Is Cyprus debt really sustainable?

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Why direct bank recap is critical for Cyprus

By Fiona Mullen, Director Sapienta Economics Ltd


Published in hard copy on 24 October 2012 
In a speech to the Association of International Banks on Monday, the Central Bank governor, Panicos Demetriades, gave three reasons why the public debt of Cyprus should be sustainable: direct bank recapitalisation, bank privatisation in three years’ time and natural gas.
The problem is that all three reasons are based on highly questionable assumptions.
The first and the most critical assumption is that the planned European Support Mechanism (ESM) will allow the European Central Bank (ECB) to recapitalise banks not only directly but with retroactive effect, meaning that money borrowed to recapitalise the banks could be assumed by the ECB instead of the Cyprus government.
As shown in the table, I estimate that this could reduce the debt/GDP ratio to less than 100% of GDP by 2016, which is just about sustainable, compared with a very unsustainable ratio of 140% of GDP—around the ratio of Greece before it fell into crisis.

ESM may not be retroactive
But there are still many obstacles to overcome before the ESM, agreed in principle in June, is in place.
While the legal framework might be in place by the end of 2012, Germany among others is insisting that it is proven to work properly before any of the EUR 500 bln in funds can be released.
A second obstacle for the ESM is that its very legality is currently being challenged at the European Court of Justice by member of the Irish parliament.
But the real risk for Cyprus is that even if ESM does come into force, it may not have retroactive effect. On Friday Bloomberg quoted Germany’s Chancellor, Angela Merkel, saying “There will not be any back-dated direct recapitalization”, although Ireland has already been on the phone to Merkel trying to argue the case for its own banks.
If ESM does not have retroactive effect, then according to my estimates Cyprus would already have a debt/GDP ratio of more than 100% of GDP by the time any direct recapitalisation comes into force (possibly January 2014) and getting on for 130% of GDP by the end of 2014.

Privatisation will not bring in billions
The second assumption is that Cyprus Popular Bank (CBP, Laiki) and, presumably, Bank of Cyprus if it ends up in government hands, could be privatised in three years’ time.
If these two banks can clean up the EUR 22 bln they have lent to the Greek private sector in three years it will be nothing short of a miracle. Only if the Greek loans are somehow hived off from the core bank operations would the banks we attractive to any buyer.
But they would not fetch billions. Currently their market capitalisation is only a few hundred thousand.

Gas revenues still 15-20 years away
This third assumption, that investment in natural gas will save us (at least he was careful not to claim actual gas revenues), is based on questionable assumptions about how soon we can get financing to make such investments.
The small liquefied natural gas (LNG) plant that is currently planned is based in the estimated reserves of 7 trillion cubic feet in Block 12.
But a small plant has poor economies of scale. Financing it will therefore be extremely challenging for a junk-rated country in the context of downward pressure on global gas prices as a result of discoveries of US shale gas.
Financiers are more likely to wait until greater quantities of gas have been secured, so that a larger plant with better economies of scale and therefore less dependence on high gas prices can be built.
This, in turn depends on either more gas finds or a decision by Israel to allow some of its gas to be exported from a non-Israeli facility. All of this puts financing back a few years and revenue generation even further.
Unless we suddenly become as efficient as the Australians, an LNG plant will take around 10 to 12 years to build–and that is after all the feasibility studies have been conducted.
A more realistic timetable for gas investment is therefore four to five years from now, which puts actual gas revenues another 15 to 20 years away.

Our only hope is special pleading
With all of these considerations in mind, our only hope, like Ireland, is for special pleading – the kind that should have happened when Cyprus signed up for the Greek haircut but never did because no one would grant and audience to the former Central Bank Governor, Athanasios Orphanides, who foresaw what it meant for Cyprus.
The new governor has better relations with the government. Let’s hope that despite his reassurances in public, he is fighting hard to ensure that whatever the eurozone leaders decide about direct ECB bank recapitalisation in general, they will make sure that it does indeed apply to little Cyprus.