Cypriot Economic Crisis: Causes and Consequences, Research Paper Example

Introduction

Cyprus, highly reliant on tourism and import was hit significantly by the global economic crisis, and – according to the Press and Information Office of Cyprus (2014)  – is struggling to recover more than other countries in Europe. Clerides & Stephanou (2009) wrote four years ago that it was extremely hard to predict when the crisis would be over. While Cyprus gained political independence in 1960, it is highly reliant on world economy, and is far from being economically independent. This high level of dependence resulted in the country being hit extremely hard by the consequences of the credit crisis and property market collapse. The below paper will focus on the reasons behind the Cypriot economic crisis, relying on independent analysis, reports, statistical data,  and investigative research aiming to reveal the main reasons for the long term economic difficulties of the country.

Problem Statement

A speech made by Demetriades (2009), Governor of the Central Bank of Cyprus, published by the government of Cyprus has investigated the reasons behind the economic crisis, and the potential methods of recovery. The main hindering effects related to economic recovery are identified by the author as: banks’ deleveraging (the holding back of normal credit flows), high unemployment, the governments’ fiscal austerity, and sovereign debt exposure combined with a weak economy. The speech summarizes the events that led to the economic crisis worldwide and in Cyprus, while highlighting the main challenges of recovery. The main issue the author of the current research would like to investigate is whether or not the current economic policies and international initiatives designed to help Cyprus recover are able to deliver measurable results long term, and whether or not they carry increased risk of dependency on international markets, property trends, and policies introduced by international trade organizations and the European Union.  The author of the current research will investigate the four above mentioned reasons behind the economic crisis in Cyprus, and revisit them, in order to determine whether or not the current government and international policies are suitable for eliminating them. The main purpose of the research is to evaluate the approaches of the government and international organization, based on their effectiveness of supporting the country’s economy in recovery.

Country Analysis

The Cyprus country analysis (Press and Information Office, 2014) highlights some of the main features of the country that have an impact on the overall economic development. First, only an independent country since 1960, the country has little experience in policymaking, controlling of the economy, and the representation of Cyprus on the international field. At the same time, Cyprus is a member of the European Union, and the Eurozone, which provided it with an advantage in the international tourist industry, however, made it more dependent on Euro currency fluctuation and the performance of other EU economies. The country is also a member of the World Trade Organization since 1995, the The Organisation for Security and Cooperation in Europe, the Commonwealth, the Council of Europe, the United Nations, the World Bank, and the IMF (International Monetary Fund).

One of the main drivers of Cyprus’ economy is tourism. The Mediterranean climate and mild winters attract visitors to the country all year round. The abundance of sunshine makes Cyprus popular among European and American retirees, investing in property and relocating to the country. Indeed, the booming property market of Cyprus was fueled by the strong demand for apartments and condos in the countries, however, the global economic crisis deeply affected this segment of the economy. 18.6 percent of the country’s residents are foreign citizens (Press and Information Office, 2014). The total number of residents is 956,500 (Press and Information Office, 2014). Further, due to the ongoing dispute between the Turkish and Greek parts of the country, there is a large number of displaced Greek Cypriots.

Cyprus adapted the Euro in 2008, further increasing the impact of European economy on the country. In 2013, upon the request of the Cypriot government, the Eurogroup provided the country with financial assistance to support the introduction of a macroeconomic program, the consolidation of the country’s banking sector, and the restructuring of public administration / finances. The Economic Adjustment Program was developed to outline a detailed plan for recovery for the years 2013-2016. Funded by the European Stability Mechanism and the IMF, providing 10 billion Euros for the implementation of the reforms, the initiatives detailed in the plan are expected to recover growth in the country and reduce the government’s deficit, while maintaining political and economic stability.

