In the 50 years since independence in 1960 from the British, who left behind a strong institutional legacy including a solid public administration, Cyprus had experienced an impressive economic transformation and rapid economic development. In the context of a close public/private partnership, characterized by the provision of supportive infrastructure, prudent economic policies and dynamic entrepreneurship, Cyprus took advantage of external opportunities to build a strong service-oriented economy, based on export. In parallel, Cyprus implemented much-needed economic and structural reforms in the process of joining institutions with sound economic practices, which promote trade expansion and free capital movement in pursuit of investment opportunities, such as the WTO, the EU and the Eurozone. A robust legal framework based on English Common Law, first-rate professional services and an attractive tax regime underpinned the central contribution of international business to the Cypriot growth model.
As in several other countries in the eurozone, the severe and protracted worldwide recession resulting from the financial crisis of 2007-2008, brought to the surface pre-existing and home-grown economic weaknesses. A costly misallocation of resources, resulting from massive investment of capital inflows in construction, had gone unnoticed by policymakers in the face of rapid growth, low inflation and near full employment. These investments were financed by excessive bank credit expansion which was allowed to happen by inadequate macro-prudential regulation, weak bank corporate governance and the prevailing philosophy of “light touch” bank supervision. By 2010, the assets of the Cyprus banking system had grown to eight times its 19-billion euro GDP, with non-residents accounting for about one-third of bank deposits. It is now widely acknowledged that the absence of limits to private bank credit expansion and of surveillance rules to prevent excessive sector concentration, was a serious fault in the design of the European Monetary Union, and a major contributor to the unfolding of the eurozone crisis, especially in the periphery countries.
In a short five-year period between 2007 and 2012, through (historically uncharacteristic for Cyprus) fiscal laxity, one of the best fiscal performers in the eurozone was transformed into one of the worst. During this period, Cypriot public debt rose sharply from 48 percent to 86 percent of GDP, and Cyprus joined other eurozone countries deep into the trap of mutually reinforcing sovereign and banking risks: weak public finances unable to support banks in need of capital, and banks underestimating risk, becoming embattled and thereby undermining the sustainability of public finances. Following the loss of access to financial markets to cover government borrowing needs in May 2011, Cyprus missed several opportunities to apply to the European Stability Mechanism under a relatively moderate program of fiscal and structural adjustment.
By the time a new government took office in March 2013, the deposit outflows during the previous several months of uncertainty, and the deteriorating quality of bank loan portfolios, raised the estimated capital requirements of the Cypriot banks to much higher levels than was the case just a few months earlier. This opened the door to the stronger member states of the eurozone, which were “politically fatigued” of financing “bailouts” such as those for Greece, Ireland and Portugal, supported by the IMF, to push for a “bail-in” of bank depositors. This decision was justified by these stronger member countries mainly on the grounds that lending the full amount of the required rescue package to Cyprus would have led to unsustainable public debt levels. With Cyprus threatened with bankruptcy, politically isolated and with little bargaining power, the Eurozone finance ministers were able to impose a “bail-in,” involving the resolution of Laiki Bank and the forced exchange of almost half of the uninsured deposits into shares at the Bank of Cyprus, the largest of the two systemic banks.
About half the affected deposits by value were non-resident. As a condition for the rescue package, Cypriot banks were also required to sell their branches in Greece and, as a result, the ratio of their assets to Cyprus’s GDP fell from eight to four.
As should have been expected, confidence in the banking system was lost and capital controls had to be imposed. The immediate impact on the economy was not as severe as had been feared. However, it is not yet possible to gauge whether the impact of the “bail-in” on Cyprus’s debt sustainability was any less severe than that of a conventional “bailout.”
Future economic historians may be able to shed more light on whether the “bail-in” was a costly experiment at the expense of Cypriots, or a rational approach to dealing with Cyprus’s challenges at the time. What we do know is that some three-and-a-half years after that severe blow, the Cyprus economy is well on its way to recovery, recording steady economic growth of around 2.5 percent. The unemployment rate has declined faster than anywhere else in Europe, from 16 percent in 2014 to 12.5 percent in 2016, and medium-term prospects are promising. This successful turnaround, which has earned consecutive credit rating agency upgrades and praise from top IMF and European Investment Bank officials, is largely due to sound government fiscal and macroeconomic management, the resilience and entrepreneurship of the Cypriot people, and the loyalty shown by Cyprus’s international business partners.
