, it should be clarified that these translate to a negative capital of €2,060 million under the baseline scenario. It must also be noted that for the restructured institutions, the recapitalization now taking place is completed under a stricter target, aiming to reach 9% under the adverse scenario by the end of the programme. In that context, preliminary estimates point towards a Core Tier 1 ratio of around 18% for the recapitalized structures.

Furthermore, unlike previous exercises in peer countries, PIMCO has used a more conservative methodology in arriving to the final numbers, providing an implicit buffer for a worse than expected macroeconomic environment. Namely, in contrast to comparable stress test exercises where expected loan losses were calculated on an undiscounted basis, the calculation of expected loan losses under this exercise projected recoveries discounted at the original effective rate of the loan. Also very conservative assumptions were used for estimating the recovery amounts on defaulted borrowers including, particularly, the application of a forced sale discount of 25% on the projected declining market value of property collateral.


Under the staff-level agreement of November 23, 2012, projections of the economic outlook for 2013 and 2014 were pointing to a prolonged recession with a cumulative loss in output of around 5%, due to declines in domestic demand and investment activity resulting from fiscal consolidation and subdued credit growth. The external sector was set to provide a positive contribution to growth in both years as prospects for the export of goods and services were seen to remain favorable, particularly for tourism and business services.

Following political agreements in the Eurogroup on March 16 and 25, 2013, real GDP is now projected to contract by 12½% cumulatively in 2013-14. This arises largely from the frontloaded banking sector restructuring of the island’s two largest banks combined with the extensive bail-in of uninsured depositors. As these two banks constitute more than 70% of the domestic deposit market, the choice of this financing instrument will have severe implications on GDP via numerous channels. First, the loss of working capital by Cypriot businesses held at the two main banks is estimated to be around 50% or close to 100% of their deposits over €100,000, depending on the bank. Similarly, a number of households saw much of their wealth in the form of savings disappear overnight. Second, a liquidity shock is unraveling due to the remaining deposits in these banks being frozen for months; 90%-100% of deposits over €100,000 have either been converted or frozen. Third, the fallout from an irreversibly damaged sector that constituted a significant part of GDP i.e. banking, finance and related services. Fourth, the impact of fiscal consolidation already undertaken and new measures agreed will further hamper domestic demand. Finally, all of the above are amplified by the unprecedented internal and external capital controls required to safeguard financial stability. In turn, these will hinder international capital flows and reduce business volumes in both domestic and internationally oriented companies. Overall, the above channels will sharply reduce private consumption and business investment. Little relief can be expected from exports amid uncertain external conditions and a damaged financial service sector.

Given that the key problems are addressed upfront, a large drag on growth is expected to be lifted. As such, growth is projected to rebound in 2015. The fiscal consolidation is expected to help restoring consumers and investors’ confidence in the medium-term. The ongoing deleveraging of both household and corporate balance sheets will over time remove the impediment to a more balanced growth. At the same time, the restoration of a sound and well-capitalized banking system is expected to gradually loosen the tight credit conditions in the economy. However, the medium-term recovery of economic activity depends very heavily on the restoration of confidence, and measures and reforms to directly boost medium-term economic growth are rather sparse in the programme. In this respect, additional policy measures could entail investment projects financed from FDI and European institutions. There is no fallacy; the authorities are well aware of the risks that lie ahead. In these circumstances, any preliminary forecasts come with a high degree of uncertainty. Staff correctly point towards the difficulty in estimating the impact on real GDP and the deflator with sufficient accuracy, the potential creation of a vicious cycle of bankruptcies and unemployment given the systemic nature of these banks as well as the remaining banking sector risks such as litigation risks or risks of longer lasting lack of confidence in the banking sector. These, of course, are inherent with the choice of financing and must, or should, have been expected when that choice was being made.

Nevertheless, it is worth noting that some reprieve may be had from a programme design which builds on past experiences. Furthermore, as explained above, the bank recapitalization exercise was completed under a more conservative methodology relative to those applied in similar exercises in the euro zone. In addition, given the uncertainty surrounding the macroeconomic outlook, a buffer of about 10 percent of GDP has been included in the baseline analysis, leaving space for a larger than expected recession. Finally, it must be noted that no impact has been assumed in staff projections from investments projects related to the energy sector and the prospects of exploitation of natural gas, which should contribute significantly and increasingly to economic growth in the coming years. As such, the authorities expect a higher long-run growth than that envisaged by staff.


Although the agreement with the international partners has been accepted reluctantly by the authorities, given the constraints posed conditioning support, they are fully committed to ensure its resolute implementation. While difficult for the people of Cyprus, the degree of social cohesion in the face of the adjustment so far has been impressive and commendable. This constitutes a powerful assurance of engagement and ownership of the programme. Looking forward, Cyprus is faced with an extremely difficult and challenging path ahead through an extended period of consolidation and repair. However, after a long and tiring period of uncertainty, there is at last a paved path. With the financial support and expertise of Cyprus’s international partners, including commitments by the Russian Government on softer terms for the loan repayment for which the authorities are grateful for, the joined efforts now in place will see Cyprus through this difficult time.