Cyprus: Lack of adjustment of household sector

An analysis of the results of the Eurosystem’s Household Finance and Consumption Surveys (HFCS) reveals how Cyprus households and their counterparts in certain other financially distressed Euro area countries have been affected by and responded to their financial crises. According to the first wave results of the HFCS centered on 2009/2010 Cyprus households entered the crisis years of 2012 and 2013 with relatively high levels of real and financial assets, well in excess of the Euro area averages. At the same time Cyprus households were burdened with very high large amounts of debt, with the ratio of debt to income for indebted households estimated at 157% in 2010, far above the euro area average of 63%. As a result of the financial crisis of 2012/2013 and its aftermath Cyprus households experienced huge falls in their net wealth of 36% and income of 30% between 2009/10 and 2013/14. However, Cyprus households largely maintained their consumption over these years running down their saving balances and increasing their indebtedness. The household saving rate fell to minus 7.9% in 2014 and the debt to income ratio for indebted households rose spectacularly to 251%.  And the ratio of debt service to income for indebted households climbed to above 35% in 2014, with the ratio for the poorest 20% sky-rocketing to 64%. The failure of Cyprus households to repair their balance sheets and adjust their spending behavior to their falling incomes contrasts with that of households in Spain, Portugal and Ireland which kept their consumption below incomes and generated saving to repay debt and reduce their debt service to income ratios to more manageable levels of 18.6%, 15.1%, and 12.9%, respectively. With the very large falls in incomes, households previously categorised as being in the middle class descended into the lower ranks and along with the bottom 20% classified by net wealth became exposed to the risk of poverty as well as experiencing greater difficulties in honoring debt repayments. Indeed, there has been a large shrinking in the incomes and number of middle-class households (down by at least 20 percentage points) that has seriously reduced investments in education and healthcare, as well as outlays by the self-employed in business assets of SMEs. Beyond 2014 limited data on the behavior of Cyprus households indicate that the steep declines in their net wealth and incomes have been halted, with a small rise in real household incomes occurring in 2015 and 2016.Notwithstanding these latest developments, the financial position of households remains precarious as many households have continued to consume beyond their income and delay their servicing of debt, hence keeping non-performing household loans above €12 billion  and over 57% of their gross loans. Indeed, the NPLs of households were reduced by only €709 million or 5.5% between end-2014 and end-2016, a disturbing figure indicating the inability of many households to repay their debts. Thus, there is an urgent need for policy-makers to deal more effectively with the severe debt problem of households. Specific taxation measures and reforms should be introduced to support sustained economic growth and to redistribute the proceeds of such growth more equally. These policies would help raise the disposable incomes of lower and middle level income households giving them among other things the increased capacity to service their loans. Action, backed politically, has to be taken to induce/enforce wealthier households including so-called strategic defaulters which have the capacity to punctually repay loans to do so. But given the huge amount of household debt estimated to be around 124% of GDP, with a considerable proportion of it held by households with very limited capacity to pay, the above proposals are unlikely to contribute enough to reducing household indebtedness and in removing it as an important constraint on economic growth. Accordingly, it is proposed that banks institute a household debt relief program over a period of 24 months whereby certain loan principals of households, essentially mortgages for main home residences and business loans for self-employed persons are partly written-off. To incentivize the banks to participate in the program and for their capital not to be the victim of shattering losses from the write-offs, these losses should be allowed to be spread over a long period of say 15 years, supplemented by tax credits. Policy-makers should be aware that successful efforts and arrangements that result in large reductions in private debt involving higher savings by households and business enterprises will inevitably reduce private domestic demand over the medium-term and contribute to lower economic growth.(See “Neglect Private Debt at the Economy’s Peril”https://papers.ssrn.com/sol3/papers.cfm?abstract id=2886345). This puts a premium on assigning even greater policy orientation toward boosting net exports as the prime source of economic growth, especially through exploiting the enormous potential of the Cyprus tourism sector. Last but not least, policy-makers cannot afford to neglect the private debt problem which is impairing the foundations needed for the future growth of the Cyprus economy. Furthermore, with bank loans to the private sector, amounting to around 287% of GDP, of which around 47% are non-performing, there are serious concerns for financial stability as such huge debt weighs heavily on banks’ profitability and restricts their ability to raise capital and extend credit to support economic growth.