Cyprus: Take Note Mauritius and Get out of Untenable Situations

It is always a plus to have a well-diversified economy based on a wealth of local skills that can help tide over if the worse were to come to the worse

By Anil Gujadhur

Following a Turkish invasion of the country in 1974, the island of Cyprus was divided; a third of it went into the hands of Turkish Cypriots. The rest is in the hands of Greek Cypriots. Let us for the sake of convenience designate the Greek Cypriot part as Cyprus – which is how it is usually referred to — and consider the predicament into which it has fallen recently. During the past month and a half, Cyprus tumbled from prosperity into deep gloom.

Yet it had a stellar performance over a long period of time accompanied by a sustained impetus of growth. It was designated an advanced economy by the IMF no later than in 2011. Its per capita income increased from $1,451 in 1975 to $30,523 in 2011.

When the country’s division took place, the Greek Cypriot part embarked on a new economic course. It built itself up as a low tax, high return and lightly regulated financial centre. The emphasis on services led to the creation of ancillary layers of other services: auditing, law, company formation, shipping management, real estate, etc. Unlike Mauritius, however, it did not diversify into manufacturing. Its two major pillars were tourism, finance and finance-related services. This economic model was based on certain inherent strengths of the country: an educated workforce, a large number of accountants and auditors, the English legal system and a relatively un-corrupt bureaucracy.

The implantation of Cyprus as a service-oriented jurisdiction was facilitated and, in fact, spurred on, by many incidents taking place in its immediate vicinity. The main “accident of history” contributing to its economic development was the situation in Lebanon. Civil war broke out in nearby Lebanon in 1975 and went on until 1990 at least. Before the breakout of the civil war in Lebanon, Beirut had been the main intermediary for recycling petrodollars from the Middle East to the West. The instability which characterised Lebanon during this long period advanced the chances of Cyprus as a substitute financial centre in the region. Lebanese wars with Israel around that time also had the effect of making the shift in favour of Cyprus more enduring. Cyprus effectively became the main channel for routing international investment funds in replacement of Lebanon.

The difference was that, unlike Lebanon, which abided by strict measures of financial management, Cyprus had got into banking habits which did not favour high levels of provisioning against bad debts by its banks. While Lebanon’s financial model was based on keeping a stern eye on the banking system’s credit-deposit ratio to keep it under a tight leash as a measure of prudence, Cyprus took the easier route of relaxing such standards of best practice in its banking and financial sector. Obviously, not all the currently 26 banks of the country operated by flouting basic rules of sound financial management. Only two of them have collapsed in the recent crisis hitting the country but the problem is that these are the heart of the Cypriot economic system. The latter had made bad bets on Greek debt. They had also gone into financing unscrupulous real estate development, a sector of activity which has plummeted with the oncoming crisis, adding to the economic disarray.

Two examples should suffice to establish the dominant role played by poor practices accounting for Cyprus’ current meltdown.  Key Cyprus bankers and politicians were extremely indulgent in their support for the Serbian leader, Slobodan Milosevic, giving him all the financial ammunition he needed to prosecute wars in Bosnia and Kosovo during the 1990s. Cypriot support helped Milosevic evade western sanctions. Second, when the Soviet Union collapsed, billions of Russian oligarch dollars were flushed out of Russia. They went through an active round-tripping activity via and into Cyprus, adding to the latter’s critical mass as a banking destination. Russian money proved to be the bedrock of Cypriot financial and economic growth. It is this kind of quicksand concentricity which melted away when its banking system’s “catastrophic exposure to Greek debt” recently surfaced up and translated into a crisis of a heretofore unsuspected dimension.

It is in this context that the EU and IMF announced the heavy costs Cyprus’ bailout would impose on depositors at the affected banks. A good part of their deposits at the banks would simply be washed and taxed away to salvage whatever could be salvaged under the circumstances. Panicked depositors patiently waited for the banks to re-open, to see how much of their savings were still recoverable. This end in view is not in sight yet. Severe capital controls have been introduced to prevent any flight of money from the country.

Instead of a bailout, therefore, what was being actually proposed to get out of this situation was a bail-in by depositors, converting the latter virtually into shareholders of the affected banks and making them pay for the huge banking losses incurred. In any event, why should northern European bailers-out of Cyprus bother to salvage Russian depositors (and domestic depositors along with them) at the key Cypriot banks? In the circumstances, it was immaterial that Cyprus had joined the EU in 2004 and had adopted the Euro in 2008. For the EU, Cyprus was “expendable”. No one has a clear idea how all this will unwind and, more specifically, at what cost and in what length of time. The money to get out of the dramatic situation is simply not there.

The Cyprus situation should alert economies which are based on low tax and brass-plates that situations can change dramatically overnight. The best guess is that it will take some time to revitalize the moribund Cypriot economy. The longer it takes, the heavier will be the pain of adjustment. Given its limited economic diversification, the country will need to find new anchors on which it can reconstruct itself. It does not have a manufacturing base. It does not have mineral resources. Recent discovery of gas fields in the Eastern Mediterranean on which Cyprus could lay a claim hold out some hope in this respect. But exploiting it can prove costly. Turkey besides, with which it is not in good terms, also has a claim on the very same gas fields.

One can only hope that it will not be long for Cyprus to move on from its past banking generated wealth to something more concrete as a gas exporter and, who knows, as a prospective export manufacturer? It is always a plus to have a well-diversified economy based on a wealth of local skills that can help tide over if the worse were to come to the worse.


* Published in print edition on 19 April 2013

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