CYPRUS looks increasingly set to become the fourth euro-zone country to seek financial aid under the European Union’s temporary bailout fund, as early as this month, as it scrambles to protect its banking system from Greece’s widening financial crisis that is threatening to engulf its tiny island neighbour.
The fallout from the Athens crisis already has forced Cyprus’s second biggest bank to seek government support for a planned multibillion euro recapitalization, something that will push the island’s public finances deep into the red and cause it to miss this year’s budget targets.
Cyprus – faced with soaring bond yields hovering around 14% on the 10-year bond, and with its debt considered junk status by two of the world’s leading ratings firms – has few places to turn to cover its financing needs.
Officially, the economy is expected to grow 0.8% this year, according to government projections, but the International Monetary Funds says a 1.2% contraction is more likely.
Late last year, the country negotiated a €2.5 billion bilateral loan from Russia. Now, Cyprus is in talks with China for another bilateral loan, of an undisclosed amount, that looks unlikely to materialize in time.
In the past few days, Cypriot officials have been preparing public opinion by hinting that a bailout from the European Financial Stability Facility may be imminent, but without saying so directly. Finance Minister Vasos Shiarly told state-owned radio last week that “avoiding the EFSF is our No. 1 priority.”
Cyprus also is scrambling to announce a new package of austerity measures within the next 10 days, amid signs of disagreements within the government over the scope of planned cutbacks. Parliament will soon vote to adopt Europe’s new fiscal pact.
Those austerity steps will likely weigh on the island’s already fragile economy, but are seen as necessary to restore confidence and head off any deeper cuts that Cyprus’s euro-zone partners may demand in exchange for a bailout.
“Cyprus is starting to feel the effects of the Greek crisis and may have no other recourse but to ask for European aid,” says Alex Apostolides, an economics professor at Nicosia’s European University. “There has been a narrowing of all other options that were available, to the point where going to the EFSF looks increasingly likely, almost inevitable.”
Cyprus’s parliament recently approved a plan to bail out No. 2 lender Cyprus Popular Bank, after it wrote down some €2 billion from Greece’s recent debt restructuring.
The rights issue, which will be underwritten by the government, is due to kick off June 15 and last about two weeks. With private investors unlikely to cover the full sum, the plan creates potential liabilities of €1.8 billion for the state, which in Cyprus’s tiny economy, could translate into a budget deficit of more than 10% of gross domestic product – four times this year’s target.
The sums involved aren’t likely to strain Europe’s rescue fund. Even after bailing out Greece, Portugal and Ireland, the EFSF still boasts a war chest of about €250 billion. But a financial rescue for Cyprus would come as another reminder that Europe’s leaders have failed to stop Greece’s crisis from spreading.
Any Greek exit from the euro could have unpredictable consequences on Cyprus—possibly collapsing its banking system and dragging it out of the common currency as well.
The island’s geopolitical significance in the eastern Mediterranean has been growing with the discovery of large gas reserves. Those gas reserves could provide Cyprus with badly needed revenue, but would take time to fully exploit – about five years, according to some government estimates. In the meantime, investor interest could sour.
Cyprus is closely linked to Greece through the exposure of its banks. The three largest Cypriot lenders, Bank of Cyprus, Cyprus Popular Bank and Hellenic Bank, are heavily dependent on the Greek market, in which their retail operations boosted profits the past few years.
As Greece’s economy has tanked, Cyprus lenders, like their Greek counterparts, have seen nonperforming loans soar. Those are now hovering in the neighbourhood of 20%.
Deposits are another worry: Cypriot banks have generally benefited from Greece’s two-year-long outflow of capital, but prospects of a sudden Greek exit from the euro may test depositors’ confidence.
Some already are leaving. In the past two weeks, Cyprus’s lenders have been offering teaser rates to keep depositors locked in, with some banks boosting deposit rates to as much as 6.5% for certain time deposits.
Cyprus’s banks are relatively well positioned to weather the storm, said George Vasiliou, a former president of Cyprus, now an economist and businessman. But a Greek euro exit could change that: “The main concern from a Greek exit would be the loss of confidence among foreign depositors and investors, which might become a self-fulfilling prophecy,” he said.
Meanwhile, higher interest rates and shrinking bank lending volumes is starving the economy of funds just as Cyprus is struggling to shake off the effects of a continuing downturn. A deadly munitions blast at a naval station in July knocked out half the island’s power production and helped send the economy into recession.
Concern among the island’s 800,000 inhabitants is growing. Since April, consumer confidence has plunged, slipping 13% compared with the previous month, while business sentiment in the island’s all-important services sector is down 22%. Joblessness is close to 9% – edging record highs.
Cyprus is facing a “race against the clock,” said Mr. Vassiliou. “The constitutional amendment implementing Cyprus’s obligations under the fiscal compact—that will close the door to new deficits—will be crucial, as will a new fiscal package in the order of €200 million. What matters is for Cyprus to regain its trustworthiness among foreign observers.”
This article was first published in The Wall Street Journal.