Specifically, despite the disappointment with the treatment Cyprus received at the hands of our European partners, Cypriots reached an early and strong consensus that the country’s political and economic future lies firmly within the eurozone. This was an important message of stability for both local and potential international investors and for the many foreign clients using Cypriot professional services. Furthermore, a strong focus on budgetary discipline and fiscal consolidation, as was agreed in the Memorandum of Understanding with the Troika (the European Commission, the ECB and the IMF), resulted in a budgetary primary surplus by 2015, well ahead of the agreed timetable. In parallel, there was a serious effort toward reforming the welfare state, resulting in a much better targeting of social expenditure on protecting the most vulnerable population groups. Agreed structural reforms, such as privatizations in electricity and telecommunications and the restructuring of the public sector, which typically tend to be politically more demanding than fiscal consolidation, are taking longer to reach a consensus over and to implement.
Substantial strengthening in bank regulation and supervision, together with improvements in the corporate governance of financial institutions, have contributed to the relatively rapid restoration of confidence in the financial sector, as evidenced by the return of bank deposits to stable levels. Banks have been restructured and are now fully capitalized, mostly by foreign investors. Capital controls were gradually reduced and completely removed in record time, just two years after they were imposed – faster than it was feared at the time of the “bail in.” As should have been expected, the transmission of the severe macroeconomic shock of March 2013 to bank Non-Performing Loans (NPLs) was both fast and strong: within a short period, NPLs for the banking system rose toward 40 percent of its loan portfolio. It has taken some time to modernize the private sector insolvency framework and to develop a more efficient model for NPL management, but some progress is now being made in reducing NPLs, thereby freeing much-needed financial resources for lending to the economy’s more productive sectors.
The fact that Cyprus has reinforced its position as an attractive investment destination so soon after such a severe shock, and continues to be open for business, is testimony to the strength and resilience of its fundamental competitive advantages. Beyond its strategic location, modern infrastructure and high quality of life, Cyprus has, and is committed to maintain, a low corporate tax rate at 12.5 percent, an extensive network of more than 60 Double Taxation Treaties and an attractive tax regime for both corporates and individuals.
The Common Law-based legal system ensures the transparency and reliability of business practices, while the authorities are committed to working harder to improve the speed with which legal disputes are resolved. Similarly, more far-reaching public sector reform aimed at improving service delivery and simplifying further foreign investment procedures is high on the government agenda. More recently, specific naturalization and immigration permit schemes, based on minimum investment amounts in Cyprus assets, have been developed, as well as a fast-track licensing process for priority investments.
This investor-friendly business environment has fostered impressive growth over the years in traditional sectors such as shipping, tourism, banking and financial and professional services.
There has also been investment activity in new sectors such as medical tourism, education and information technology. The recent commercialization of the port of Limassol and the upcoming development of a luxury casino resort is creating new investment opportunities in shipping and tourism. The discovery of hydrocarbons and the establishment of a modern and well-regulated framework for investment funds are attracting growing investor interest in these sectors. Stability also plays a key role in attracting groups of companies with operations in the region. In a clear manifestation of its strong commitment to cooperation with other states in combating tax evasion and money laundering, Cyprus signed the relevant OECD-sponsored agreements, and introduced domestic legislation to allow exchange of information. A constant factor in the successful Cypriot international business development story line, is a modern accounting and legal profession characterized by reciprocal loyalty through good and bad times: highly qualified professionals serving demanding clients at any time on any matter, and fully satisfied business people retaining trust in their service providers throughout Cyprus’s years of crisis.
Foreign direct investment in traditional and, especially, new sectors, aimed at bringing modern technology and higher productivity to Cyprus, is the key to sustainable economic growth and the creation of quality employment opportunities for its well-educated and skilled human resources. With the key ingredients already in place, the government and business community are determined to do whatever it takes for Cyprus to be a business center of excellence and the destination of choice for international investors. Michael Sarris, a former department director at the World Bank, served twice as finance minister in Cyprus: in 2005-2008 when the country adopted the euro, and in March 2013.
Michael Sarris, a former department director at the World Bank, served twice as finance minister in Cyprus: in 2005-2008 when the country adopted the euro, and in March 2013.