I have just spent three days in Cyprus talking to political and economic figures in the island. I encountered a very strong sense of determination to overcome their present severe economic difficulties.
These difficulties arise from mistakes made in the banking sector, whereby very large overseas deposits (mainly from Russia) were invested by the banks in lending to the Greek private sector and in Greek Government bonds. Banks exposure to Greece totalled 28 billion euro, or 170% of the entire Cypriot GDP. This concentration of risks in one place was bad banking practice, in the same way that excessive concentration of risks in the construction sector, was bad banking practice in Ireland and Spain.
Meanwhile the Cypriot economy also lost competitiveness.
At the end of 2011, the EU/IMF/ECB found that the situation of the public finances of Greece was so severe that senior bondholders(whose position had been famously protected from haircuts by the ECB in the Irish case) would have suffer a 75% haircut. This created an immediately critical situation for the Cypriot banks. They lost 33% of their capital.
This crisis for the Cypriot banking system was known to the EU/IMF and to the Cypriot Government of the time of the Greek haircut. Apart from a temporary loan from Russia, nothing was done. The EU/IMF/ECB, who should have confronted the problem immediately, did not do so, and it got worse.
THE MYTH ABOUT RUSSIAN HOT MONEY
Meanwhile a press campaign was mounted to suggest that the Russian depositors in the Cypriot banks were tax evaders, money launderers, oligarchs or worse.
This campaign seemed to be designed to persuade public opinion that depositors in Cypriot banks were less deserving of protection than depositors in banks in Athens, London, or Frankfurt. In fact, little evidence has subsequently emerged to justify any of these stories.
And, indeed, there is a perfectly good, and legitimate reason for these Russian deposits in Cypriot banks.
Many Russian businesses did not trust their OWN legal system, and felt that their assets would be better protected in a country like Cyprus, with a common law legal system, and which was in the euro. But in March of this year, they were to be brutally disabused of the notion that euro zone banks were a safe haven.
Eventually the problem was tackled, in March 2013, in an agreement by IMF, the EU, and the ECB with a newly elected Government in Cyprus, who had had little or no time to assess the options for themselves.
TROUBLING ASPECTS OF EU DEAL
The March 2013 agreement contained a number of elements that are troubling.
For the first time this century, depositors have had to take a haircut. The fact that this procedure was followed creates a new and permanent uncertainty for depositors who hold more than 100000 euros on deposit in any bank in the euro zone. They now must, to protect their assets, scrutinise the situation of their bank on an ongoing basis, and move money out of banks that seem to be pursuing risky strategies. But getting the relevant information will be difficult and time consuming. There will be a tendency to move money towards bigger banks, which will aggravate the “too big to fail” problem.
No haircut was, however, imposed on the depositors in the Greek branches of the Cypriot banks, and those branches were transferred to Greek banks. This inflicted additional losses on Cyprus, and is hard to justify, within a monetary union that comprises both Greece and Cyprus as equal partners.
CREDIT FROZEN FOR CYPRIOT BUSINESS
The Cypriot banking model of attracting overseas deposits has been destroyed, although Russians continue to invest and holiday in the island, which disproves the suggestion that they were all fly by night tax evaders and hot money merchants. . It would be interesting to know which country’s banks are now benefitting from these Russian deposits that were formerly in the Cypriot banks.
Meanwhile, viable Cypriot businesses, that were well capitalised and equipped with working capital before March, are struggling to access funds to keep going.
Deposits they could have used have been reduced by haircuts, and capital controls mean that what remains in their accounts cannot be used freely. Bank credit is frozen.
A Cypriot export model, to replace the old bank deposit led model, cannot be put in place without access to day to day funding.
I left Cyprus feeling that, if Cyprus did not constitute a mere 0.2% of the euro zone GDP, and was physically closer to the centre of Europe, it would not have been the subject of these radical experiments in European banking policy.
It would, instead, have been the subject of much timelier, and less harsh, actions by its partners.
Of course, Cyprus must abide by the terms of the March agreement, and, like Ireland, establish a good track record.
But if it does so, it should, like Ireland, see progressive easements in the terms of its bailout, so that its economy can be allowed to breathe again.
There is a tendency, whenever a euro zone country gets in to difficulty, and needs help from its neighbours, to blame Germany for the severity of the terms imposed, and to say there is bullying involved.
