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IIF RESEARCH NOTE

Cyprus: Just The Facts

March 19, 2013

IIF.com Copyright 2013. The Institute o International Finance, Inc. All rights reserved. CONFIDENTIA

A credit-driven boom concealed large macroeconomic imbalances pre-2008

Cyprus was hit twiceby the global crisis and the Greek PSI

Economy in deep recession, market access lost

Government debt structure leaves little scope for PSI

Deposits were stable until recently, withdrawals have picked up this year

Domestic banks remain heavily vulnerable to deposit runs

Large NPLs to boost banks capital needs

Lubomir MitovCHIEF ECONOMIST

European Department

1-202-857-3653

[email protected]

The purpose o this note is to shed light on the circumstances that have led to the current

crisis in Cyprus and the vulnerabilities related to public fnances and domestic banks. The

note does not address the implications o the recent Eurogroup decisions and the

associated political tensions in Cyprus. Instead, it provides background inormation or

urther analysis. The note is organized as ollows: Section 1 (p. 2-3) looks into the buildup o

macroeconomic imbalances during the boom years; section 2 (p. 4-5) discusses the impact

o the crisis; sections 3 and 4 (p.6-9) summarizes the state o public fnances, and section 5

(p.9-13) examines the state o the banking system.

Strong output expansion in the years ollowing EU accession helped boost income and livingstandards in Cyprus, but also masked growing macroeconomic imbalances that were

uncovered by the 2008 fnancial crisis. Instead o addressing the underlying problems, the

previous government attempted to mitigate the recession with a large fscal stimulus. This

helped initially to contain the drop in output albeit at the expense o sharply wider fscal

defcits.

Jared Bebee

ASSOCIATE ECONOMIST

European Department

1-202-857-3639

[email protected]

The 2008 fnancial crisis

uncovered large

macroeconomic imbalances

Domestic banks were hit

hard by the Greek PSI

40

50

60

70

80

90

2000 2002 2004 2006 2008 2010 2012

Chart 1

General Government Debt

% GDP

0

500

1000

1500

2000

Jan 11 Jul 11 Jan 12 Jul 12 Jan 13

Chart 2

CDS Spreads

basis points

Ireland

PortugalCyprus

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Cyprus: Just the Facts


However, a second shock ollowing a power plant accident in 2011 and the restructuring o

Greek government debt (to which domestic banks were heavily exposed) has plunged the

economy back into recession. Access to markets has been lost, the fscal defcit and

government debt has risen and domestic banks have become all but insolvent (Charts 1

and 2, previous page). Attempts to secure oreign unding and recapitalize the banks were

only partially successul, prompting the authorities to ask or EU and IMF assistance.

However, reluctance by the previous government to accept key demands by the Troika has

delayed approval o the program until now. In the meantime, the fscal defcit remains large,

government debt has approached 90% o GDP and domestic banks remain operational only

thanks to a large inusion o liquidity through the Emergency Liquidity Assistance acility (ELA)

o the ECB.

Cyprus circumstances leave little room or maneuver. With most government debt held by

domestic banks, a Greek-style PSI looks impractical. On the other hand, the heavydependence o domestic banks on nonresident deposits and the large size o the system

relative to GDP leaves banks extremely vulnerable to deposit runs. Stemming bank runs is

especially important given the large amount o insured deposits (180% o GDP).

A CREDIT-DRIVEN BOOM MASKED GROWING IMBALANCES

During most o the preceding decade, Cyprus experienced an extended period o robust

growth, low unemployment and strong public fnances. Real GDP rose 3.6% a year on

average during 2000-2008, led by strong expansion in services (mainly business services

and shipping), construction and real estate. Growth was particularly impressive ater EU

entry in 2004 and ahead o euro adoption in 2007 (Chart 3), when stepped-up capital inows

and alling risk premia acilitated a surge in bank lending that ueled a real estate boom. The

unemployment rate ell rom 4.8% in 2000 to as low as 3.7% in 2008 despite the inux o a

large number o oreign workers.

