Cyprus: from safe haven to verge of insolvency

The Republic of Cyprus (the Greek Cypriot ruled majority of the island) seemed in 2009–at the time when the Greek sovereign debt burst into the international financial scene and set off the wider euro zone crisis–to be a relatively safe haven. Its then successful banking sector continued to thrive helped by deposits from a wide range of foreign investors from Greece itself to Russia. The move over four years from safe haven to country on the edge has been a gradual deterioration rather than the sudden plunge that happened in the case of Greece. However, today, Cyprus is arguably the most problematic country in the euro zone after Greece through the interplay of sovereign debt crisis and banking crisis—the latter resulting partly from contagion from Greece. Recapitalisation by the Cypriot state of Cypriot banks, to make them viable following losses in Greek and other investments, now looks likely to cost €10bn or 55% of Cyprus’s GDP, which combined with ongoing government deficits would push sovereign debt to about 140% of GDP by 2016. This would be substantially higher than in any other euro zone country other than Greece and, according to consensus opinion, by around 20% of GDP higher than the solvency threshold. On the positive side, some of the gap could be closed by privatization which could bring in €2bn and the situation of the country should be also helped by the development of gas reserves, although their extent remains uncertain and they are not a panacea.

Nicos Anastiades, who is likely to be elected as president of Cyprus in the second round on February 27th, faces tough negotiations to secure a bail-out by euro zone partners which would put the state on the path back to solvency and restore confidence in the economy. For this to happen, the conditions applied –, though stringent in terms of policy – will have to be favourable as regards interest rates and repayment schedules. For the euro zone’s European Stability Mechanism (ESM) of €500bn, the amount required to rescue Cyprus is relatively small, but that does not make it easy from a political standpoint. A haircut on sovereign debt as already applied to Greece (itself exacerbating the problems of Cypriot banks) would damage the credibility of the insistence by euro zone policy makers that that the Greek haircut was a one-off and so could have adverse repercussions across the euro zone.

A bail-out, especially one on favourable terms, itself faces resistance from creditor countries like Germany and the Netherlands, because such a rescue would in part go to rescue banks from the consequences of expanding deposits from often dubious sources. For this reason a bail-in of large deposit-holders has been mooted. This would be a powerful discouragement to the use of small countries as tax havens but it would be disastrous for the Cypriot economy given the importance of its banking sector. But any bail-out should insist on increased transparency for bank deposits. This should apply even if tax evaded is in a non-EU country like Russia.

To get back to managing its sovereign debt and stabilising its banking sector, Cyprus is likely to require ongoing support. At the very least this should be on condition that Cyprus commits to not blocking closer relations between the EU and Turkey bearing in mind that it was the Greek Cypriot side not the Turkish Cypriot side which in 2004 blocked the most recent UN-led effort to solve the division of the island. Ideally, although that would require careful and skilled diplomacy, rather than threats, the Greek Cypriots should be persuaded into new negotiations on ending the stalemate in which part of the island has for almost 40 years, been under the authority of an entity, the Turkish Republic of Northern Cyprus, which is only recognised by Turkey.

 

Budget negotiations are key to future image of EU

On February 5th Herman Van Rompuy put out a video message (http://tvnewsroom.consilium.europa.eu/event/video-messages-of-herman-van-rompuy/eu-budget-negotiations-the-bigger-picture-must-not-get-lost) which made an admirably concise plea for a budget to focus on jobs and particularly jobs for young people and also insisted on moderation, which he surprisingly defined as a real terms cut. This would imply that the demands of the UK, Sweden and the Netherlands in terms of expenditure discipline would be met or even exceeded.

Budget is small in relative terms,but high in absolute terms

As a percentage of national budgets (about 2%) the EU budget is much smaller than implied by the claims of over-centralisation of power. It has remained at around 1% of gross national income (considered a fairer measure than gross domestic product) over the last 20 years well below its allowed maximum of 1.24% of GNI. To have done this during a period when the EU has expanded to include 12 new countries almost all well below the 75% of average income threshold which entitles them to substantial funding to help catch up, and when a monetary union has been created for 17 member states, an embryonic diplomatic service has been set up and effective measures for criminal justice have been put in place is a significant achievement.

The gains in terms of both political stability and prosperity from the single market are not possible to measure but surely hugely outweigh the costs of the EU. Nevertheless when expressed in absolute terms, the amounts are large enough to become politically contentious, at a time when all countries are having to make cuts which are causing large scale public redundancies, closures of hospitals, and other public services like libraries. The UK, France and Italy are currently spending about €16bn (£13bn) in gross terms and €6bn (£5bn) in net terms in contributions to the EU budget.

Some but not all is all is well spent

Some of this money is very well spent. There is huge over-demand for the 11% of the total EU budget spent on boosting collaboration between EU countries (and sometimes also other countries) on scientific research and the development of new technologies. This is money well spent on boosting the EU’s economic potential and ability to thrive in the face of competition from rapidly growing economies like China and India. A strong plea for this spending to be maintained was made on February 5th in a letter to the Financial Times by leading British scientists. Another area of money well spend is co-operation on justice mainly criminal justice, which takes up just 2% of the budget. According to the British Association of Chief Police Officers (ACPO) if, as is being considered, the UK were to opt out of the European Arrest Warrant (EAW) just one of about 20 important EU measures in the field of criminal justice, the result would be “fewer extraditions, longer delays, higher costs, more offenders evading justice and increased risks to public safety”.

Slightly lower in terms of money well spent is the category of administration which absorbs 6%. At 0.06% of national income this is good value for underpinning the benefits of a rules-based single market with a level playing field evened by the enforcement of rules on competition. Yet at a time of austerity the pay and privileges of the upper tiers of the Commission which exceed those of leaders of national governments look excessive.

The largest items of spending are agriculture and regional policy. Agricultural spending, narrowly defined to standard income support for farmers amounts to 27% of spending. If the EU were starting from scratch this might see excessive, but there has been a continuing decline from about 70% when the UK joined the EU in 1973 and most of the spending no longer supports (ie increases) prices as it used to. There is however an additional item called rural development environment and fisheries which absorbs 10% of the total. This is almost as much as is spent on research and innovation and yet its purpose. It includes the very different objectives of environmental conservation or improvement and diversification to non-farming economic activities. It is a category which at least merits careful scrutiny.

Focus of regional spending should be on job creation

But the category which needs most attention is the 37% spent on helping the poorer or most economically troubled regions. This spending has in the past been heavily focused on infrastructure, which does not necessarily bring fundamental economic development. What is most needed is to foster the development and expansion of new micro, small and medium businesses which having already  been responsible for the great majority of job creation across the EU in recent years have the best potential to provide employment opportunities in southern European regions where rates of youth unemployment often exceed 50%.