John Mauldin: The Bang! Moment Shock
Future shock is the shattering stress and disorientation that we induce in individuals by subjecting them to too much change in too short a time.
– Alvin Toffler
What is it about humans that we fail to see a crisis in advance, yet when we look back, its likelihood or inevitability so often seems blindingly obvious? Rather than a flaw, our under-reliance on foresight as opposed to hindsight is perhaps a necessary evolutionary design feature that has allowed us to make rapid progress as a species (especially over the last few thousand years), but in a complex modern society it can really create quite the crisis for individuals. This week we resume our musings about Cyprus, to see what that tiny island can teach us about our own personal need to engage in ongoing critical analysis of our lives and investment portfolios. Cyprus is not Greece or France or Spain or Japan or the US or … (pick a country). I get that. No two situations are the same, but there may be a rhyme or two here that is instructive.
In 1974, Turkey invaded Cyprus. Eventually the island was divided into two zones, and Greeks in the Turkish zone, like Turks in the Greek zone, were forced to leave with only the clothes on their backs and little else. That was a defining moment for Cyprus, and the aftershock is still evident when you get past the normal polite conversation. Plus, the wall dividing the two countries is always there when you are in the capital city of Nicosia, although lately there are a few places where you can cross into the other zone. The first night I was in Nicosia, we ate dinner outside at a Greek taverna (what else?) that stands almost in the shadow of the wall.
One hundred years after the Civil War, the South of my childhood was still mixed up with the aftereffects of that war. The war in Cyprus was less than 40 years ago. Another evening we went to a local club where the members were Greeks who had been expelled from a particular neighborhood in the Turkish-occupied area. Many looked young enough that they could not have been alive during the war, but the memory of the "old neighborhood" was still strong among them.
These people lost homes and businesses, jobs – everything. They had to start over. (I am sure it was that way for the Turks who had to relocate as well.) But for the next 40 years there was very steady economic growth, 4% or so a year over time. The people took advantage of what they had. There was no university, so children went abroad to study and work and then came back, generally with skills. The legal and accounting professions grew particularly strong. Like two other former British island colonies, Singapore and Hong Kong, Cyprus became a financial center. Fifty double tax treaties later, the island had become a place to domicile companies, handle taxes and accounting, etc.
And then they branched out into banking. After the creation of the euro, the deposit base of Cypriot banks went through the roof, until it was up to six times the size of local GDP (depending on whom you believe – official sources make it closer to five times). By some measures, Cyprus had the second wealthiest population in Europe and certainly one of the best educated. Twenty-five percent of the world's ships were operated under the flag of Cyprus. Because the country had been a member of the nonaligned movement in the '80s (remember that?), it had good ties (and double tax treaties) with Eastern Europe and the USSR. Some of the kids went to university in Russia and developed contacts there. After the collapse of the Soviet Union, it was natural for Russians to use Cyprus as a conduit to the West.
Cyprus has, by some accounts, the best beaches in the Mediterranean, and so more and more people came and built vacation homes. They brought their money with them and deposited it in the local banks and took out loans to build their homes. Real estate prices climbed and climbed. Below are Cypriot bank deposits and loans from 2009 through April of this year (data from the central bank).
Unemployment was quite low, less than 4% in 2008, although the global credit crisis led to a gradual rise (though nothing like that seen in the rest of Europe). Much of the new unemployment was in the construction industry, which fell into a slump along with the rest of Europe during the crisis.
Banking soon became the biggest industry. There were more banking branches per capita in Cyprus than anywhere else in the world, more than double the European average. And there were over 40% more employees per branch than in the average eurozone country. Money was easy to get, so debt exploded by over 50% in both businesses and households in just six years, from 2005–2011.
The country had always run a current account deficit, but by 2008 that deficit had topped 15%, keeping pace with Greece's and Portugal's. However, earnings and productivity had more than kept up. Cypriots worked hard and offered good value for their services. They saw themselves as different from the other Southern European countries. But, as in much of the rest of Europe, public-sector employment doubled from 1990, with the second-highest government wage bill (behind Denmark's) and a monstrous 50% growth in social benefits in the last 10 years.
Still, starting in 2003, public debt-to-GDP actually fell. Why ring the alarm bell when things are getting better?
Cyprus: Public sector debt as % GDP 1995-2012
There were in fact no alarms bells ringing as 2012 opened. But there should have been. Cyrpiot banks were flush with cash. They bought foreign banks in Greece and Russia. They made ever more loans and then looked around and decided that Greek sovereign debt was something they needed more of. And then came the Greek sovereign debt crisis, and the capital base of the Cypriot banks was essentially wiped out. But the ECB and the EU had bailed out Irish and Spanish banks; and so depositors in Cyprus, many of them Russian, decided, along with the local citizens, to leave their money in the banks.
The country had been under the parliamentary control of the Communist Party since 2008. Seriously. Supported by the Orthodox Church. (Note that public debt began its serious rise after the communists came to power). No one reined in the banks, and they grew ever fatter and more exposed until the crisis hit. Then Cyprus could no longer fund its debt and needed EU help. Further, the Central Bank of Cyprus (not to be confused with the commercial Bank of Cyprus) had to make emergency liquidity loans to Cypriot banks that had to meet demands for withdrawals and could no longer raise capital. There was not a bank run, but there was a fast-paced walk.
The ECB balked, as the quality of the collateral offered did not come close to the standards of the Emergency Lending Assistance (ELA) program. The government of Cyprus needed money to fund its basic needs as well as to "roll over" its debt as it came due. The EU basically declined to negotiate, as there was a Cypriot election scheduled for late February, and the EU preferred to wait to see the results before acting. There was talk of a "bail-in" (where depositors would shoulder some of the loss), but as usual that proposal came from the Germans, and the rest of Europe would surely not agree.
The new president assumed office and saw immediately that the country was in trouble. He tapped Michael Sarris, a "technocrat," to be his finance minister. Sarris was the man who had helped bring Cyprus into the euro and who oversaw the reduction in Cypriot debt. While he was not a member of the winning political party, he had been at the World Bank and had relationships with many of the finance heads of Europe.
Sarris went to Brussels, only to find no friends of Cyprus there. The Germans privately told him they would approve no bailout of Russian depositors (rumored to account for over half of the base of some of the banks) prior to the German elections this fall. Cyprus was seen as a money haven and a place for rather loose tax accounting. I have to admit that many of the Cypriots I talked to knew that money laundering was going on. It was a very open secret. Cyprus had very strict rules, but it seems there were ways to engineer exceptions.
In the end, Cyprus makes no difference – that was the perception in Europe, and while they were just talking a few billion euros here and there, a fraction of what Ireland or Spain needed, there was just no sympathy for Cyprus. Many of the European finance ministers wanted to establish the questionable principle that bank deposits were no longer sacrosanct, and Cyprus was just not seen as a systemic risk. The best deal Sarris could get was a 6.75% "tax" on deposits of less than €100,000 and 9.9% above that, with the aim of raising €5.8 billion. That was on a weekend, and by Monday, when Sarris returned, the indignation in Cyprus had grown to the point that not one politician voted to accept the deal.
A bank holiday was declared and Laiki Bank was put into receivership and closed as a "bad bank," but within a week the EU decided to insure all deposits up to €100,000, the number that "everyone" had understood to be the safe deposit amount. The banks eventually reopened, but Cyprus placed capital controls on deposits and limited withdrawals. A euro in a Cypriot bank was no longer the same as a euro in an Irish bank.
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