Cyprus experienced an

extended period o robust

growth through most o

last decade

-6

-4

-2

0

2

4

6

8

10

12

2000 2001 2002 2003 2004 2005 2006 2007

Net Exports Fixed Invest.

Public Cons Private Cons

Chart 3

Real GDP Growth, 2000-07

12-month change in % GDP

GDP

30

35

40

45

50

2000 2002 2004 2006 2008

Chart 4

General Government Revenue and Expenditure

% GDP

Expenditure

Revenue

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The rapid growth in business services reected a avorable business environment and the

availability o an educated, English-speaking labor orce.

Foreign capital was attracted by one o the lowest income tax rates in the EU (10%, zero

or dividends) and the existence o double taxation treaties with many countries.

Construction grew 6.7% a year on average during 2000-2008, and the number o newly

built houses tripled between 2000 and 2008. Housing prices rose 50% during 2006-2008.

Growth since EU entry was driven by domestic demand, with private consumption rising

6.5% a year rom 2005 on average through 2008 and fxed investment rising 9% a year.

Most o the increase in investment was centered in construction, however.

Driven by the boom in domestic demand, general government revenues rose by 6.8% o

GDP between 2000 and 2008. Strongly rising revenues helped shit the fscal balance rom a6.6% o GDP defcit prior to EU accession in 2003 to surpluses in 2007 and 2008, despite

substantial real increases in spending (Chart 4, previous page). Government debt declined to

49% o GDP by the end o 2008 rom 70% in 2003 as a result.

However, the rapid expansion in growth and fscal surpluses concealed the accumulation o

substantial macroeconomic imbalances. Key among these were the ollowing:

A sharp widening in the current account defcit. With the savings rate alling rom 15%in 2004 to just 7% in 2008 and the investment rate rising rom 19% to 23%, the current

account defcit jumped rom 5.1% o GDP to 16.8% o GDP (Chart 5). (Excluding

reinvested earnings and dividends, which reect accounting entries rather than actual

transactions, the defcit widened to 12% o GDP in 2008 rom 1.4% o GDP in 2004.)

A marked worsening o competitiveness. Relative unit labor costs rose 20% between2000 and 2008, more than in other periphery countries.

A sharp deterioration in the net international investment position (IIP). Persistentcurrent account defcits and large inows o oreign capital shited the net IIP rom a

The rapid expansion

concealed large

macroeconomic imbalances

-16

-14

-12

-10

-8

-6

-4

-2

0

2

2003 2005 2007 2009 2011

Chart 5

Current Account Balance

% GDP

CAB

CAB (excl. reinvestedearnings and dividends

-2

0

2

4

6

8

10

12

14

UnemploymentRate

Chart 6

GDP and Unemployment Rate

12-month % change and %

GDP

2007 2008 2009 2010 2011 2012

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positive 14% o GDP in 2004 to a negative 15% o GDP in 2008.

A large increase in private sector debt, rom 160% o GDP at the end o 2004 to

235% at the end o 2008, the second largest ratio in the EU. (The risks associated with the

high leverage ratio are mitigated by the large fnancial assets held by households,

however.)

Signifcant increase in banks exposure to real estate and to Greece.Theshare o housing loans in total loans to households rose rom 30% in 2005 to 45% in

2008. By June 2011, the exposure o domestic banks to Greece amounted to 28 billion,

or one-third o total assets and 170% o GDP. O the 28 billion, government bonds

amounted to 4.7 billion; the rest were loans to Greek residents.

THE IMPACT OF THE FINANCIAL CRISIS

Cyprus economy has suered two rounds o external shocks since 2008: frst, the allout

rom the global fnancial crisis in 2008-2009 and second, the consequences o the

destruction o the Vassilikos power plant and the restructuring o Greek government bonds

in the second hal o 2011 and in 2012.

The global fnancial crisis aected the economy through a number o channels:

Faltering oreign demand led to a sharp decline in services exports and tourism earnings.

Construction came to a virtual halt as demand or housing ell, both oreign and domestic.

Inows o oreign capital slowed (and even reversed or a while late in 2008-early 2009).

Growing fnancial ragmentation made it increasingly difcult or Cypriot banks to secure

unding rom abroad.

