Cyprus Economic Policy Review, Vol. 10, No. 2, pp.

3-40 (2016) 1450-4561 3

A Decade Long Economic Crisis: Cyprus versus Greece

Gikas A. Hardouvelisa, and Ioannis Gkionisb
aUniversity of Piraeus, Greece and bEurobank Ergasias, Greece

Abstract
The paper compares the recent economic crisis in Cyprus with the much larger
and still on-going crisis in Greece, traces the causes behind their differences and
assesses each country’s future economic prospects. Cyprus entered its crisis with
less onerous macroeconomic imbalances, yet with less robust financial and real
estate sectors. Cyprus delayed signing its MoU with the lenders but subsequently
delivered quickly on the program requirements, front-loading the fiscal policy
restrictions. Greece reduced its fiscal deficits, yet, after its economy stabilized and
began recovering in 2014, it suddenly adopted in 2015 a very naïve and backward-
looking confrontational strategy with its lenders, which brought a second
recession. Today, at the end of 2016, Cyprus has managed to keep its international
comparative advantages and has the luxury to focus on its long-term growth
strategy, having lost only 5% of its pre-crisis income. Greece, after having lost
over 22% percent of its pre-crisis income, has not yet escaped its crisis, is still
burdened by economic stagnation, an unsustainable public debt and unusually
high tax rates that constrain growth. The two countries share common risks today:
A very weak financial sector with unusually high no-performing loans, and an
unusually low ratio of investment to GDP.
Keywords: Cyprus, Greece, crisis-comparison, macroeconomic imbalances,
banking-crisis, NPLs.

1. Introduction
As the year 2016 comes to an end, Cyprus is slowly and robustly emerging
out of its economic crisis, while Greece continues to remain deep inside it.
Today economic output in Cyprus is only 5% below its 2011 pre-crisis GDP
level, whereas in Greece output is far below its own 2009 pre-crisis GDP
level, showing an astonishing 22% gap. In current prices, Cypriots have


We would like to thank Theodoros Stamatiou as well as the editor of the journal and two
anonymous referees for their comments. The paper extends an earlier presentation of the
first author in Nicosia, Cyprus on April 21, 2016 in a conference organized by the Cyprus
International Institute of Management on the topic: “How to kick-start growth.”

Corresponding author, Address: University of Piraeus, Department of Banking &
Financial Management, Karaoli & Demetriou 80 Piraeus, GR 18534.
Email :[email protected]
4

lost €1,569 in income per capita, but Greeks have lost €5,263. 1 These
differences are even bigger when the comparison is made on disposable
incomes, as taxes have gone up a lot more in Greece. And on the social
front, Cyprus has almost closed its unemployment gap relative to 2012Q2,
whereas Greece remains 12 full percentage points above its own 2010Q1
unemployment level.
Today Cyprus has access to the international markets and can borrow
freely at reasonable rates, whereas Greece is shut out of the market. In
Cyprus, capital controls are a distant memory, whereas in Greece they
remain in full force. Year 2016 economic growth is projected at 2.7% in
Cyprus, but negative in Greece, just below zero. Sovereign yield spreads
are declining in Cyprus but are stuck at high levels in Greece. And
economic sentiment is rising fast in Cyprus and in synchronization with
the rest of Europe, whereas sentiment in Greece is relatively flat and stuck
alone on its own, having decoupled from the rest of Europe for more than
a year and a half, since early 2015.
These differences in economic fortunes are striking and raise a number of
questions: Are they due to differences in the two countries’ initial
conditions before their respective crises hit? Are they due to the different
policy responses? Or perhaps are they due to both of the previous reasons?
Did other factors - related to the different timing of the two crises or the
nature of shock that hit each country, contribute to the outcome we
observe? Did the lenders treat each country in a different manner, hence
contributing to the differences? More importantly, is the present economic
situation a prelude to what the future may bring? What is the appropriate
policy recipe for each country? We tackle these and many other questions
in the present paper.
The rest of the paper is organized as follows: Section 2 describes the origins
and the two phases of the Greek crisis, the first which ended in late 2013 -
early 2014, and the second which began in January 2015 and is still with us.
Section 3 describes the crisis in Cyprus and its particular special banking
roots. Then, armed with the knowledge of what actually took place in the
two countries, Section 4 compares the experiences in the two countries
from the time markets denied them access and, hence, the countries were
forced to ask for official help, until today. The analysis flushes out a
number of interesting differences as well as similarities and thus digs
deeper into true causes of the crises. The comparison enables the reader to
form an informed opinion on the correct policy recipe for each country.
We provide our own recipe in Section 5, which also concludes.