As the engine power of Cyprus’ economy is the service sector (Press and Information Office, 2014), and the second largest driver is manufacturing. Prior to the global economic crisis, Cyprus enjoyed low unemployment rates, and reliable economic growth. As the cost of borrowing increased, foreign investment declined, and there was a large number of Government bonds in circulation, the country was hit extremely hard by the crisis. Adjustments to the monetary policy have been made, such as the Central Bank of Cyprus becoming a member of the European System of Central Banks, and being provided with guidance on reforms and strategies. The main focus of the fiscal policy is to consolidate the country’s public finances, and provide them with a strategy that secures long term sustainability. Further, Cyprus has engaged in developing and implementing reforms that focus on the labor market, the market competition within the services sector, in order to improve the country’s performance on the international scale, social security reforms, and strategies to increase the productivity of the public sector. Still, following the reform, the GDP growth of the country entered negative figures in 2012. While inflation has decreased, the GDP per capita has been declining since 2010, and unemployment rate stood at 15.9 percent in 2013 (Press and Information Office, 2014). Public debt increased to 102.2 percent of the GDP.

Global Perspectives

While the vulnerable economic situation of Cyprus, and its strong dependence on tourism and European economies had a great role to play in the negative effects of the global recession, international policies and trends also increased the impact of the credit crunch and affected the country’s ability to deal with the emerging issues. Below, the author of the current research would like to review these global perspectives, in order to reveal their connection with the country’s lack of ability to recover.

Hardouvelis (2014, p. 4) explains the reason for the extended crisis in Cyprus, and the country’s lack of ability to recover: “Naturally, as the international environment worsened, the earlier vulnerabilities and risks grew bigger. Yet more risks emerged. Those new additional risks of the post 2007 period carried the potency to permanently derail the earlier Cypriot economic miracle. ”.The author states that the investment in Cyprus declined sharply after 2010, following the economic crisis. Compared with investment into the entire Eurozone, which stagnated from 2010 and recovered in 2014, the investment in Cyprus is likely to remain at the current low level, due the the lack of trust from international markets. The fears from the Greek exit from the Eurozone, lingering in international politics since 2010 have decreased investor confidence. The Mari accident in 2011 has made the international markets aware of the instability of the country’s economy, and investors became less likely to buy government issued bonds. The confidence in the Cypriot government’s  abilities to protect citizens and carry out reforms declined sharply. On the international scale, before the economic crisis, Cyprus had several hidden vulnerabilities, such as an uncompetitive economy, the increased reliance on the real estate sector, and the exposure to Greek government bonds.

The main causes of the global economic crisis are reviewed by the research study created by Clerides & Stephanou (2009). The authors state that the increased liquidity of private and company finances, the new mortgage market rules due to liberalization, lack of market discipline, inadequate consumer protection, and the oversight of domestic and international legislation requirements affected all countries. In the case of Cyprus, it is evident that lending and the liberalization of financial markets had a huge impact on the country’s level of vulnerability. However, each country affected by the economic crisis created different policy responses. The main measures combined by countries were: making emergency liquidity available, increasing the financial safety nets, capital injection, reconstruction of financial institutions, and kick start lending policies (Clerides & Stephanou, 2009).

According to Dematriades (2014), the exposure to Greece in the financial sector of Cyprus carried great risks, and should have been eliminated prior to the start of the crisis. Therefore, it is evident that Greece “pulled down” Cyprus in a way while falling.

Orphan ides (2014) highlights the fact that while Cyprus’ joining to the Eurozone was celebrated across the country, it increased its vulnerabilities. As the author states: “By March 2013, euro deposits in Cyprus became unequal to euro deposits elsewhere” (Orphanides, 2014, p. 2). At the same time, the author argues that the government of Cyprus failed to act and address the crisis, while other European Union member countries requested early assistance, such as Greece, Portugal, Ireland, and Spain did so.

Literature Review

The below review of literature will focus on the connection between the weaknesses of the Cypriot economy and the opportunities for recovery, based on country and economic analyses. The author would like to determine which hindering effects have the greatest influence on the ongoing crisis and the country’s performance.

