The main problem is that the country’s reform reflexes have weakened
The banking sector and public finances, by pursuing exactly opposite strategies, have both managed to underpin the creditworthiness of the Cypriot economy — a fact also confirmed by the recent assessment by Morningstar DBRS.
March 2013 was undoubtedly a turning point for both pillars. The deposit haircut, the forced consolidation of banks, and the forced asset sales on the one hand, and the memorandum that imposed drastic cuts in government spending on the other, forced both the private and public sectors to start from scratch.
ΣΧΕΤΙΚΑ ΑΡΘΡΑ
For several years, their paths ran parallel. Just as the banks were forced to sell off non-core operations and subsidiaries abroad, so too did the government proceed with the privatization of ports and the closure of loss-making state-owned companies (such as Cyprus Airways). However, upon completion of the adjustment program, the two sides took entirely different paths.
The Path of Tough Decisions for the Banks
The banking sector chose—or, more accurately, was forced—to leave behind the easy practices of the past. The zero interest rates of the previous decade, combined with strict European rules on capital flows (especially after the expulsion of Russian deposits), forced management to make difficult organizational decisions.
The sale of non-performing loans (NPLs)—which, while removing the risk from bank balance sheets, often shifted it to the real economy and servicers— the exclusion of credit-unworthy customers, generous voluntary retirement packages, the mass closure of branches, and major investments in technology constituted the standard playbook for restructuring.
Today, the sector offers upgraded digital services (which significantly outperform those of state-owned banks), posts strong organic profitability, distributes dividends to shareholders, and provides full security to depositors. The sharp rise in ECB interest rates in recent years has acted as a catalyst, turning banks into attractive investment destinations and offering high returns to those who liquidated their holdings.
At the same time, banks support growth and demonstrate resilience in absorbing shocks (such as, for example, managing agricultural debt following natural disasters). Nevertheless, their public image remains tarnished, with Central Bank Governor Christodoulos Patsalides speaking of a real “reputational risk.”
The State’s Tactics of Easy Solutions
In contrast, the state did not have the “luxury” of dealing with social discontent, nor the ability to make drastic decisions without political consensus. At the same time, there was a lack of the necessary pressure for the rapid adoption of new technologies and the substantive modernization of public administration.
Under these circumstances, the government chose to cover its funding shortfalls initially through the controversial “golden” passport program. When the European Union mandated its termination, attention shifted to incentives for attracting foreign companies and relocating their headquarters to Cyprus (the “headquartering” program).
The increased revenue from foreign companies, combined with inflation—which boosted excise tax revenues—and previously low borrowing rates, did indeed achieve a significant deleveraging of public debt, but at the same time created a fiscal surplus that supported an increase in public spending beyond the limits set by EU rules.
The cost of postponing reforms
These solutions bought Cyprus valuable time, allowing for a smooth transition without immediate economic pressure. However, they did not resolve the structural productivity problem of domestic firms, which lag behind both in wages and in returns.
Most importantly, however, they have weakened the country’s capacity for reform. Dependence on cyclical revenues and the presence of foreign companies makes the Cypriot economy even more vulnerable to international turmoil, as well as to the whims of multinational corporations, which can relocate their headquarters outside Cyprus at any moment. And the rating agencies know this…