In both Greece and Cyprus, we hear references to the Second World War, as if offering Greece a low interest loan to keep its state functioning , was equivalent to a military invasion, of the kind Greece experienced in 1941.
There is also talk of the “solidarity” that Germans ”owe” the rest of the rest of the euro zone, even though any money Germany might pay has to be raised from German citizens, under the German tax system. This is the way it has to be done, only because there is no common euro zone tax system, applicable to all euro zone citizens, from which the money might otherwise come. Indeed those who call most loudly for “solidarity” would probably be the first to object, if a common euro zone tax system, equally applicable to all euro zone citizens, was proposed.
Others criticise Germany for insisting on “austerity” in spending by countries that are spending more than they are earning, as if there was some alternative to spending less in those circumstances. The fact is that some countries, including Ireland, are still spending more than they collect in taxation, even after one has left out of account the interest paid on past debts. Such countries have what is called a “primary deficit”.
Ireland had a huge primary deficit in 2010, has a small one today, and hopefully will have a tiny primary surplus next year.
But if it is to reduce its debts, and thus not be vulnerable to disaster, if there was to be a sudden increase in international interest rates, of the kind that occurred in 1979/80, Ireland will have to have a primary surplus for many years to come.
That is the only way to reduce the debts it ran up through the primary deficits it ran in the recent past. This is not something “imposed by the Germans”, it is imposed by the rules of mathematics, and by compound interest in particular.
Of course there is one alternative-inflation- the alternative of inflating debts away. Inflation devalues everything. It reduces the value of money, and in so doing, it also reduces the value of debts…….and, of course, of savings.
If inflation is greater than the rate of interest, debts will reduce. But the value of pension funds, of bank deposits and of life assurance policies would also reduce. Inflation would mean falling living standards all around, because, if a country is to stay competitive, wages would have to increase at a slower rate than prices. Those on fixed incomes would see their living standards decline even more, because they could buy much less each year with their fixed income.
Inflation is very hard to keep under control, once it starts to take hold. Germany tried to inflate away its First World War debts in the 1920s, and the experience was a complete disaster. Understandably, it does not see inflation as a solution to Europe’s debt problems today, and nor should we.
Some argue that Germans themselves should spend more and save less, and say this would help other countries in Europe. This is already happening to some extent . German imports were 10% higher in 2011, than they were before the recession, whereas almost every other European country is importing less now that it was then. It is fair to say that Germany’s balance of payments surplus, at 6% of GDP, is very high indeed, too high, and that this surplus is not being used all that wisely. Germany could do more to free up its own internal market, and the OECD has been critical of it on that score, but that offers a long term, rather than a short term, solution for the rest of Europe.
It is also important to deal with the myth than Germany is a terribly wealthy country, that it can afford to bail everyone else out.
Germany’s present competitiveness is of recent origin. A dozen years ago it was the “sick man” of the European economy, struggling with the unexpectedly high costs of absorbing East Germany.
Germany got a big bonus from the opening up of China, which imports a lot of German engineering goods, while other European countries( eg.Italy) have lost for the same reason, because Chinese consumer goods are undercutting them in their specialist markets.
Germany is an elderly country, with far more people approaching retirement age than are preparing to enter the work force.
Probably for this reason, its medium term growth potential, and thus its medium term debt repayment potential, is low, by comparison with other countries in Europe.
The OECD did an estimate of real growth potential for different countries from 2016 to 2025. Its estimate for Germany was only 1.2% pa over the ten year period, for Netherlands 1.4%, for Italy 1.5%, for Portugal 2.1%, for Spain 2.3%, and for Ireland it was projected to be 2.7% a year!
German families are apprehensive about the future, and if those OECD figures are to be believed, it is hard to blame them.
German families do not FEEL wealthy.
Only 44% of Germans own their own home, as against 58% of French people, 69% of Italians, and 83% of Spaniards. According to a recent Bundesbank study, the average household wealth in Germany is 195,000 euros, as against 229,000 euros in France, and 285,000 in Spain.
This is the reality with which German politicians have to cope.
It does not mean that they are always right, but it does mean that they have to be cautious. It also means that Germany alone cannot solve Europe’s financial problems.