1 The drop in Cyprus is from €22,535 in 2011, to €20,966 in 2016, and in Greece from €21,386
in 2009 to €16,123 today. (Source: AMECO data base).
 5

2. The Two Phases of the Greek Crisis

2.1. Macroeconomic imbalances pave the way for the crisis
The Greek economic crisis began when the international financial crisis
was tapering off. It dates back to October 2009 when a newly elected
government discovered the country’s on-going fiscal deficit was three
times its earlier forecast, a few months earlier. The eventual – finally
revised - deficit number for 2009 turned out to be €36.0bn or 15.2% of GDP.
The size of the deficit was 38.9% of the size of total revenues, an
unprecedented amount by any previous historical standard. Naturally, it
shocked everybody: the European politicians at the Eurogroup, who were
supposed to be looking over any aberrations over 3% of GDP, the rating
agencies which were previously placing Greece in one of their best credit
risk categories, A-, and of course, the markets, which were pricing Greek
government bonds quite close to the Bunds. The respective spread in 10-
year yields at the end of September 2009 was only 130 basis points (i.e.
1.3%).
Fiscal deficits in Greece were getting larger since 2006, but had escaped the
attention of markets, perhaps because the debt-to-GDP ratio had not been
affected. Although the nominal size of debt was rising, nominal GDP was
rising equally fast, keeping the debt to GDP ratio more or less constant in
the neighborhood of 100%.
In late 2009, the fiscal imbalance was not the only macroeconomic problem.
The current account was also in deficit, at 12.3% of GDP, showing that the
country was not in a position to export goods and services of equal value
as the ones it imported, primarily for its domestic consumption. Again, this
deficit was consistently present for a number of years, revealing a deeper
problem of lack of competitiveness. For some time, the country was
consuming beyond its means, that is, beyond its ability to produce. And
this over consumption was made possible through borrowing, which
markets were willing to amply provide at very low interest rates.
The lack of competitiveness had already showed up in cost competiveness
indices and other globally followed indices, like the Word Bank’s Doing
Business Index. Greece was ranked 96th among 181 countries in the Index,
while at the same time the OECD average ranking was at 31 (World Bank
(2008)). Yet the warning signals of those indices were consistently being
ignored as the country was growing fast, with an average rate of growth of
3%, the second highest in Europe after Ireland. Since 1992, growth was
uninterrupted and even accelerated after the country made a serious effort
to eventually join EMU in 2001. Thus, in an environment or rising living
standards, no one paid serious attention to economic imbalances, which
were always being justified. The over-consumption and over borrowing,
6

for example, were being explained away as a rational response to the

expected future upcoming higher national income, which the EMU
participation would bring (Blanchard & Giavazzi (2002), Lane (2012)).

