Barely five years after it adopted the euro, Cyprus notched up a more unwelcome date in the history books. In March 2013 it became the fifth country in the single-currency area to be rescued. The terms of European creditors for its bail-out included not just the usual demands for austerity and reforms but an unfamiliar demand for a banking 'bail-in' — getting debt holders and uninsured depositors to absorb bank losses and to stump up new capital. The experience of this small island has big implications; bailing-in creditors will be how future banking crises are tackled in Europe.

The trauma of last spring, when banks were closed for nearly two weeks and capital controls imposed, was expected to have a devastating effect on Cyprus. The economy is indeed suffering: after a 2.4% drop in 2012, output fell by 5.4% last year. Though painful, that was nonetheless milder than the 8.7% decline forecast last April by the troika, representing the European authorities and the IMF.

The Cypriot economy has turned out to be more resilient than many people had expected. At the time of the rescue the economy was commonly characterised as one that had boomed solely on the back of its overextended banks. At their peak, in 2009, these had reached Icelandic proportions, with assets worth nine times GDP. But Cyprus has other strengths, notably tourism and business services, which have held up reasonably well.

Tourist numbers did fall in 2013, especially from the rest of Europe, but an influx of Russians tempered the reduction to 2.4%. And because the Russians were higher-spending, income from tourism rose by 8%. At the Four Seasons hotel in Limassol, Russians make up nearly half the guests; a local taxi service has hired a Russian-speaker to manage its bookings.

One fear was that another pillar of the economy, business services (especially law and accounting), would suffer along with the financial sector because of capital controls. Although business services have taken a knock, they have declined less than the economy as a whole. In fact, as Evgenios Evgeniou, head of PWC Cyprus, points out, the sector’s rise predated the banking surge of the past decade; Cyprus replaced conflict-torn Lebanon as a business hub in the eastern Mediterranean.

Remaining domestic restrictions on capital movements will be removed this spring, says Harris Georgiades, the finance minister, though controls on transfers out of the country will remain in place. Despite these encouraging signs, it was premature of Nicos Anastasiades, the Cypriot president, to claim recently that the country was on the way to “a new economic miracle” (the first was the recovery after the Turkish invasion of 1974). The troika now think the economy will do worse in 2014 than their April forecast, with GDP declining by 4.8% rather than by 3.9%. Andreas Assiotis, an economist at Hellenic Bank, predicts a contraction of 5.8%.

The main cloud hanging over the economy is the sorry state of Bank of Cyprus (BoC), the country’s biggest bank. Since Cypriot banks were mainly deposit-based, with little debt issued to bondholders, the bail-in involved tapping uninsured deposits—those above €100,000, or $135,000—to cover losses and reboot the bank. As part of the deal, BoC absorbed the loans and insured deposits of Laiki, formerly the second-biggest bank, after its uninsured deposits had been comprehensively bailed in. The new bank was then recapitalised by converting 47.5% of BoC’s uninsured deposits into equity.

The bank re-emerged from this process at the end of July with a respectable capital ratio of 10.5% of its risk-weighted assets. It has a new and energetic boss, John Hourican, who took over in October. He had previously spent over four torrid years dealing with another broken bank as head of investment banking at Royal Bank of Scotland, a job he had to quit a year ago after the LIBOR-rigging scandal (the bank cleared him of any involvement in or knowledge of the misconduct).

One step that Mr Hourican is taking at BoC is to reduce its remaining international exposures. Another is to rationalise its core activities in Cyprus, which represent around 85% of its loans and deposits. The number of branches has been slashed (from 203 last May to 130) and the workforce cut back. Mr Hourican is also shaking up the culture not just of BoC but of Cypriot banking by intervening early when clients fail to service their debts.

The task of turning round BoC is, however, immense, for two related reasons. First, by absorbing Laiki’s gross loans in Cyprus, the bank doubled up on its exposure to the Cypriot economy—and in particular to property, which provides the collateral for its loans. At the end of last year 53% of its loans were non-performing (more than 90 days overdue in payments), up from 36% in June. With the economy and property market still falling, this bad-debt mountain will get even bigger, while the collateral will shrink further.

Second, the extraordinary events last year, when for a week insured as well as uninsured deposits faced a bail-in, have sapped confidence in banks, particularly in BoC. There is a gaping hole in BoC’s balance-sheet between its loans and its deposits, such that its loans are 45% greater than its deposits. The shortfall is met by €11 billion of central-bank funding, of which almost €10 billion is emergency liquidity assistance, a measure of the bank’s plight.

As long as the country’s main lender remains stricken, it is hard to see how Cyprus can stage a sustainable recovery, says Sir Christopher Pissarides, a Nobel-prize-winning economist who heads the country’s economic council. Even though the economy has been hurt a bit less than expected, it remains in intensive care.

Source: The Economist