The impact o the 2009 crisis was relatively mild, with real GDP alling just 1.9% in 2009, the

smallest decline in the Euro Area. Output contraction was contained thanks to a large fscal

stimulus equivalent to 4% o GDP. The latter, however, came at a steep cost. Stepped-up

spending and a cyclical drop in revenues shited the general government to a defcit o 6.1%

o GDP in 2009 rom a 0.9% surplus in 2008. Real GDP growth resumed or a while in 2010

and early 2012 thanks to frmer oreign demand and recovery in tourism, but growth

remained much slower than beore 2008.

Despite the modest recovery, unemployment continued to grow, more than doubling rom

2008 to 7.8% in 2011. This mainly reected large job losses in construction, whose output

ell by one-third between 2008 and 2011 (Chart 6, previous page).

The fscal situation did not improve. A slight reduction in the defcit in 2010, due mainly to

one-o actors, was ollowed by renewed widening to 6.3% o GDP in 2011.

Cyprus economy has

suered two rounds o

external shocks since 2008

The impact o the 2008

crisis was mitigated by

sharp fscal expansion

The fscal situation did not

improve

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On the positive side, a larger drop in import than in export volumes and reduced income

payments (mainly reecting lower reinvested earnings) helped cut the current account

defcit rom the 17% peak in 2008. At more than 7% o GDP in 2011, the current account

shortall remained outsized and well above the 2004-2005 level.

Financing pressures intensifed, especially or the government, which has largely lost

market access since 2010. To ease the fnancing difculties, the government negotiated in

late 2011 a 2.5 billion our-year loan rom Russia at an interest rate o 4.5%.

The mild recovery was interrupted in the summer o 2011 when another round o external

shocks hit the economy:

The explosion o a weapons cache in July 2011 destroyed Vassilikos, the country's largest

and newest power plant, knocking out hal o the island's power supply and resulting in

rolling blackouts. Reconstruction would cost up to 3% o GDP, with the plant unlikely to

be ully operational beore the end o this year.

An even larger shock ollowed as a result o the restructuring o Greek government bonds.

Cyprus two largest banksBank o Cyprus (BoC) and Popular Bank (Laiki), together

held 4.7 billion o Greek government bonds at the end o 2011. The 75% PSI haircut

resulted in losses equal to roughly 3.5 billion, or 33% o both banks aggregate capital

and 20% o GDP.

Even beore the Greek PSI, the EBA estimated that both banks would need an additional

3.6 billion in capital to meet the 9% Core Tier 1 capital ratio and create adequate buers or

mark-to-market losses on their holdings o government debt. (The latter already incorporated

losses on the Greek bond portolio equivalent to 11%.) PSI-related losses and the urther

drop in prices o Cypriot government debt probably doubled the capital shortall rom the

initial EBA estimate. Both BoC and Laiki have been unable to raise the needed capital,

prompting the government to recapitalize them with 1.8 billion in one-year government

bonds. This added 10% o GDP to government debt.

Both the Vassilikos accident and the drop in confdence ollowing the Greek PSI have had

a much stronger negative eect on the economy than the fnancial turmoil in 2008-2009.

Real GDP declined in seasonally-adjusted terms in the third quarter o 2011 and has

remained on a declining trend ever since, with a cumulative decline o 4% rom the middleo 2011 through the end o 2012.

Output contraction has been exacerbated by renewed fscal adjustment in 2012 and

growing fnancing constraints.

The deteriorated growth outlook and worries about the solvency o Cyprus large banking

system triggered a slew o rating downgrades, pulling Cyprus' sovereign rating well into

junk category. This has made access to markets even more difcult or both the sovereign

and the banks and eventually made local banks ineligible or direct ECB refnancing.

The Greek PSI deal dealt a

severe blow to domestic

banks

The Greek PSI deal and the

Vassilikos incident have had

a strong negative eect on

the economy

The current account defcit

adjusted as fnancing

pressures intensifed

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Cyprus entered 2013 with an economy mired in deep recession, sizable macroeconomic

imbalances and largely insolvent banks without access to market unding.

