DR. JIM LEONTIADES
Cyprus International Institute of Management
Too much borrowing. That is the common root of much of the current financial crisis. If growth is to be resumed in the Euro-zone, many citizens, businesses and governments will have to reduce the proportion of their borrowed funds, to deleverage.
The McKinsey Global Institute, an arm of the well known McKinsey consulting firm was established in 1990 to study the evolving global economy. MGI’s latest report, Debt and Deleveraging: Uneven progress on the path to growth, studies ten of the world’s largest mature economies to see “where they stand” in the deleveraging process. Special attention is given to the experience of Sweden and Finland, both of which successfully deleveraged in the 1990s. The report ends with a summary of six conditions it finds are useful indicators of deleveraging. It concludes that, without these, “growth and public sector deleveraging are unlikely.”
1. The first condition is a stable banking system. In Finland and Sweden, which have successfully gone through this process, the government intervened. Banks were recapitalised and some nationalised. Special institutions were set up to manage bad loans.
Our banking system in Cyprus is in the depths of probably the worst crisis since 1974, largely due to unprecedented losses suffered from the Greek default on its sovereign debt. This has drained bank equity reserves just when new, higher reserve requirements have been imposed by bank regulators. This double blow comes on top of a depressed national economy and a general scarcity of capital. Cypriot banks are in the midst of a drastic deleveraging process, raising new equity, restricting loans, cutting dividends and selling assets. The end is not yet in sight.
2. A credible plan for long term fiscal responsibility. MGI finds that although a plan for long term fiscal sustainability is essential, moving too soon and too aggressively to cut government spending can be counterproductive, slowing down a potential recovery (Angela Merkel, please note).
Cyprus cannot be accused of moving too fast and too aggressively to reduce its deficit. Quite the contrary. Steps in this direction have been too slow and too modest. According to Eurostat data, Cyprus was one of the few countries in the European Union whose deficit actually increased (from 5.3% to 6.3%) between 2010 and 2011.
3. Structural reforms should be in place. Sweden and Finland enacted reforms to raise productivity and to stimulate growth in retail and banking. They also joined the EU during this period. Japan did not and entered into a 15 year recession whose end may not yet be in sight.
The largest Cypriot private sector (financial) is undergoing a far reaching and painful restructuring. Reform of the public sector is the most obvious structural change needed in Cyprus. Whereas many public sector workers in Greece have seen their wages reduced by 25% and many such workers have lost their job entirely, public sector changes in Cyprus have so far been minor and temporary.
4. Rising exports have long been a recipe for exiting a recession. Finnish and Swedish exports grew rapidly, thanks in part to their membership in the European Union (although neither was in the Euro zone at that time). Unlike Finland and Sweden then, the Euro zone countries today are not able to lower their exchange rate as a means of stimulating exports.
In Cyprus, our main export is tourism, the export of services and our main source of foreign exchange. Our performance here has yet to exceed the arrivals figure of 2.7 mln tourists which Cyprus enjoyed in 2001. There has been a modest 10-11% improvement recently largely due to tourists diverted because of civil unrest in the “Arab Spring” countries.
5. A revival of private investment is another sign of successful deleveraging.
The crisis in Cyprus has been accompanied by a steep drop in the establishment of new companies. In the 2008-2011 period annual new company registrations have dropped by 20%, from 24,596 to 19,509. Hopefully, new efforts to attract Chinese investment and offshore drilling will reverse this trend but this remains a hope.
6. A stabilised housing market and a rebound in construction are important. Housing not only provides jobs in construction, it also drives sales of the many durable goods required to furnish new homes.
Cyprus, along with Spain, has yet to experience the hoped-for rebound in this sector. Moreover, house prices here have not experienced the same rate of decline as in some other countries. House prices in Cyprus have dropped at an annual rate of 5% between the second quarter of 2010 and the same quarter in 2011. Spain’s house prices fell 11% just in the final quarter of 2011. Deleveraging here has still some way to go.
Cyprus, along with most other countries of the Euro zone, has not yet completed its deleveraging process. How long this will take is not something many economists agree on.
Perhaps more important is the question of strategy. Is the current focus on austerity likely to bring about the desired result?
There is no doubt that deleveraging has become necessary but the timing and method with which it is carried out can make all the difference between success and failure.
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