The main challenges identified by Orphanides (2014), regarding the chances for economic independence and recovery are: government debt, high unemployment rate, and an outdated pension (public sector) system. That taken into consideration, it is evident that overly optimistic government policies were partly responsible for the increased negative impact of the economic crisis on Cyprus. The main issue that the country is facing is that its government that serves less than one million people is ineffective in many ways. It lacks policies focusing on sustainability, just like it did back in 2008. The government failed to recognize the risks of joining the European Union, and the increased dependence on international markets and banking systems. At the same time, the economy of the country is mainly focused around the service industry, and this makes it vulnerable to credit crises and recession. The public service still fails to create policies to increase employment rates among Cypriots, and create jobs that are less dependent on international trends. The two main sectors that drove the growth of the country’s economy prior to 2008 were tourism and property development. It has been proven that both sectors depend on foreign investment and spending power. As the spending power of investors and holidaymakers weakened, the Cypriot economy declined at an unprecedented rate. Cyprus was also an international business hub, due to the government’s policies related to investments and developments, however, the trust of foreign capital owners was quickly lost after the 2011 Mari accident. The government was unable to prove that it is capable of creating and maintaining policies that provide stability for both residents and international companies. The labor market of Cyprus is far from being competitive, according to the author (Orphanides, 2014). Indeed, the increases in public sector wages were not followed by private company workers’ salary rises, and made the public sector  less effective. The author recommends that the country revises its wage indexation mechanism, in order to improve the overall competitiveness of government agencies. Other structural reforms mentioned by the author include pension system revision, and this might bring forward an increase of retirement age, just like it was introduced by other EU member countries, triggered by the demographic trends. It is possible that retirement benefits will need to be reduced, while contributions would increase gradually in the following years. These reforms in the pension system could make the country’s economy more sustainable long term, and help eliminate government deficits.

Another area of the public sector, often overlooked by analysts is related to tax collection and compliance. By making government agencies collecting tax more efficient, Cyprus could increase state income, and overcome GDP deflation easier. In recent years, the lack of cost-effectiveness in the public sector of Cyprus has been highlighted by several authors. Structural, long-term reforms are needed to ensure that the government debt is eliminated.  Orphanides (2014)  found that the government needs to focus on debt sustainability, and increase its GDP. One of the recommendations included in the speech involve policies related to natural gas exploitation in order to increase government revenues. Recent natural gas discoveries in Cyprus opened up opportunities for the country to exploit natural resources and increase revenues, eventually reducing the debt-to-GDP ratio.

The comprehensive analysis of Hardouvelis (2014) concludes that the greatest challenge of the country’s economy is to create a long term strategy focusing on the “creation of a new growth model in which public consumption will have a slightly smaller share of GDP, and, particularly, investment will be boosted drastically” (Hardouveis, 2014. p. 17). The author reviewed what led to the events of the financial crisis, and found that prior to 2007 the living standards in the European Union rose sharply. Before the crisis, government debt to GDP ratio was low, and unemployment was below 5 percent in most countries. However, the growth brought forward several vulnerabilities in Eurozone countries, in particular in smaller, dependent economies, like in Cyprus. In Cyprus, the lack of competitiveness created a high level of risk for market vulnerability on the global scale. The great scale of current account deficit almost predicted the outcome of the crisis for Cyprus. The balance between export and import was not covered by economic policies, therefore, the country was unable to export, while the population grew. Still, one of the main risks  of the country’s economic policies before 2007 was based on the fact that “the country’s high growth was also based on on-going and unsustainable external borrowing” (Hardouveis, 2014. p. 2). If Cyprus does not address the issue of competitiveness, it will not be able to overcome the crisis. Between 1999 and 2007, unemployment in Cyprus was 4.3 percent on the average, compared with 10.2 percent in Greece, and 10.6 percent in Spain. Starting from a relatively better position than these two countries, Cyprus still struggles to recover from the economic crisis. The relatively large size of the financial sector, compared with the population of the country also created elevated risks. Further, the large leverage of the domestic private sector of the country was a great risk, as businesses carried on borrowing beyond means. Unlike in other countries, corporate debt accounted for 96.9 percent of the country’s GDP in 2007. This liberal approach to credit should have been spotted as a risk factor before the crisis in order to eliminate or reduce the negative impacts of this rate of outstanding credit. By 2012, corporate debt rose to 139.2 percent of GDP (Hardouveis, 2014, p. 3). After the slowdown of the economy in 2007, further risks emerged from the changes in the global conditions. The main risk was associated  with the large, expensive, and ineffective public sector of the country. Primary surplus slowly disappeared, and as  the author (Hardouveis, 2014, p. 4) confirms: “From a primary surplus of 6.5% GDP in 2007, we witness a decline to a primary surplus of 3.8 % in 2008 and then an overwhelming reduction to a primary deficit of -3.6% of GDP in 2009”. Finally, both private and public investments declined after 2009, and this reduced the ability of the country to produce services and goods, generating GDP. As the author states, the policy that allowed the investments into sustainable businesses and services disappear was the main reason for Cyprus’ inability to recover from the crisis, and blaming the problems solely on the real estate market would be simplifying a complex question. Instead of focusing on the consumption of future generations, the government of Cyprus created initiatives that were built around maintaining the level of consumption within the current generation. The forecast of investment rates is not looking good for Cyprus, either. While in 2014 investment rates across the European Union’s states is expected to rise, it will continue to remain at a low level and rise only slightly in Cyprus (Hardouveis, 2014). The fears of the Greek exit from the Euro Zone also affected Cyprus’ investment markets negatively. Interestingly,  Hardouveis connects the lack of consistency, and the dismissal of the above quoted Governor of the Central Bank of Cyprus, Orphaniades with the country’s inability to recover. According to  Hardouveis (2014), the governor and the mainstream political leaders of the country had a major difference in opinion related to policies focusing on the future of Cyprus’ economy. The fact that Orphaniades was respected by the EU leaders, and had a good working relationship with the European Central Bank shows that this decision could have negatively impacted the EU’s trust in the country’s  ability to successfully recover after the crisis. While the Troika (collective name for delegates consisting of EC/ECB/IMF) visited the country during the Cypriot presidency in 2012, no agreements were made between the experts and the country’s leaders to increase Cyprus’ prospects for economic recovery. Reports about money laundering activities that took place in Cyprus’ financial institutions did not help the country’s competitiveness, either. The country’s image was damaged, and investors’ trust declined further. While the following meeting with the Euro-Group resulted in the initiation of reforms to reshape the country’s banking system, this step was not enough to change the trend, and the reforms came too late. The newly created Bank of Cyprus was finally recapitalized in 2013, and some risks were eliminated. Still, several remain to this day that need to be addressed by the government.

