Institutional Affairs

  • Cyprus joined the euro only five years ago (Photo: ec.europa.eu)

Analysis

Cyprus 'business model' was no mystery to EU

22.03.13 @ 09:30

  1. By Valentina Pop
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Berlin - Be it the German finance minister, European Central Bank (ECB) officials or the head of the Eurogroup - they all agree on one thing: Cyprus must scrap its "unsustainable business model" based on low taxes and attracting large amounts of bank deposits from abroad, mainly Russia.

The Cypriot banking sector, relying largely on deposits, is more than seven times the size of the island's economy - which means that if the banks go bust, the state cannot cover their losses.

And if Cyprus wants help from its fellow eurozone countries, Russian and local depositors will have to take a hit.

"The banking sector in Cyprus simply has no future in its current form. Everyone in the Eurogroup agreed on this," German finance minister Wolfgang Schaeuble told public broadcaster ARD earlier this week.

"The Cypriots' hope they could continue like this, attracting capital with low taxes and lax regulation, and then others should pay for it when the model doesn't work any more - this is unfortunately an illusion and the ones in charge should explain this to their population," he added.

Speaking in the European Parliament on Thursday, Eurogroup chief Jeroen Dijsselbloem also said that Cypriot banks "have to be downsized and rebuilt on a healthy and sustainable business model."

But the Cypriot business model is not something that they all discovered just now.

In a so-called convergence report dated 2007, one year before Cyprus joined the eurozone, the ECB mentioned the large influx of capital.

"Much of the financing of the deficits in the combined current and capital account over the past two years has also come from capital inflows in the form of 'other investment,' comprising non-resident deposits and loans," the report says.

"Other investment inflows amounted to a sizeable 11.3 percent of GDP in 2006. Since capital inflows exceeded the current and capital account deficit between 2004 and 2006, Cyprus experienced an accumulation of official reserve assets in this period," it adds.

One data chart on foreign deposits published on the ECB website shows that the inflows of foreign deposits increased to a peak of over €19.2 billion in 2011, €1 billion more than the size of the overall economy.

"The ECB did know about the Russian money flowing into the island. Technically it's impossible not to know it," says Yasen Iliev, an investment banker with New Europe Corporate Advisory, a Sofia-based consultancy.

"Large imbalances in the GDP components, such as the oversized Cypriot banking sector, were an obvious time bomb easily noticeable to students in macroeconomics, let alone central bankers," he told this website.

He said the main reason why nobody said anything at the time was political.

"I believe the Cypriots somehow thought the party will go on indefinitely. The rule of thumb in Brussels and Frankfurt was to 'let go,' probably because of [Cyprus'] dispute with Turkey or maybe because the island's economy was too small to care about. As a consequence, the Cypriots grew up like kids who know their parents will get angry at them from time to time, but they will never kick them out of the house," he added.

For his part, Peter De Keyzer, chief economist with BNP Paribas bank in Brussels, agrees that letting Cyprus into the eurozone had less to do with economics than politics.

"Ten years ago, Cyprus was not even an EU member. Then it joined the EU, the eurozone, it even held the rotating EU presidency last year. This was clearly a political process," he told this website.

"And it strikes me that with Latvia potentially joining the euro next year - with all due respect to what they've been through and accomplished - it is again a political decision that has nothing to do with economics," he added.

Pressed on how much the German government knew about the business model in Cyprus over the past few years, government spokespeople in Berlin say that the flaws became evident only after the financial crisis.

"The crisis has uncovered weak spots in the business models that were built on very thin ice," said Martin Kotthaus, the spokesman of the German finance ministry.

"We now have to deal with the situation as such. It is not a reproach, each country is free to set their own taxes as they please. But then nobody can claim that a state that has chosen low taxes on purpose, should be completely financed with the tax revenues of other states," he added.

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