We
Must Not Forget The Lesson Of The Cyprus 'Bang! Moment' Shock
By
JOHN MAULDIN,
"Future shock is
the shattering stress and disorientation that we induce in individuals by subjecting
them to too much change in too short a time."
– Alvin Toffler
What is it about
humans that we fail to see a crisis in advance, yet when we look back, its
likelihood or inevitability so often seems blindingly obvious? Rather than a
flaw, our under- reliance on foresight as opposed to hindsight is perhaps a
necessary evolutionary design feature that has allowed us to make rapid
progress as a species (especially over the last few thousand years), but in a
complex modern society it can really create quite the crisis for individuals.
This week we resume our musings about Cyprus, to see what that tiny island can
teach us about our own personal need to engage in ongoing critical analysis of
our lives and investment portfolios. Cyprus is not Greece or France or Spain or
Japan or the US or ... (pick a country). I get that. No two situations are the
same, but there may be a rhyme or two here that is instructive.
This Country Is
Different
In 1974, Turkey
invaded Cyprus. Eventually the island was divided into two zones, and Greeks in
the Turkish zone, like Turks in the Greek zone, were forced to leave with only
the clothes on their backs and little else. That was a defining moment for
Cyprus, and the aftershock is still evident when you get past the normal polite
conversation. Plus, the wall dividing the two countries is always there when
you are in the capital city of Nicosia, although lately there are a few places
where you can cross into the other zone. The first night I was in Nicosia, we
ate dinner outside at a Greek taverna (what else?) that stands almost in the
shadow of the wall.
One hundred years
after the Civil War, the South of my childhood was still mixed up with the
aftereffects of that war. The war in Cyprus was less than 40 years ago. Another
evening we went to a local club where the members were Greeks who had been expelled
from a particular neighborhood in the Turkish-occupied area. Many looked young
enough that they could not have been alive during the war, but the memory of
the "old neighborhood" was still strong among them.
These people lost
homes and businesses, jobs – everything. They had to start over. (I am sure it
was that way for the Turks who had to relocate as well.) But for the next 40
years there was very steady economic growth, 4% or so a year over time. The
people took advantage of what they had.
There was no
university, so children went abroad to study and work and then came back,
generally with skills. The legal and accounting professions grew particularly
strong. Like two other former British island colonies, Singapore and Hong Kong,
Cyprus became a financial center. Fifty double tax treaties later, the island
had become a place to domicile companies, handle taxes and accounting, etc.
And then they
branched out into banking. After the creation of the euro, the deposit base of
Cypriot banks went through the roof, until it was up to six times the size of
local GDP (depending on whom you believe – official sources make it closer to
five times). By some measures, Cyprus had the second wealthiest population in
Europe and certainly one of the best educated. Twenty-five percent of the
world's ships were operated under the flag of Cyprus. Because the country had
been a member of the nonaligned movement in the '80s (remember that?), it had
good ties (and double tax treaties) with Eastern Europe and the USSR. Some of
the kids went to university in Russia and developed contacts there. After the
collapse of the Soviet Union, it was natural for Russians to use Cyprus as a
conduit to the West.
Cyprus has, by
some accounts, the best beaches in the Mediterranean, and so more and more
people came and built vacation homes. They brought their money with them and
deposited it in the local banks and took out loans to build their homes. Real
estate prices climbed and climbed. Below are Cypriot bank deposits and loans
from 2009 through April of this year (data from the central bank).
Unemployment was
quite low, less than 4% in 2008, although the global credit crisis led to a
gradual rise (though nothing like that seen in the rest of Europe). Much of the
new unemployment was in the construction industry, which fell into a slump
along with the rest of Europe during the crisis.
Banking soon
became the biggest industry. There were more banking branches per capita in
Cyprus than anywhere else in the world, more than double the European average.
And there were over 40% more employees per branch than in the average eurozone
country. Money was easy to get, so debt exploded by over 50% in both businesses
and households in just six years, from 2005– 2011.