UNSUSTAINABLE PUBLIC FINANCES

Government fnances have deteriorated sharply since the 2008 crisis. Cyclical actors have

combined with signifcant shits in the structure o growth to cut government revenues 5% in

nominal terms between 2008 and 2012, a decline equal to 5.2% o GDP.

Most o the reduction in tax receipts reected the shrinkage o the tax base. Private

consumption ell 9% rom 2008 through 2012, three times as much as GDP, and fxed

investment dropped 27%.

The drop in revenues was accompanied by a marked increase in noninterest spending. The

latter rose 6% in real terms between 2008 and 2012, or by 3.6% o GDP.

Most o the increase reected the 4% o GDP fscal stimulus extended in 2009.

Ater remaining little changed relative to GDP in 2010 and 2011, noninterest outlays were

cut 5% in real terms last year, or by 0.8% o GDP. Most o the decline reected cuts in

discretionary spending, while mandated expenditures such as social outlays and wage

payments rose urther relative to GDP.

Compared with 2008, the ormer were 1.8% o GDP larger in 2011 than in 2008, and the

latter 3.2% higher. This points to a structural spending problem, which would require

corresponding structural reorms rather than ad-hoc cuts (Chart 7).

Spending restraint last year helped cut the fscal defcit to 5.5% o GDP rom 6.3% in 2011.

Adjusted or the cycle and net interest outlays, the 2012 outcome reected underlying

tightening o perhaps 0.7% o GDP, largely osetting a similar easing in 2011. Relative to

Government fnances have

deteriorated sharply since

2008

The persistent increase in

mandated spending points

to a structural problem

Spending restraint helped

cut the defcit to 5.5% o

GDP last year

30

35

40

45

50

2007 2008 2009 2010 2011 2012

Chart 7

General Government Revenue and Expenditure

% GDP

Revenue

Expenditure

0

20

40

60

80

100Bank Recapitalization

NonresidentsDomestic Nonbanks

Domestic Banks

Chart 8

General Government Debt by Creditor

% GDP

2008 2009 2010 2011 2012

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2009, the underlying fscal stance has tightened by less than 1% o GDP, much less than

required under the Stability and Growth Pact and the fscal compact.

Aware o the predominantly structural nature o the defcit, late last year the Cypriot

parliament passed a number o measures aimed at correcting the structural fscal problems.

These measures, totaling 7.3% o GDP over three years, have been identifed by the

Troika and incorporated in the Memorandum o Understanding. Parliament had passed

two-third o these, equivalent to about 4.5% o GDP by the end o last year.

I implemented, these measures should be sufcient to cut the defcit to less than 5% o

GDP next year and close to 4% in 2014.

A reduction towards 3% o GDP does not look likely beore 2015, and then only i growth

rebounds strongly, which looks unlikely at present.

GOVERNMENT DEBT: LITTLE SCOPE FOR PSI

The combination o low growth and high fscal defcit has led to an explosion o government

debt. Preliminary estimates suggest that the latter jumped to 87% o GDP at the end o last

year rom 71% at the end o 2011 and 49% at the end o 2008. Two-thirds o last years

increase, or 10.5% o GDP, reected the issue o 1.9 billion in one-year bonds to

recapitalize the two largest domestic banks. A closer look at developments in recent years

points to substantial structural shits:

O the 15 billion in general government debt at the end o September 2012 (the latest

period or which detailed data are available), some 6.6 billion, or 45%, were held by

nonresidents according to the external debt statistics (Chart 8, previous page).

Some 40% o the government debt held by nonresidents represented medium- and long-

term bonds, with the remaining 3.9 billion loans mostly rom ofcial creditors. These

include the 2.5 billion loans rom Russia and 1.1 billion or so in loans rom the EIB and

the Council o Europe Development Bank.

Nonresident holdings o government bonds have been gradually declining since 2010 and by

September 2012 amounted to 2.8 billion.

No data are available on the specifc composition o oreign holdings o government

securities, but it appears that these are almost exclusively Euro Medium Term Notes

(EMTN) issued under British Law.

