Services prevent free fall in Cyprus, provide hope for recovery
Although banking has taken a hit after the island’s bailout, performance of other sectors gives some encouragement for tough road ahead
Leaving Larnaca Airport, on the road to the island’s capital, you meet two large billboards advertising courses at Nicosia University. One invites young Cypriots to study law, the other accounting. They are symbols of Cyprus’s past, when the economy was largely built around banks that seemed to be thriving. But perhaps they are a sign of the island’s future as well. A Eurogroup decision in March to apply a huge haircut to deposits at Cyprus’s main banks put paid to the island’s financial sector and dealt a body blow to its economy. But services still provide the country’s best route to stability and prosperity.
The Eurogroup’s decision was driven by a belief among some eurozone members that Cyprus’s economic model was unsustainable due to the size of its banks, which came to almost eight times the country’s GDP. But as a small, semi-arid island, Cyprus’s options for generating revenues and jobs are limited. The services sector accounts for more than three-quarters of the Cypriot economy, while manufacturing amounts to less than 10 percent.
The overwhelming belief on the island is that the economic model should not be rebuilt from scratch but simply improved. This means that Cypriot banks have to be smaller, as they already are, and better managed. It also means that all the elements which gave Cyprus an edge over other countries in terms of business services and tourism should still form the basis of the island’s economic future.
“Cyprus cannot become a different beast,” says Charis Papacharalambous, director general at the Cyprus Investment Promotion Agency. “Each country has its comparative advantages and ours are in the services sector, not heavy industry or anything else. We have built on this for many years but now there is an opportunity to add to it.”
Cyprus is gradually coming to terms with the shock of the Eurogroup decision in March, which led to the country agreeing a 10-billion-euro bailout with the eurozone and International Monetary Fund. Greek Cypriots, who have to work within the boundaries of capital controls (the restrictions on the movement of money enforced in March to prevent remaining deposits being withdrawn), are still bristling with anger and frustration at the way they were handled by their peers in the euro area.
“Cyprus was an experiment,” says Papacharalambous. “Those who took the decision didn’t really know how it would be implemented. This made things much worse.”
Confidence returning
A number of recent developments have led to some confidence returning to Cyprus, though. In November, the troika, which has given two positive quarterly reviews of the Cypriot adjustment program so far, revised its economic forecast for last year, predicting the economy would shrink by 7.7 percent, rather than the 8.7 percent it originally thought.
At the beginning of November, Hellenic Bank completed its 100-millioneuro recapitalization through private investment, with US fund Third Point putting up 40 million euros for a 30 percent stake in the lender, which had been short of the equity needed to meet core capital adequacy requirements.
On November 29, Standard and Poor’s raised Cyprus’s long-term sovereign debt rating to B-, the first ratings upgrade for Nicosia in three years. Savings, a good tourism season and “resilient” business services sectors had helped Cyprus avoid an even deeper recession, the ratings agency said.
Then, there is the promise of serious revenues from the sale of natural gas. One gas field, Aphrodite, has already been discovered and there are high hopes that more reserves will soon be confirmed.
These are among the factors that are helping some Cypriots see the future in a slightly more optimistic light than during the dark days of March.
“Since then, a lot of changes have happened in Cyprus and people here have seen things with the belief that the glass is half full,” says Papacharalambous. “We realize that we cannot turn back time.”
Tourism boost
Tourism, such an important driving force of the Cypriot economy, has not suffered as had been feared. Last year was the second best on record for Cyprus in terms of arrivals during the last decade, with 2.4 million people visiting the island. This was partly on the back of a simplification of the visa process for visitors from Russia and Ukraine, who were able to make their applications online.
“There were indications that we were on course for a record year in 2013 but the negative events at the Eurogroup caused serious damage and the flow of bookings dropped by up to 70 percent compared to the previous year,” says Marios Hannides, director general of the Cyprus Tourism Organization.
At the time there was extensive coverage of events in Cyprus, much of it reflecting negatively on the island and questioning whether it would be a suitable place for a vacation due to supposed fears about whether ATMs would be able to dispense cash and stores would have supplies.
Nevertheless, concern that visitors would stay away proved unfounded. By the end of October, 2.2 million tourists had been to Cyprus – just 2.5 percent lower than in 2012. Between January and September 2013 tourism revenues came to 1.7 billion euros, an impressive 8.3 percent up on the previous year. Hannides puts this down to Cypriot officials moving quickly to reassure tour operators and making efforts to counterbalance the negative coverage.
“Tourism is the only sector in Cyprus that has succeeded,” says Hannides. “Our aim is to build on this success so we can use it as a powerful weapon to help Cyprus move forward and as a basis to put the country on the global tourism map.”
However, to make more of its tourism potential Cyprus will also have to adjust its image as a largely summer destination.