Hardouveis (2014) states that the financial sector is still not reliable or secure, and this hinders the country’s success to recover, as it affects several areas of the economy. The instability of the financial markets reduces the confidence level among international investors, while it reduces domestic companies’ ability to plan ahead and start new ventures. The contraction of the average income (worth of take-home money), and the rising rate of unemployment also negatively affect the country’s chances for recovery. The above risks, as  Hardouveis (2014, p. 12) states: “feed on each other”, multiplying the risk and negative impact associated with them. The risk associated with the financial sector is described by the author as a “Damoclean sword”.  Hardouveis (2014) highlights the fact that the economic health of a country is greatly dependent on the health of the banking system. Therefore, banks that are not stable will not increase credit availability, and economic contraction will occur. Long-term recession, on the other hand,  will reduce banks’ profitability, due to defaults and delays in payments. Both the demand and supply of credit declined since 2007, due to the recession, and the percentage of non-performing loans (NPL-s) is still extremely high. Bank deposit levels reached some of the lowest levels, and unemployment carried on rising sharply even after 2012, when the rise in the rest of the European Economic area slowed down. Finally, it is important to note that Cyprus used to be an international business hub, and gained a substantial amount of tax income before the crisis from new companies establishing themselves in the country. Today, Cyprus is doing well in this area, and has  the potential to increase its competitiveness through business activities, as well as the exploration of natural gas resources, mentioned previously. Examining future potential risks of financial problems,  Hardouveis (2014) states that contraction of the economy seems to be constant, and there are not enough policies that focus on regaining competitiveness and growth. For this, the country’s economic leaders need to create an individual, country-specific growth model and strategy for long term. Competitiveness can also be defined by country ratings, such as perceived corruption, ease of doing business in the member state, rule of law, and government effectiveness. Without focusing on improving the country’s rating in the above areas, Cyprus runs the risk of further financial problems.