2.2. Phase I of the crisis

In late 2009, when the fiscal imbalance became visible, Phase I of the Greek
crisis began. The rating agencies began downgrading the country and by
April 27, 2010, Standard and Poor’s had already cut Greece’s credit rating
to speculative grade status. Bond yields began rising as well. Soon worried
bond investors would refuse lending the Greek government any money at
all. A sudden stop of imports for lack of cash was precluded only after the
intervention of the remaining EMU countries, which rushed to prevent a
Greek default by putting aside the so called “no bail out” principle.
In May 2010, Greece signed a set of bilateral agreements with other EMU
countries for an €80bn loan plus another €30bn Stand-By-Arrangement
(SBA) with the IMF. The loans were planned to be disbursed over a period
of three years, i.e. until the time Greece was expected to be in a position to
access international financial markets at reasonable borrowing rates. The
loans were accompanied by a Memorandum of Understanding (MoU) –
what later became known as the first economic adjustment program for
Greece – on specific economic policy conditionalities, which described the
actions Greece would have to undertake in order to bring its finances back
to balance, reform its economy and ensure its financial system remains
stable and healthy (IMF (2010), European Commission (2010)). The loan
money would be provided in installments after Greece would show
conformity to those actions.
The subsequent fiscal contraction caused a bigger recession than
anticipated. Almost 14.1% of real GDP was lost within three years (2009-
2011) and the unemployment rate skyrocketed from 8.4% on an annual
basis at the end of 2007 to 17.9% at the end of 2011. The size of the fiscal
multiplier had been underestimated (Blanchard & Leigh (2013), IEO
(2016)), partly due to misjudgment, partly due to a punishing attitude by
the Europeans and partly due to a credit crunch since 2009. Greek
politicians also proved reluctant to fully carry the reforms they had signed
to do. Lenders also pushed labor market reforms prior to product market
reforms. This made the recession a lot worse, as product prices did not
adjust downward immediately, and the drop in nominal wages was
translated into a bigger drop in real incomes and domestic aggregate
demand.
By 2011 the large recession, together with the continuing – yet lower –
fiscal deficits, were pushing the debt – to – GDP ratio way up to
 7

unsustainable levels. This brought calls for a debt haircut, which

eventually took place in February 2012, through the so called Private
Sector Involvement. Outstanding government bonds and loans were
swapped for new bonds. Essentially, bond holders received cash EFSF
bonds (of maturity up to two years) for 15% of the old face value and
bonds that matured over a twenty year period from 2023 to 2042 for 31.5%
of the old face value (Zettelmeyer et. al. (2013)). In present value terms,
old bondholders lost about 78% of their investment (Bank of Greece
(2012)). One class of such investors was the domestic Greek banks, which
had not been affected by the earlier international crisis, but now their
capital base was completely wiped out. They were thus recapitalized
mainly with public funds, with money which originated from a new,
second, lending arrangement with the same official creditors.
The second economic adjustment program was signed together with the
agreement on the PSI in February 2012. At the time, only €73.0bn of the
original €110bn from the first economic adjustment program was lent out
to Greece.2 The new second loan extension amounted to another €164.5bn
loan (with the EFSF and IMF contribution at €144.7bn and €19.8bn
respectively (IMF (2012))), on top of the money that had already been
disbursed. And €48.8bn of that amount together with another €1.2bn from
the first rescue program, thus a total of €50bn, was earmarked for the
needs of the banking system. The new European funds came from the
newly created European Financial Stability Fund (EFSF), the predecessor
of the current European Stability Mechanism and would cover borrowing
needs until the end of 2014. The IMF also extended its earlier SBA for four
years, up to March 2016. This second program was based on a forecast of
positive growth past 2014 (real GDP target for 2014 at 2.5%) plus the
optimistic assumption that the debt-to-GDP ratio would decline to 120%
by year 2020. The new conditionalities were a lot more detailed than those
of the first program, as lenders decided to micro-manage the necessary
reforms (IMF (2012)).
Greek banks went through two recapitalizations, in 2013 and in 2014. In
the first, most of the capital came from the borrowed public funds, which
resulted in a de facto nationalization of the Greek banks. In 2012 many
banks were sold to healthier ones and the banking system was
consolidated into essentially four systemic banks (Bank of Greece (2012)).
Yet the continuing recession in 2013 and the rising non performing loans
by companies and individuals, forced a second bank recapitalization in
early 2014. This was accomplished entirely with private funds, as the