“Cyprus has to be about more than sea and sun,” says Hannides. “Neighboring countries have these elements and are more competitive than us but we have quality, small distances to cover, history, culture, dignified people and hospitality that you can’t find in surrounding countries.”
From this year there will be an effort to make Cyprus a year-round destination as hotels and resorts that closed in the fall will remain open after the tourism organization spoke to owners. “Even in December temperatures exceed 20 Celsius and people can go to the beach,” he says.
Hannides believes alternative forms of tourism could also help Cyprus boost visitor numbers. Religious, sports and health tourism are just some of the forms that have the potential to attract more people to the island. “For example, Cyprus is in the top five countries in the world in terms of successful heart surgeries,” he says.
Nelly Koulia, director of trade at the Ministry of Energy, Commerce, Industry and Tourism, also believes that Cyprus can attract health tourists due to the high quality of its private-only healthcare system. She adds that dental treatment and plastic surgery are two other services that could potentially attract visitors. A rise in health tourism would then allow other businesses, such as wellness centers and health spas, to be built around it.
Papacharalambous believes that Cyprus could even become a focal point for the international film industry. “We have the top-to-bottom facilities needed to host a film industry here, not just offer tax credits for films to be made on the island,” he says. “Our geographical position, distances, costs, hotels, infrastructure are very important factors in this.”
Koulia says that tertiary education is also another area where Cyprus is looking to do more in terms of pulling in people from abroad.
Doing business
Cyprus’s geographical location means that it has long been a place to trade and somewhere for people of many nationalities to meet. More recently, it proved an attractive spot for Russians to do business. Moody’s ratings agency estimated that there was 31 billion euros of Russian money deposited in Cypriot banks ahead of March’s haircut. While much was implied earlier this year about the shady nature of some of these deposits – allegations the Cypriot authorities denied – numerous Russians still own holding companies in Cyprus despite the hit they took following the deposits haircut.
“I don’t think the Russians will leave Cyprus,” says Kyriakos Angelides, business associations’ coordinator at the
Banks decisive
into a Bank of Cyprus branch in the capital, Nicosia. Cyprus’s central bank agreed last year a 47.5 percent haircut with international creditors on deposits exceeding 100,000 euros in the Bank of Cyprus in an attempt to recapitalize it. The country’s secondlargest bank, Laiki, went through a resolution process. Cyprus Employers and Industrialists Federation.
“Russians have many reasons to stay: Our corporation tax, which is still just 12.5 percent despite an increase from 10 percent, social and religious connections and the fact that the Russians have been in Cyprus for some time – they have their lawyers and accounts here.”
Legal and accounting services flourished when Cypriot banks boomed but their foundations go much deeper than just the last decade or so. Cyprus adopted international accounting principles in the 1980s and its legal system is based on English common law. It also has a straightforward tax system that boasts one of the lowest corporate rates. Last year’s events have not changed the fact that these elements remain attractive to foreign entrepreneurs and firms, providing a convincing argument for those already based on the island to remain there.
“Foreign investment in Cyprus has traditionally been low but we will see this change now with privatizations and other projects such as natural gas and the building of a casino resort,” says Papacharalambous, whose job it is to help attract foreign capital to Cyprus.
“We have seen interest in Cyprus grow over the last few months. This is the result of two things: There are investors who believe there are opportunities here, whether those are distressed assets or something else, but there are also those who are seeking other kind of investments. They see that the situation is improving and the state is changing.”
According to the World Bank, Cyprus is 39th in terms of ease of doing business, which is one of the highest rankings in the eurozone, while Greece finds itself in 72nd place despite a recent improvement.
“Foreign firms have not departed en masse, as we feared. There has, however, been a reduction in the number of new firms setting up in Cyprus,” says Kyriakos Iordanou, general manager at the Institute of Certified Public Accountants of Cyprus.
“As an accounting institute, our interest is that they keep their holding companies here and not so much their banking activity. Our simple and low taxation, double taxation agreements with other countries, and the cost of services that we offer in comparison to competing countries, such as Luxembourg, are helping to keep foreign firms here.”
There is, however, another reason keeping foreign-owned companies in Cyprus: Many of them have inadver- tently become shareholders in the island’s main bank as a result of the March Eurogroup decision. The bailout terms meant that Laiki Bank, the country’s second-largest lender, had to be wound up and deposits over 100,000 euros in its largest lender, Bank of Cyprus, had to undergo a 47.5 percent haircut. Investors were compensated for their losses by receiving shares in the Bank of Cyprus. In September, six Russians were appointed to the bank’s 16-member board of directors.
Some steps have been taken toward shoring up local banks but the sector remains in a fragile state. Bank of Cyprus in particular is in a precarious position. It holds around half of the island’s loans and deposits but it has also been lumbered with around 10 billion euros in Emergency Liquidity Assistance (ELA) granted to Laiki by the European Central Bank. Cyprus’s banks may be picking up the pieces after the bail-in bomb was dropped on them in March but they are not yet in a robust enough position to drive an economic recovery.