This suggests that a voluntary restructuring o the EMTNs will be very difcult and would

require a high threshold or triggering the collective action clauses (CACs).

Residents hold some 8.4 billion in government debt, or roughly 45% o GDP. A sixth o

these, or 1.4 billion, represent medium- and long-term loans rom the central bank. Other

The drat MoU calls or

large fscal adjustment,

most o which has been

legislated already

Low growth and high

defcits have led to an

explosion o government

debt

Nonresidents hold 45% o

government debt, mostly

ofcial bilateral loans

Nonresidents holding o

government bonds mostly

represent EMTNs

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Table 1

billion

2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3

General Government Debt 11.1 11.9 11.9 12.8 13.4 14.8 15.0

Currency and Deposits 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Central government 7.2 7.3 7.3 7.4 7.5 7.5 7.6

Owed to SSFs -7.2 -7.3 -7.3 -7.4 -7.5 -7.5 -7.6

Securities 7.9 8.5 8.6 8.9 7.5 8.8 9.0

Long-term 6.6 6.7 7.4 7.4 6.4 6.3 6.3

Resident 2.8 2.8 3.4 3.2 3.0 3.5 3.6

Central Bank 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Deposit Money Banks 1.7 1.8 2.4 2.4 2.0 2.0 2.0

Nonbanks 0.5 0.5 0.6 0.6 0.5 0.5 0.5

SSFs 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Central Government 0.3 0.4 0.4 0.4 0.4 0.4 0.4

Held By SSFs -0.3 -0.4 -0.4 -0.4 -0.4 -0.4 -0.4

Other 0.6 0.5 0.4 0.2 0.5 1.0 1.1

Nonresident 3.8 3.9 4.0 4.3 3.4 2.9 2.8

Short-term 1.3 1.8 1.1 1.4 1.1 2.5 2.6

Resident 1.2 1.4 0.7 1.1 0.6 2.5 2.6

Central Bank 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Deposit Money Banks 1.2 1.4 0.7 1.1 0.6 2.5 2.6

o/w Cyprus Popular Recap. 0.0 0.0 0.0 0.0 0.0 1.9 1.9

Nonbanks 0.0 0.0 0.0 0.0 0.0 0.0 0.0

SSF and Administered Funds 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Central Government 0.2 0.2 0.2 0.1 0.1 0.2 0.1

Held By Admin Funds and SSFs -0.2 -0.2 -0.2 -0.1 -0.1 -0.2 -0.1

Nonresident 0.1 0.4 0.4 0.3 0.5 0.0 0.0

Loans 3.2 3.4 3.3 3.9 5.9 6.0 6.1

Long-term 3.2 3.4 3.3 3.9 5.9 6.0 6.1

Resident 2.3 2.3 2.3 2.3 2.2 2.2 2.2

Central Bank 1.5 1.5 1.5 1.5 1.5 1.5 1.4

Other 0.8 0.8 0.8 0.8 0.7 0.7 0.8

Nonresidents 0.9 1.0 1.1 1.7 3.7 3.8 3.9

Ofcial 0.0 0.0 1.0 1.6 3.6 3.7 3.8

Russia 0.0 0.6 2.5 2.5 2.5

EIB 0.7 0.7 0.7 0.7 0.8

France 0.0 0.0 0.0 0.0 0.0

EDB 0.3 0.3 0.3 0.3 0.3

EFSF 0.0 0.0 0.0 0.0 0.1 0.2 0.2

Other 0.9 1.0 0.1 0.0 0.1 0.1 0.0

Short-term 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Resident 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Nonresidents 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Cyprus General Government Debt

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domestic creditors hold 7 billion, one-third o which are short-term.

Most o the short-term debt, however, represents the 1.9 billion in bank recapitalization

bonds, which were issued with maturity o one year.

Much o the remaining short-term debt, or 0.7 billion, reects regular Treasury bill

holdings by domestic banks, which have allen by one-third since the start o 2011.

Domestic holdings o medium- and long-term government debt other than by the central

bank amounted to roughly 4.4 billion, the bulk o which is in the orm o securities.

Loans held by entities other than the central bank amounted to 0.8 billion, apparently

under special legislation, and have remained stable since 2010.

