Cyprus is one of the eurozone countries stuck in a deep economic crisis, which was aggravated with the restructuring of the Cypriot banking sector that the troika (the European Union, European Central Bank and International Monetary Fund) demanded when a 10 billion-euro bailout agreement was negotiated in March 2013.
The main reason Cyprus needed a bailout had to do with the country's large banking sector; before the bailout, the banking sector's balance sheet was around eight times the country's gross domestic product. Problems in Cypriot banks built over years, and restructuring the banking sector was the international creditors' core demand in return for aid. Cyprus' accession to the European Union and the eurozone fueled credit growth and a boom in, for example, the island's real estate sector. The global financial crisis put an end to this growth, and strong financial ties to Greece further aggravated the situation for the Cypriot banks, particularly after Greece partially defaulted on part of its debt in 2012.
The Cypriot bailout did not come as a surprise, but the demand that depositors in Cypriot banks contribute to restructuring the banking sector caused turmoil in Cyprus and set a precedent for what future bank bailouts are likely to look like in the European Union. Austerity measures weaken the support for governments, and EU politicians want to signal that taxpayers and governments would not be the only ones that have to carry the burden to rescue banks — creditors and depositors would be included in bailout cost sharing as well. Cyprus was the first test case.
To mitigate the potential outflow of deposits from Cyprus, the government, with the troika's consent, put capital controls in place. Among other restrictions, daily cash withdrawal was limited to 300 euros per person. Transfers abroad were largely prohibited and when traveling, people were not allowed to take more than 1,000 euros cash outside the country. Since first implemented in late March 2013, restrictions have been regularly revised and gradually loosened. For example, the daily limit on transactions for normal business has been increased and people can take more cash on trips abroad.
To mitigate the negative effects on Cypriot financial sector ties abroad, foreign banks and international customers were largely unaffected by the controls, apart from having to contribute to bank restructuring with their deposits held in Cypriot banks. Foreign banks are still restricted in taking on new domestic customers, but international customers can transfer funds in and out of foreign banks operating in Cyprus freely. Sixteen foreign banks have been exempted from the controls, among them the Russian Commercial Bank (a subsidiary of the VTB Group, of which the Russian government owns 60.9 percent) as well as a number of banks with ties to Lebanon and Jordan. The continued business of these banks in Cyprus highlights the country's position as a financial gateway in the European Union and its relative stability compared to the near Middle Eastern countries.
Cyprus' banking sector has shrunk over the past year, but providing financial services for foreigners will continue to be one of the country's most important economic activities. Nicosia will likely continue to make great efforts to shield foreign institutions and depositors from the Cypriot crisis while the domestic population will benefit little from the business of foreign banks since the domestic banks and real economy will stay weak for years.
Despite capital controls, Central Bank of Cyprus statistics show that between April and November 2013 total deposits in Cypriot banks dropped from around 57 billion euros to 47 billion euros. This decrease likely can be attributed to the restructuring of deposits into equity, drawing down savings due to high unemployment, weak business and people circumventing the controls. For Cyprus, attracting and retaining foreign deposits will become increasingly important considering the country's rising unemployment. Since the bailout agreement, unemployment in Cyprus has increased at the fastest pace among EU countries and stands at more than 17 percent. High unemployment means there are less domestic savings to be deposited in banks and aggravates debt repayment problems.
Officials and banks recognize that high debt is a persistent threat to the stability of the Cypriot banking sector and is likely to lead to tension between the banks, the Cypriot government and the Cypriot population as ways to tackle the problem are debated.
During a conference in Cyprus on Jan. 27, IMF and EU officials noted that nonperforming loans in Cyprus were the equivalent of 120 percent of the country's GDP, and for certain banks, half the loans that have been issued are considered nonperforming. Corporate and household debt is reportedly higher than in any other EU country — private sector debt stands at 300 percent of GDP.
High ratios of nonperforming loans are a problem in numerous European economies, and politicians as well as central bankers are well aware of it. There is no easy fix. Because European banks are so important as providers of credit to the real economy, a low return on their loans leads to further lending restraint and weakens economies. Going after the debtors more fiercely would often mean taking over real estate that was put up as collateral and hence further repressing the real estate market. Ireland, Spain and Greece have all seen strong opposition from debtors, for example, in the form of protests when banks put more pressure on repayment or enforce evictions to take over collateral.
So far nonperforming loans have been piling up on banks' balance sheets without devastating consequences because of loose monetary policy. It is likely that a few banks will collapse or be taken over due to the burden of nonperforming loans. The trigger for such a collapse can be a shift in market perception of a certain country's financial health. For example, as a result of continued tapering by the U.S. Federal Reserve, sovereign borrowing costs in certain eurozone countries could rise again and consequently destabilize European banks that heavily buy sovereign debt, adding to the nonperforming loan problem. The European Central Bank will intervene if necessary, possibly by providing a new round of long-term cheap lending to banks as it did in late 2011 and early 2012 in order to avoid a Europe-wide banking crisis, but single banks will likely need to be restructured.
Over the past year numerous Cypriot banks already were restructured. Most important, the second-largest bank in Cyprus, Laiki Bank, merged with the country's largest institution, Bank of Cyprus, which was restructured by freezing deposits of more than 100,000 euros and turning 47.5 percent of those deposits into equity. This restructuring has helped stabilize the banking sector over the past year, but new turmoil could be coming. As part of the effort to strengthen Europe's banking sector, the European Central Bank in late 2014 will become the supervisor for the eurozone's largest banks. This means that a number of banks in Cyprus will face greater scrutiny. Especially since the European Central Bank is paying special attention to nonperforming loans, it is likely that the Cypriot banking sector and government will be forced to undertake further controversial measures, such as releasing frozen deposits more slowly than planned or pressuring banks to realize losses related to nonperforming loans.