A Reality check - Facing the Hard Truth about Private Debt and the Cyprus Economy

After more than three years of self denial, finally, a report was recently published by the Central Bank, The Household  and  Non-Financial Corporations Indebtedness Report[1] of May 2016 stating what was more than obvious to any objective researcher who wanted to find out the truth about the Cyprus Economy after the bail-in. In short, that the country is facing a gargantuan private debt problem which constitutes the biggest obstacle for kick-starting and putting the economy back on a sustainable economic growth path. The report concedes that private debt (by households and non-financial corporations) is 358% of Gross Domestic Product (GDP). Add to that a public debt of almost 110% of GDP and the country is up against a debt of almost 5 times its GDP! The argument that private debt is not so important is both conceptually and empirically wrong (see, for example, Steve Keen's research[2]). Private debt is the main cause of economic crises. Fisher (1933), Minsky (1992)[3] and Keen (2001) among many others have argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. Moreover, Vague (2014)[4] notes "runaway growth in private debt, especially when combined with high existing levels of that debt, is what has caused most major economic crises of the last century". The chronic debt situation of Cyprus is further compounded by the fact that a large proportion of bank deposits are owned by foreigners while almost all loans extended by banks have been taken up by Cypriot entities. Moreover, most of these loans were given out by banks without proper credit risk assessment and, as result, the funds were put in mostly unproductive and wasteful investments[5]. Therefore, Cyprus has an acute problem not only because of the extremely high level of private debt but also because much of this debt is now poorly performing in creating the income and wealth to effect a timely repayment of loans. Furthermore, with Cyprus experiencing continuous and considerable deflation over the last three years (consumer prices fell by 2.2% in 12 months to June 2016) the real debt burden on the Cyprus economy is being constantly aggravated pushing the country into a debt-deflation downward spiral as articulated and highlighted by the eminent economist Irving Fisher. The most incredible thing during these past three years of denial was the almost co-ordinated attempt of politicians in power, civil servants and the academia in general (with only few exceptions) to downplay the importance and even the existence of the problem of the enormous private debt at the very core of the real economy as being the major obstacle obstructing economic development and the road towards a sustained growth. When anyone (physical or legal entity and even a whole country) owes almost five times the gross income that can be generated in a year then, simply, something has to give. The ability to even cover the interest payments is seriously impaired and at the very least questionable in an economy where levels of  real economic activity apart from tourism are still very low. Although it is easy for the Government to present the numbers in a nice format and create fake success stories, like the ability to borrow from the markets at, albeit, very high interest rates, or to publicise the endeavours of some international investors who are more interested in securing conditions for prowling the assets and resources of the country as votes of confidence for the Cyprus economy, the hard truth remains that an economy which is so deeply indebted needs a major overhaul to kick- start a sustainable process for economic development. The report of the Central Bank of Cyprus rightly mentions that the debt of the Cyprus private sector remains extremely high, but fails to report how the debt of other previously very highly-indebted nations such as Iceland and Ireland has been reduced substantially in recent years by effective policy action which has lowered considerably the volume of private debt and raised its quality, thereby substantially reducing the non-performing loans component. In the executive summary of this report we read “During the past year, strong policy action has been taken and the economic adjustment programme was followed through – which was important in mitigating the impact of the high level of indebtedness and the vulnerabilities being faced by the financial sector. GDP in Cyprus is forecast to increase by 2,0% in 2016, which is expected to be financed to a large extent by banks. This shows that Cyprus is on a path of recovery following three years of recession”.  In contrast we would contend that it is indeed the lack of effective policy action by the Cyprus authorities that has maintained private indebtedness at extremely high levels and jeopardised severely the prospect of achieving solid and sustained economic growth. Leslie G. Manison is an economist, specialising in macroeconomic policy analysis and international financial relations. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus Ministry of Finance, and a former senior advisor in the Central Bank ofCyprus. Savvakis C. Savvides is an economist, specialising in economic development and project financing.  He is a former senior manager at the Cyprus Development Bank and has been a regular visiting lecturer at Harvard University and more recently at Queen’s University, Canada. Author page: http://ssrn.com/author=262460.