The review of the financial and economic situation published by Orphanides (2014) clearly criticizes the government for not doing enough to increase the country’s ability to deal with risks and challenges. The author states that through the reforms the government lost control over its financial sector. When pension gaps were announced by the government in 2011, investors and the public started to panic, not without a reason. The author states that the government should have taken control of the situation by addressing the most important issues within the 2011 budget, however, it failed to do so. As a result, the government lost access to international markets, and the power supply of the country was destroyed by the Mari disaster. The disaster is often mentioned as one with some of the highest economic costs. GDP started to decline again, after a rise in 2010, and unemployment rate reached its historic high. A warning letter urging the government to take action was ignored and classed as “alarmist”. The report clearly states that the government’s lack of action addressing the risks resulted in the lack of ability to overcome the economic crisis.

The initial review of the Cypriot economy created by Clerides & Stephanou (2009) also warned about the risks related to the uncompetitiveness of the country. While central banks around the world stepped in to ease credit and help the economy recover, the government of Cyprus failed to do so. The influence of the Greek economy was great, and in 2007, when the Cyprus Stock Exchange (CSE) mirrored the movements of the Athens Stock Exchange, this reliance was clearly visible. Unfortunately, for both markets the trends resulted in the loss of billions of Euros in company stock values. The credit boom in 2007-2008 (leading up to the introduction of the Euro) was growing at a rate of 20 percent per year, and the Central Bank failed to contain the current account deficit that was the result of higher level of borrowing. The main industries responsible for the credit boom were the real estate and construction sectors. Lending growth between 2007 and 2008 was 18.6 percent for local residents, and 22.6 percent for housing. A growing number of loans were given out to non-residents, which increased the level of risk associated with the credit. Offshore deposits also accounted for 35 percent of the country’s total deposits in 2005. As a conclusion, the authors (Clerides & Stephanou, 2009) state that the initial reason for the increased negative impact of the crisis on Cyprus’ economy is that the government allowed the financial sector to grow “disproportionally large relative to the economy’s size” (p. 48). As the previously reviewed studies, this report also assigns the responsibility to policymakers, and the fact that they did not deal with the most urging matters in time.

Personal Opinion

In my opinion, Cyprus should have focused more on making its economy sustainable to reduce the potential impact of global economic crises. Indeed, the government failed to address country competitiveness issues, increase income, state revenue, and stabilize the financial sector. Another reason why I believe Cyprus was hit more than other countries by the economic and Eurozone crisis is because it relied on other economies, in particular Greece’s industries and banks. If the country was not involved in trading Greek government bonds, it would not have been impacted by the effects of the Greek crisis and speculation over the Gr-exit.

The economy of Cyprus was not balanced before the crisis, either. The rapid growth of the real estate industry, and the reliance on foreign investment made the country extremely sensitive to changes in Western Europe and the Eurozone. The country’s dependence on the European Union’s policies increased in 2008, when Cyprus joined the Eurozone.

However, as several authors have confirmed, the government of Cyprus failed to address risks and issues in a timely and effective manner, further hindering the country’s ability to regain growth and become independent.

Conclusion

As a conclusion, the economy of Cyprus will only recover if the government is able to create a long term sustainability strategy that focuses on the country’s competitiveness, independence, and effective government. While reforms have already been started,  and the Economic Adjustment Program is aiming to address some of the problems related to government debt, lack of growth, and unemployment, the country is still highly dependent on international banks and investors. Creating a more balanced economy that focuses on long term growth and competitiveness is the only way forward for Cyprus.

References

Clerides, M., & Stephanou, C. (2009). The Financial Crisis and the Banking System in Cyprus. Cyprus Economic Policy Review, 3(1).

Demetriades, P. (2012) Cyprus financial crisis: the framework for an economic recovery within the eurozone. Speech by Panicos Demetriades, Governor of the Central Bank of Cyprus, at a discussion organised by the Hellenic American Bankers Association and the Cyprus-US Chamber of Commerce. New York, 11 December 2012. Retrieved from http://www.centralbank.gov.cy/nqcontent.cfm?a_id=13421&lang=en

Hardouvelis, G. A. Overcoming the crisis in Cyprus. Retrieved from http://www.eurobank.gr/Uploads/Reports/20January2014Q.pdf

Orphanides, A. (2014). What happened in Cyprus? The economic consequences of the last communist government in Europe.

Press and Information Office of Cyprus (2014) The Republic of Cyprus. An Overview. Retrieved from http://www.mfa.gov.cy/mfa/