EU rescue mechanism would be good for Cyprus

.

By Shavasb Bohdjalian
Minister of finance Kikis Kazamias said that the government is considering a complete freeze in public sector wages, a tax on revenue of local companies and a contribution of private sector workers earning more than 2,500 euros monthly as part of efforts to help Cyprus avoid resorting to a bailout, but perhaps the EU rescue mechanism is what really this country needs.
Kazamias announced the freezing of the state payroll, which would save the state around EUR355 mln in 2012 and 2013, but would do nothing to help make Cyprus competitive again and more importantly, find a way for the economy to grow again.
Kazamias stated that his latest measures aim at restoring Cyprus’ access to international markets for its financing needs, which it lost after successive downgrades by all ratings agencies. He did not however, mention that the real reason why Cyprus was downgraded is because of the dire situation of the major banks and not state finances.
Reducing the budget deficit to under 3% of GDP and bringing the overall debt below 60% of GDP are measures that Cyprus has to take as part of its commitments given to stay in the eurozone, but the high deficit is not the reason why rating agencies have been lowering the country’s much prized AA+ rating to B- in such a short period of time.
As Kazamias knows well, the aggressive rating cut was made because rating agencies are afraid the major Cyprus banks will not be able to withstand a 50% haircut on their Greek government debt holdings, and the possibility of billions of euros in additional hit to their earnings because of the collapse of the local real estate market.
Cyprus is facing two problems at the same time. We have lost our competitiveness as a nation and have been living beyond our means for several years, with successive governments having added to the number of civil servants and giving them massive salary increases and additional perks that in the current slowdown the country can ill-afford to maintain. So on this front, the country needs more than a two-year wage freeze. What Cyprus needs is to start cutting down on the number of civil servants, outsource most government tasks to the private sector and scrap all additional perks. Once this is done, the burden on the state budget will ease, allowing more money to be channeled to investments on infrastructure and other projects aimed at helping the country grow again.
The second front that Cyprus is facing is the situation with the major banks, which were allowed to risk shareholder and depositors money by first investing in Greek government debt when it was obvious that the country would not be able to pay back its debt and even more worrisome, for encouraging the public to engage in rampant real estate speculation by offering cheap and abundant loans for real estate purchases at inflated prices.
With the balance sheet size of the banks more than 7 times the size of the country’s GDP, Cyprus faces the same problem as Ireland that its banks are too big to be rescued and it will need to resort to the EU’s rescue mechanism to salvage the situation.
But perhaps this will be good for the country since when the EU task force takes control of the country, it will immediately move to force a massive pay cut in the civil service, force the banks to reduce their expenditure by cutting down on excessive pay and other perks, and move to open up the closed professional services, which are blocking competition in the country.
An entry into the EU rescue mechanism will see the VAT rate rise closer to 18-20% while the corporation rate tax will also be increased, perhaps to above 15%, which would force many foreign companies to flee the country. While this may be highly negative in the short term, but would force Cypriot professional firms to improve their service in order to retain their clients and not rely on Cyprus’ low tax rate to attract clients.
And in any event, the offshore sector risks collapse because of the situation with the banks, with many foreign nationals openly worried about their deposits placed with Cyprus banks in view of the recent rating cuts. Once those deposits move, the offshore sector will be in trouble.
In my opinion, the sooner Cyprus enters the EU’s rescue mechanism the sooner this country will be able to go through the painful readjustment process and regain its competitiveness.

(Shavasb Bohdjalian is an approved Investment Advisor and CEO of Eurivex Ltd., a Cyprus Investment Firm, authorized and regulated by CySEC, license #114/10 and approved by the Cyprus Stock Exchange to act as Nominated Advisor for listings on the Emerging Market. The views expressed above are personal and do not bind the company and are subject to change without notice)