The country had
always run a current account deficit, but by 2008 that deficit had topped 15%,
keeping pace with Greece's and Portugal's. However, earnings and productivity
had more than kept up. Cypriots worked hard and offered good value for their
services. They saw themselves as different from the other Southern European
countries. But, as in much of the rest of Europe, public-sector employment
doubled from 1990, with the second-highest government wage bill (behind
Denmark's) and a monstrous 50% growth in social benefits in the last 10 year
Still, starting in
2003, public debt-to-GDP actually fell. Why ring the alarm bell when things are
getting better?
There were in fact
no alarms bells ringing as 2012 opened. But there should have been. Cyrpiot
banks were flush with cash. They bought foreign banks in Greece and Russia.
They made ever more loans and then looked around and decided that Greek
sovereign debt was something they needed more of. And then came the Greek
sovereign debt crisis, and the capital base of the Cypriot banks was
essentially wiped out. But the ECB and the EU had bailed out Irish and Spanish
banks; and so depositors in Cyprus, many of them Russian, decided, along with
the local citizens, to leave their money in the banks.
The country had
been under the parliamentary control of the Communist Party since 2008.
Seriously. Supported by the Orthodox Church. (Note that public debt began its
serious rise after the communists came to power). No one reined in the banks,
and they grew ever fatter and more exposed until the crisis hit. Then Cyprus
could no longer fund its debt and needed EU help. Further, the Central Bank of
Cyprus (not to be confused with the commercial Bank of Cyprus) had to make
emergency liquidity loans to Cypriot banks that had to meet demands for
withdrawals and could no longer raise capital. There was not a bank run, but
there was a fast-paced walk.
The ECB balked, as
the quality of the collateral offered did not come close to the standards of
the Emergency Lending Assistance (ELA) program. The government of Cyprus needed
money to fund its basic needs as well as to "roll over" its debt as
it came due. The EU basically declined to negotiate, as there was a Cypriot
election scheduled for late February, and the EU preferred to wait to see the
results before acting. There was talk of a "bail-in" (where
depositors would shoulder some of the loss), but as usual that proposal came
from the Germans, and the rest of Europe would surely not agree.
The new president
assumed office and saw immediately that the country was in trouble. He tapped
Michael Sarris, a "technocrat," to be his finance minister. Sarris
was the man who had helped bring Cyprus into the euro and who oversaw the
reduction in Cypriot debt. While he was not a member of the winning political
party, he had been at the World Bank and had relationships with many of the
finance heads of Europe.
Sarris went to
Brussels, only to find no friends of Cyprus there. The Germans privately told
him they would approve no bailout of Russian depositors (rumored to account for
over half of the base of some of the banks) prior to the German elections this
fall. Cyprus was seen as a money haven and a place for rather loose tax
accounting. I have to admit that many of the Cypriots I talked to knew that
money laundering was going on. It was a very open secret. Cyprus had very
strict rules, but it seems there were ways to engineer exceptions.
In the end, Cyprus
makes no difference – that was the perception in Europe, and while they were
just talking a few billion euros here and there, a fraction of what Ireland or
Spain needed, there was just no sympathy for Cyprus. Many of the European
finance ministers wanted to establish the questionable principle that bank
deposits were no longer sacrosanct, and Cyprus was just not seen as a systemic
risk. The best deal Sarris could get was a 6.75% "tax" on deposits of
less than €100,000 and 9.9% above that, with the aim of raising €5.8 billion.
That was on a weekend, and by Monday, when Sarris returned, the indignation in
Cyprus had grown to the point that not one politician voted to accept the deal.
A bank holiday was
declared and Laiki Bank was put into receivership and closed as a "bad
bank," but within a week the EU decided to insure all deposits up to
€100,000, the number that "everyone" had understood to be the safe
deposit amount. The banks eventually reopened, but Cyprus placed capital
controls on deposits and limited withdrawals. A euro in a Cypriot bank was no
longer the same as a euro in an Irish bank.
The Economist wrote
shortly thereafter:
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