2 Under the first economic adjustment programme for Greece, the Euro-area member states
disbursed to Greece €52.9bn and the IMF €20.1bn (European Commission (2012)).
8

economy had stabilized and the new investors were forecasting a brighter
future for the banking sector (HFSF (2015)).
Indeed, as year 2014 was moving along, the economy showed signs of
revival. Economic sentiment was rising, new FDI had surpassed its
previous pre-crisis peaks, investment in machinery and equipment became
positive after years of decline, unemployment began declining and
privatizations picked up momentum. Gross domestic product rose in 2014
by 0.6% and was forecasted to rise further to 2.7% in 2015. The government
was even able to access the markets twice and issue a 5-year bond in April
with a coupon of 4.75% (yield 4.95%) and a 3-year bond in July with a
coupon of 3.375% (yield 3.5%).
The budget for 2015, which was submitted to Parliament in November
2014, was balanced, as it forecasted a primary surplus of 3% of GDP, equal
to the interest expenses. Furthermore, in the fall of 2014, when the newly
formed Single Supervisory Mechanism (SSM) conducted the first European
wide asset quality review and stress tests, it found the Greeks banks in its
dynamic scenario as adequately capitalized all the way to the end of 2016
(ECB (2014)).

2.3. Phase II of the crisis

At the end of 2014, as the economy was picking momentum, Greece was
ready to leave the lenders’ bailout program, like Ireland and Portugal had
done before. The government had already secured an Enhanced
Conditions Credit Line (ECCL) from the Europeans with €11bn unused
bank recapitalization funds. Another €13bn of unused IMF money was
soon to be added to that pool. The credit line would serve as a safety pool
in 2015 and later, in case the country had trouble accessing the markets.
And at that moment, debt was perceived as sustainable. The IMF, which
in the past had expressed reservations, now had come out strongly,
claiming that the public debt was on a sustainable path (IMF(2015)). In
addition, further debt relief measures were already under discussion
according to the November 2012 agreement (Eurogroup (2012),
Strupczewski (2014)).
The optimistic expectations of 2014 were subsequently cut short by a new,
inexperienced coalition government of left-wing (the majority) and right
wing (the minority) populists, who came to power following the snap
elections in late January 2015. They had essentially promised a magic
wand would solve all problems. But reality slowly crushed the illusion that
there was another – easier - way of reinstating the lost living standards,
which earlier politicians had presumably failed to deliver.
 9

The new government caused the economy to stall, thus bringing Phase II
of the crisis. It ignored the economy’s supply side and the need for
continuing reforms and, instead, wrongly focused on a possible nominal
debt haircut. It followed a very naïve confrontational strategy with the
lenders, attempting to bring the negotiating clock for debt relief back to
2010. It thus deprived the economy of the necessary cash installments and
forced the ECB to decline cheap funding to the Greek banks (ECB (2015a))
just one week after the elections. Greece was subsequently exempted from
the ECB’s Public Sector Purchase Programme (PSPP), the quantitative
easing (QE) that started in March 2015 (Claeys et al (2015)). The earlier
expected smooth exit from the rescue program, which had been
orchestrated with great care back in 2014, was destroyed. State arrears
went up to €6.1bn, drying up liquidity of the private sector, while €7.6bn
were squeezed out of the state entities’ cash buffers.
The erratic and experimental policy of the first half of 2015 created fear and
anxiety in the population, who gradually pulled about €45bn from the
banks or 25% of their deposits. Economic sentiment fell drastically,
splitting away from its earlier European trend, the flow of new
investments stopped and the economy froze. Everybody was kept on hold,
essentially searching for survival in an environment of uncertainty of what
the next day would bring. And capital controls were put in place in late
June 2015 to prevent further deposit drainage, thus dealing another blow
on the private sector and on exports (Gogos and Stamatiou (2015)).
By mid-year 2015 the economy was in front of imminent collapse, so the
penniless Greek government finally woke up to the danger, yet chose to go
through a political gimmick of calling a yes or no referendum for July 5th
for agreeing with a new rescue program, which would include further
austerity measures. The government openly favored the No vote on a
presumably lenders’ program. 3 A referendum on fiscal matters is
unconstitutional in Greece for obvious economic reasons. It nevertheless
took place.
The population objected to new austerity and delivered a No vote with
61.31% majority (Yes vote at 38.69%). Yet, despite the overwhelming No
vote, which the government itself had openly supported, within three days
after the referendum the government switched its policy by 180 degrees. It
was dragged to accept even stricter conditions than it had negotiated three
weeks earlier, and a specific third rescue program for 2015-2018, for
otherwise it faced “Grexit.”Under the third economic adjustment
programme for Greece, an amount of up to €86bn would be lent to Greece
(ESM (2015a)).