“The main problems our economy faces are reduced economic activity, a lack of liquidity, high interest rates, nonperforming loans, a drop in consumption and high unemployment,” says Marios Tsiakkis, secretary general at the Cyprus Chamber of Commerce and Industry. “More than 99 percent of our companies are small and medium-sized and they are facing difficulties. Some have closed, others have fired staff or reduced employees.”
Obstacles ahead
In upgrading Cyprus’s credit rating in November, S&P warned of the precariousness of its economic situation. “Factors preventing a more severe contraction – savings that have helped to support consumption and Cyprus’s tourism and business sectors have proved resilient – are, in part, temporary,” it said.
The third quarter of last year was the eighth consecutive three-month period of contraction for the Cypriot economy and a lack of liquidity due to the fragile state of the island’s lenders.
“Banks do not have the ability to finance companies and, combined with capital controls, this makes it very difficult for firms to do business,” adds Tsiakkis. “Also, those companies that had deposits in Laiki Bank lost money and are financially weak at the moment.”
By the end of September, unemployment had reached 17.1 percent, from 12.7 percent a year earlier. This was the highest increase in the eurozone for that period and leaves Cyprus with the third-highest jobless rate among the 17 members of the single currency.
“Unemployment has grown, income has been squeezed as a result of job losses and wage reductions, commercial activity has contracted partly due to the capital controls but also a lack of credit, and a number of small companies have closed,” says Iordanou, who represents the island’s accountants.
“In terms of our domestic clients there is a problem, mainly due to the lack of liquidity,” he adds. “Those who haven’t shut down find it difficult to pay or at least to pay on time. For accounting firms that deal with foreign clients, the situation is better.”
Other sectors are suffering too. After a real estate boom over the last few years, the construction sector has now suffered a big decline. The number of building permits issued in September was 30 percent down on a year earlier.
“The services sector has shrunk but things are not as bad as some people had feared,” says Angelides of the Cyprus Employers and Industrialists Federation. “Construction and real estate, on the other hand, have suffered irreversible damage.”
Full circle
The hope on Cyprus, though, is that its beleaguered banks are on the way back. Cypriot authorities announced in July that the Bank of Cyprus had been fully recapitalized by converting 47.5 percent of uninsured deposits into shares in the bank. This was followed by news of Hellenic Bank’s recapitalization in November. Beyond Cyprus’s two main lenders, the island’s credit cooperative banks, which represent the bulk of the remainder of the banking system, are due to receive a 1.5-billioneuro capital injection and be restructured as part of Nicosia’s bailout program.
The credit rating of Cypriot banks remains poor but in a statement in October, Fitch Ratings said the completion of the recapitalization and restructuring process for the main banks should improve confidence and contribute to funding stability in the system.
“We think it’s a positive development that Bank of Cyprus has been recapitalized via deposits and that Hellenic Bank has been able to attract foreign investors,” says Tsiakkis. “This is a sign that trust in our banking system is returning.”
Nevertheless, the ongoing effort to stabilize Cypriot banks after the almighty jolt they suffered last year, the continuing lack of liquidity, a second year of recession and the public spending cutbacks the government has to implement as part of the EU-IMF bailout agreement, mean that 2014 will bring further serious challenges for the island’s economy.
“This year will be more difficult, there is no doubt about that,” says Papacharalambous. “Although the contraction this year will be smaller, it will be another year of recession.”
In fact, whereas the troika revised down its recession forecast for 2013, it now believes the Cypriot economy will shrink by more than previously expected in 2014. Cyprus’s lenders estimate the contraction will reach 4.8 percent in 2014, as opposed to the 3.9 percent they originally predicted. Fitch sees shrinkage of 4.9 percent for this year.
“We still haven’t overcome the shock effect,” says Iordanou. “The immediate impact will be felt [this] year. That’s when the real economy will suffer most.”
He makes the point that Cypriots had been dipping into their savings – or what was left of them – to cover expenses last year, citing the example of the payment of property tax, which went up from 20 million euros to about 100 million euros. “[In 2014] what will be different is that the money people had as cash reserves will not exist anymore,” says Iordanou.
This is also likely to have an impact on Cyprus’s banks, with Cypriots finding it more difficult to pay back their loans, which outpace deposits by more than 15 billion euros. In an environment where there will be substantial deleveraging, the sturdiness of the island’s lenders is likely to be severely tested – even more so when capital controls are lifted. “Financial stability does remain a key risk,” said S&P. “Once capital controls are lifted, the stability of private sector deposits will be uncertain.”
For Cyprus, it seems, the key to meeting the huge economic challenges it faces lies where it all began: with the banks. In the meantime, its services sector, driven by the pistons of accounting, legal services and tourism, has the potential to drive the country forward through this difficult period.