Holdings o medium- and long-term government securities amounted to perhaps 3.6 billion,

the bulk o which are held by domestic banks. The latter held 3.1 billion, 2 billion o which

are domestically issued bonds, and 1.1 billion in EMTNs.

Nonbank private creditors held another 0.5 billion at the end o September.

Domestic holdings o medium- and long-term government bonds have in act increased

slightly since the start o 2011.

It should be noted that state-owned social security unds hold another 8 billion in

government debt. These include 0.4 billion in bonds and a deposit o 7.6 billion with the

central government at the ECBs refnancing rate.

While these obligations are netted out o the calculation o general government debt, they

still remain an important source o unding or the central government, whose

nonconsolidated debt stood at 120% o GDP at the end o September.

This composition o government debt suggests that a Greek-Style debt reduction exercise

would be very difcult and unlikely to produce tangible results. Debt potentially eligible or

restructuring amounts to only 7.2 billion, 2.1 billion o which are EMTNs held by oreigners.

Most o the remainder is held by domestic banks, a haircut on which will directly increase

the already high bank recapitalization costs.

Haircuts on state-owned social security unds holdings would be counterproductive, too,

as they would require the government to compensate them with new bonds, thus with no

impact on government debt.

BANKING SYSTEM HEAVILY RELIANT ON NONRESIDENT DEPOSITS

Cyprus outsized banking system has become the ocal point o the current crisis. By the

end o 2012, its total assets amounted to 700% o GDP. This was a marked reduction rom

near 750% as recently as September 2012 and more than 800% by the middle o 2011.

Domestic banks hold most

o domestically-issued

government bonds

Social security unds hold

another 8 billion in

government debt

A debt reduction exercise

similar to that in Greece is

unlikely to produce tangible

results

Cyprus outsized banking

system has become a ocal

point o the crisis

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Banks in Cyprus can be classifed in our groups:

Domestically supervised banks account or 58% o the system's assets (at the end o

September), or more than our times GDP.

The second largest group, 23% o the market in terms o assets, represents subsidiaries

o oreign banks, mainly rom Greece and a large state-owned Russian bank.

This group, along with oreign branches (5% o assets) are attracted to Cyprus mostly or

tax reasons, have limited interaction with the local economy and are predominantly unded

by their parents.

Cooperative banks (13% o assets) are ully exposed to the domestic economy, but they

are regulated separately rom domestic banks by a special supervisory authority.

The domestically supervised banks are dominated by three institutions (Bank o Cyprus

(BoC), Popular Bank (Laiki), and Hellenic Bank, which together account or 97% o the

assets o the domestic group. They also have large oreign operations, mainly in Greece but

also elsewhere, especially in Eastern Europe.

Unlike many others in Europe, domestic banks in Cyprus have traditionally relied on deposits

or unding. As o the end last year, deposits o banks operating in Cyprus (domestically

supervised banks and co-ops) amounted to 70 billion, or nearly three-ourths o total assets

(Chart 9).

Deposits have remained pretty stable since 2010, with a sharp decrease in July 2012

(apparently in response to the recapitalization at that time o Laiki) osetting a slight increase

earlier in the year.

The trend appears to have changed since the start o the year, however, with deposits

plummeting by 1.4 billion during January and press reports suggesting an even larger

drawdown in February.

Domestic banks are

dominated by just three

institutions

Cypriot banks rely heavily

on deposits or unding

0

10

20

30

40

50

60

70

80

2010 2011 2012 2013

Chart 9

Bank Deposits

billion

Resident

Nonresident

0

10

20

30

2010 2011 2012 2013

Chart 10

Nonresident Bank Deposits by Location

billion

Rest of World

Euro area

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Deposits raised in Cyprus accounted or three-ourths o the total, or 52 billion at the end o

September (the last period or which detailed data are available) (Table 2, page 12).

However, slightly more than hal o these were raised rom Cypriot residents.

Deposits raised rom nonresidents in Cyprus amounted to as much as 20 billion.

Another 13 billion were raised by the Cypriot banks operating in Greece.