3 Yet the Government had previously agreed to more than 90% of its content.
10

New elections were soon called for September of 2015 as the policy switch
and the third program created waves of departures within the leftist party
of SYRIZA, the major coalition partner. Many of its members objected to
the earlier “surrender” and the third rescue package and openly called for
Grexit. The September elections brought again the same coalition of left-
wing SYRIZA with right-wing ANEL to power. Apparently, the
population had not yet absorbed the deeper causes of the new negative
Phase II economic shock and what had actually happened during the first
eight months of 2015, and thus gave the earlier government the benefit of
doubt and a second chance. At the same time, the previous SYRIZA
“Grexiteers” did not manage to muster 3% of the popular vote and thus
failed to enter the Greek Parliament, which shows that despite the pain,
the Greek population continued to perceive participation in EMU as an
anchor of long-term economic and political stability.
The reversal of economic fortunes in 2015 has created an annual loss of
about €14bn in real GDP relative to earlier forecasts. Now the economy is
expected to be at 76% in 2017 of where it was back in 2007, instead of being
at 82%, as was expected back in 2014. 4 Moreover, Crisis-Phase II has
added to Greek nominal debt approximately another €40bn. To see the
latter, observe what happened to only one item, the value of State holdings
in Greek banks. The new recession in 2015 took a heavy toll on bank stock
prices, which fell to almost zero by the fall, creating a loss of close to €25bn
for the State. 5 Banks’ capital base also shrank from new losses originating
from a new generation of rising non-performing loans. The SSM
performed a new AQR and new stress tests on the Greek banks, one year
before the scheduled time for all European banks. New capital needs of
about €14.4bn were discovered (ECB (2015b), ESM(2015b)). A third
recapitalization took place in November 2015, in which two of the four
systemic banks failed to find all the necessary funds from the private
sector. The other two are now completely in private hands, with the State
owning a very small percentage of the outstanding shares.
By the fall of 2016, the economy remains in recession and non-performing
loans continue to rise. Non-performing exposures, which include some of
the restructured loans and are higher than NPLs, have jumped up by ten

4 Authors’ calculations.
5 Among other items, the most prominent is the foregone primary surpluses for three years
in a row, which add to the nominal debt ca €22bn based on the IMF(2014) and IMF(2016)
projections. Ironically, the current Greek government considers this loss as a gain because
it was not forced to take restrictive measures! Yet, the surpluses would be naturally
generated by a growing economy, without any new fiscal measures, had the new 2015
government continued on the earlier policies.
 11

parentage points relative to 2015 and are now in the vicinity of 50%. And
on their liability side, banks are unable to bring back, but very little of the
lost deposits. Their dependence on Eurosystem borrowing and on the
expensive ELA remains high, although ELA is on a declining path as the
stock of loans on the asset side of their balance sheets to be financed is
declining.
By the end of October 2016, the government did manage to close the first
review of the 3rd rescue program with a one-year delay and now is trying
to expedite the second review. Government arrears to the private sector
are declining – thanks to tailor made European funding, and some
liquidity has come back to the system. Yet economic policy is heavily
leaning on new higher taxes, which are bound to trap the country in a low
growth trajectory over the long term.
Consensus private forecasts for 2017 by foreigners point to an exit from the
recession and a positive growth rate of 1%, while official forecasts are
higher, at 2.7%.6 The IMF’s official forecast assumes that substantial debt
relief is coming soon (IMF (2016a), (2016b)), and that the country would be
able to join ECB’s Quantitative Easing program after its debt would be
deemed sustainable. The Greek government is hoping and betting on
achieving both.

