Cyprus is on the edge of the cliff

2011-11-27

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The Republic of Cyprus is facing the increasing threat of coming to the need of a bailout as its economy continues to deteriorate. The malignancies of the Cyprus economy are indeed numerous and are found both in private and public sector.

Cypriot banks suffer from their exposure to debt-ridden Greece, creating a major source of uncertainty regarding their capacity to withstand the mounting pressures. Given the sheer size of the country’s banking sector, that is seven times bigger than the GDP of the country; negative expectations about the viability of the broader economy and the state’s finances, have naturally been shaped. The 50% haircut that will be imposed on private holders of Greek debt, will have a significant impact on Cypriot banks, who will be forced to raise their Core Tier 1 capital, to withstand the shock and to meet the capital ratio criteria as those were set in the October 26 Euro summit under the bank recapitalizations programme. In practice banks are forced to reduce the amount of liquidity they supply in their attempt to deleverage, as they are in desperate need of 3.6 billion euro until June 30, 2012. For the economic size of Cyprus that is a huge amount of capital if we consider that the GDP is roughly lower than 20 billion euro. This process of bank deleveraging to meet the needs will affect the real economy, as low liquidity amid anemic growth, is hindering business activity.

Reduced liquidity is also part of the government’s doings (indirectly at least). The government has been drawing funds out of the internal market to finance its needs since international borrowing costs have long now been at exorbitant rates. Last Friday the rates for 10-year bonds were above 10%, a forbiddingly high borrowing cost. Though this has successfully bought time for the government (that was not used anyhow productively) and saved it from falling a victim to international market speculation, it has had the effect of depriving the economy of much needed liquidity and has pushed up interest rates, making things even worse for the market.

Though it would be quite easy to put the blame on the “reckless” investments of Cyprus’ banks, I uphold that the problem is much broader and has to do with a series of structural problems and policy failures. The flaws of the economy of Cyprus are indeed numerous, while the state functions along anachronistic, counter-productive lines. The number of public servants in Cyprus is approximately 53.000 that absorbs around 30% of the total government’s spending. Public servants enjoy some of the greatest benefits and high salaries across Europe that are disproportionate to their productivity. Though one could be tempted to argue that this is not a problem since they take the money and they spend it, thus stimulating the economy; this conclusion would have been pure fallacy from beginning to end. What matters is not the recycling of the money on the same goods and services, but ultimately what an economy as a whole produces. After all if the logic of people spending money without really being productive was correct, then it would also hold logically true for 60% of workers, or 99%. At that point it is clear that such views are a bunch of nonsense.

Cyprus has a significant portion of the working force in unproductive activities, while much of the country’s budget is spent in a highly wasteful manner, when it could either be used to invest in education, improve infrastructure, decrease taxes, or used in other areas of policy that would facilitate business activity, producing real growth. After all according to Eurostat, Cyprus is among the European states with the lowest expected real growth levels in 2012 (0%) and in 2013 (0.7%). These bleak numbers do not come up coincidentally. They are one of the side-effects of not investing in ways to improve the competitiveness and productivity of the real economy.

Competitiveness is something the economy is in desperate need of, yet it seems that this will not come any time soon, again thanks to decades of bad government policies. With its legislation and the incentives it produced, the government managed to give birth to quite strong labor unions, that are now reluctant to give up the generous benefits they got in the period of the “fat cows”, prior to the Great Recession. For instance unions of public servants are reluctant to accept a two-year freeze of their lucrative wages, effectively forcing the government to resort to tax policies, so as to raise the funds it requires, since any cuts in the public sector will meet staunch resistance. Plans are now being made to increase taxation on the productive parts of the society, as labor unions are asking for “business” to contribute.

What needs to be said is that “business” is already the largest contributor to government funds, since public servants do not even pay for their pensions. Even if they did though, the rationale of absorbing money out of the productive segments of the economy is indeed ill thought. Increasing taxes amid a recession has always been a self-defeating policy and Cyprus will not be an exception. Higher taxes will only depress growth even further, effectively pushing the country deeper into the hole. Increased taxation amid feeble growth also has a negative on employment. Higher tax costs put even more pressure on employers to release their employees, thus increasing unemployment. And of course the cost of unemployment is paid by the state’s budget, in the form of unemployment benefits. Understandably this not the effective way to cut deficits and reduce debts.

There are a series of other issues that could be pointed out within the context of this article, yet the above are enough to depict the environment of uncertainty and big trouble Cyprus finds itself in. Years of government failures, of bad policies and unproductive spending has brought Europe’s South-Eastern Mediterranean state on the edge of the cliff where the slightest of imbalances will push the country into a bailout mechanism.

It would be unfair to put the blame of the situation in any group of workers, or on any sector of the economy, either that is public servants, or banks, or “business” in general. The ultimate blame must be put on the government, since it created all this mess, with its ill advised, counter-productive policies. After all as the great Cynic philosopher, Diogenes of Sinope once said, “Why not whip the teacher when the pupil misbehaves?”.

President Demetris Christofias is now called to fix the errors of all the administrations that took power the last decades, including his own. Given the structure of the broader issue and the direction his government’s policies have taken, I doubt he can do much, or if done I fear it will not be enough.