Finally, 4.5 billion were raised rom other countries (hal o which rom Eastern Europe,

Chart 10, previous page).

Since 2010, deposits have allen only in Greece, rom 17 billion at the end o June 2011 to

13 billion at the end o September. Deposits raised by residents in Cyprus remained little

changed, while those by nonresidents other than in Greece actually increased slightly. This

trend, again, appears to have changed most recently, with nonresident deposits down by

7% between September 2012 and January, with most o the decline since the start o this

year. (Detailed data about the breakdown among nonresidents are not available.)

Some o the large exposure to nonresidents, however, is mitigated by a liquidity

requirement that obliges domestic banks to hold liquid assets equivalent to 70% o

nonresident deposits in currency other than in euro. (The latter amounted to perhaps 10-

12 billion at the end o September.)

Central bank data suggests that the insured deposits (o up to 100,000) amount to

30 billion, or 180% o GDP. Uninsured deposits amount to 38 billion.

Auxiliary data provided by the ECB sheds some light about the breakdown o nonresident

deposits among countries. The bulk o these, as much as 85%, or 19 billion, originated

rom non-EU countries, presumably mainly Russia and Ukraine.

Apart rom deposits, interbank borrowing appears to have been the second largest source o

unding. This amounted to 15 billion or the domestic banks (excluding interbank liabilities).

but only hal o these

were raised by residents

Ater having remained

stable through 2012,

nonresident deposits have

allen recently

The amount o insured

deposits amounted to

roughly 180% o GDP

Most nonresident deposits

come rom Russia and

Ukraine

0

10

20

30

40

50

60

70

80

2010 2011 2012 2013

Chart 11

Loans

billion

Resident

Nonresident

0

5

10

15

20

25

2010 2011 2012 2013

Chart 12

Nongovernment Foreign Credit

billion

Corporations

Households

Other

Deposits raised in Cyprus

accounted or two-thirds o

the total...

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ECB data suggests that most o this originates yet again rom non-EU countries (presumably

Russia).

On the asset side, loans to nonfnancial corporations account or most o assets. At the end

o January, these stood at 72 billion, or our times GDP.

Unlike other periphery countries, credit to nongovernment borrowers has been gradually

rising since 2010 and even through most o 2012 beore leveling o in the second hal o

the year.

Nearly two-thirds o loans to nongovernment borrowers were extended to residents,

roughly equally split between households and corporations (Chart 11, previous page).

Loans to residents amounted to 22 billion, the bulk o which (on the order o 17 billion

or so) were to Greek borrowers (mainly via their Greek operations).

Loans to nonresidents are heavily ocused on corporations (Chart 12, previous page).

Exposure to government securities has declined sharply ollowing the Greek PSI and is

estimated at 5 billion or so at the end o last year (including 1.9 billion in bank

recapitalization bonds). This compared with as much as 10.5 billion at the end o June

2011 (one-hal o which Greek government bonds).

Unlike other periphery

countries, credit to

nongovernment borrowers

has yet to decline

Exposure to government

securities has allen sharply

ater the Greek PSI

Table 2

Cyprus Banking System Selected Balance Sheet Items1

billion

Jun-11 Sep-12

Assets 109.0 95.0

Loans 72.7 67.9

o/w to residents 36.7 42.4

o/w: to Greece 23.4 18.9

o/w: to other nonresidents 5.6 6.6

Interbank 13.5 11.1

Other 22.8 16.0

Liabilities 109.0 95.0

Total Deposits 78.3 70.1

o/w: residents 32.2 32.2

o/w: raised in Greece 17.3 13.1

o/w: other nonresidents 23.3 20.3

Other 30.7 24.9

Source: IMF, Central Bank o Cyprus

1 Domestically supervised banks and cooperative banks

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IIF RESEARCH NOTE

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RISING NPLS FURTHER UNDERMINE BANKS PROFITABILITY

The analysis o deposits and the loan portolio suggest that domestic banks were, at leastuntil the end o last year, able to maintain relatively stable deposit unding and were spared

the type o credit contraction that has plagued banks in other periphery countries.

However, the restructuring o Greek government bonds and the losses incurred rom

marking to market holdings o Cypriot government bonds has resulted in a large capital

hole.

The latter has been only partially flled by the July 2012 recapitalization.

Another source o large losses is the rapidly rising share o NPLs. The latter were reported at

23 billion, according to the internationally accepted defnition, or 27% o all loans at the end

o September.

The share o NPLs amounted to 26.5% or the domestically supervised banks and 32%

or the co-ops.

The pace o increase has accelerated as well, with NPLs rising as much as 10% during

the third quarter o last year alone.

This compared to as little as 14% by the middle o 2011 and less than 10% at the end o

2009.

Even though a substantial portion o the NPLs appear to be ully collateralized, their sharp

increase in recent months and weak growth prospects are likely to result in urther losses inthe months to come. This consideration has led both the IMF and a private consultant to

conclude that the Cypriot banks may well need recapitalization as large as 10 billion, or

60% o the country's GDP.

In the meantime, the banking system is kept aoat through the Emergency Lending

Assistance (ELA) provided by the central bank and backstopped by the ECB (Table 3, next

page). The amount o ECB refnancing (including ELA) is likely to have amounted to 8 billion

or so at the end o last year, or nearly hal the country's GDP. The recent decision by the

Eurogroup to ask or a levy on deposits is all but certain to trigger large deposit withdrawals,

which, according to the central banks estimate, would amount to at least 7 billion within a

week ater reopening the banks. With the ECB having pledged to supply liquidity, ECBrefnancing to Cypriot banks would at least double to near 100% o GDP as a result. The

increase could be much larger, however, i deposit withdrawals are not quickly contained.

The Greek PSI resulted in a

large capital hole that has

yet to be closed

The share o NPLs has risen

to 27% o all loans and the

pace o increase hasaccelerated

In the meantime, the

system has been kept

aoat by emergency ECB

Dependence on ECB

unding would at least

double to near 100% o GDP

once banks reopen

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IIF RESEARCH NOTE

page 14


Table 3

Central Bank Balance Sheet

million

Dec-10 Jun-11 Dec-11 Jun-12 Dec-12

Gold and gold receivables 472 466 544 557 563

Claims on non-euro area residents denominated in oreign currency 374 358 391 431 343

Claims on euro area residents denominated in oreign currency 536 516 399 538 171

Claims on non-euro area residents denominated in euro 0 0 0 0 0

Lending to euro area credit institutions related to monetary policy operations

denominated in euro 5466 5570 5521 5175 411

Other claims on euro area credit institutions denominated in euro 0 0 0 8020 9400

Securities o euro area residents denominated in euro 2917 2897 2485 2096 1634

General government debt denominated in euro 1503 1503 1454 1454 1403

Intra-Eurosystem claims 419 523 663 805 976

Items in course o settlement 29 32 57 23 32

Other assets 168 185 3644 210 116

Total Assets 11884 12050 15159 19309 15050

Banknotes in circulation 1516 1525 1600 1609 1643

Liabilities to euro area credit institutions related to monetary policy

operations denominated in euro 2289 2361 3173 4463 3984

Other liabilities on euro area credit institutions denominated in euro 0 0 0 0 0

Debt certifcates issued 0 0 0 0 0

Liabilities to other euro area residents denominated in euro 279 461 930 280 260

General government 270 449 924 278 257

Other liabilities 8 12 5 3 3

Liabilities to non-euro area residents denominated in euro 103 80 87 84 29

Liabilities to euro area residents denominated oreign currency 0 0 0 64 100

Liabilities to non-euro area residents den. in oreign currency 0 0 0 0 0

Counterpart o special drawing rights allocated by the IMF 154 147 158 160 155

Intra-Eurosystem liabilities 6441 6367 7908 11273 7468

Items in course o settlement 30 33 58 24 32

Other liabilities 321 285 369 403 530

Provisions 187 204 208 232 235

Revaluation accounts 478 468 549 569 566

Capital and reserves 87 120 120 148 148

Total Liabilities 11884 12050 15159 19309 15050

Source: Central Bank o Cyprus

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