3. A Banking Crisis in Cyprus

The crisis outbreak in Cyprus took place in March 2013, almost three years
after the outbreak of the Greek crisis and was different in nature.
Although it shared with the Greek crisis similar earlier disequilibria, like
fiscal deficits, declining competitiveness, or a real estate bubble, it was
nevertheless mainly a banking crisis. 7 The earlier macroeconomic
imbalances were not as big as the Greek ones, yet they were sufficient to
cause an upheaval, given the on-going European crisis. Prior to March
2013, the key external events that had shaped Cyprus’ most recent
economic history were the entrance into the European Union in 2004, the
membership in the European Monetary Union in 2008, the post 2008
international and subsequent Greek and European crisis, as well as the
Mari accident in 2011.8

6 According to Focus Economics (2016b) the consensus 2017 real GDP forecast was at 1.1%
in October 2016, down from 1.5% in January (Focus Economics (2016a)).
7 Clerides (2014) discusses the nature of the Cypriot crisis and emphasizes that the crisis in

Cyprus is not only a banking crisis.

8 For an overview of the Cypriot crisis and its different aspects, see also Hardouvelis (2016),

Michaelides (2016), Orphanides (2016), Xiouros (2016), and Zenios (2016).

12

The bank bail-in of March 2013 was shocking, yet Cyprus managed to
absorb it and subsequently recover slowly. Below we first describe the
events that led to the Cypriot crisis of 2013 and then analyze the economic
adjustment program and the overall successful response to the crisis from
2013 on.

3.1. Early vulnerabilities up to the international financial crisis

A natural point to begin the discussion is 1999, when EMU was formed.
Since then, and until the end of 2007, when the international crisis gained
momentum, Cyprus enjoyed uninterrupted economic growth. The average
rate of growth was 3.9%, the average unemployment rate at 4.3, the
average fiscal balance at -2.7% of GDP – just below the EMU requirement
of -3% - and the public debt – to – GDP ratio at 64%, close to the long-term
EMU target of 60%. Yet, economic vulnerabilities were building up.
Competitiveness was declining, the real estate sector was over-heated and
the size of the financial sector was growing bigger, becoming a huge
multiple of the country’s size (Hardouvelis (2016)).

The gradual deterioration in competitiveness can be seen in a number of

indicators. The real effective exchange rate, which measures how
expensive are a country’s products in terms of labor costs, had deteriorated
by 15%since 1999. The current account balance, which measures the ability
of the country to export goods and services relative to its corresponding
imports, had deteriorated from a small deficit of less than 1% of GDP in
1999 to an overwhelming 11.8% deficit in 2007. The country was obviously
living beyond its means and the high growth was being financed mostly
by external borrowing. 9 During the same time, the rise in domestic
demand caused a simultaneous real estate bubble. By 2007, housing prices
had gone up 80% since the year 2000 and continued increasing, peaking in
2009 at 230%. The increase was sharper than in Spain, Greece, Italy or
Portugal.

During the pre-crisis years the Cypriot banking system comprised of four
distinct types of banks: the domestic commercial banks (Bank of Cyprus,
Cyprus Popular Bank, Hellenic Bank), accounting for around 60% of total
assets, the subsidiaries of Greek commercial banks, the co-operatives, and
the international banking units. The total Cypriot banking sector grew to
become one of the largest in the EU-27. Total assets jumped from €61bn in
2005 to €155bn in 2010. The expansion was even more remarkable if

9 Some of the financing also occurred because of FDI, for example, by the inflow of foreign
capital in order to buy real estate. Some of the financing represents foreign deposits in
domestic banks, yet this is still borrowing.
 13

viewed as a percentage of GDP. According to ECB data, total banking

assets exceeded 800% of GDP in 2010 and remained at 640% of GDP at the
end of 2012, twice as much as the Euro Area average (Figure 1). 10
FIGURE 1
Total Banking Sector Assets
(%GDP)
900
800
700
600
500
%GDP

400
300
200
100
0
2008 2009 2010 2011 2012 2013 2014 2015

Source: ECB, National Statistics.

While a large banking sector does not automatically imply instability, it

does become a potential vulnerability (IMF (2010)). 11 This is because any
mistake in bank management, which results in losses to stockholders
beyond their ability to absorb them, can easily spill over to the rest of the
economy and would effectively get multiplied when it reaches the pocket
of the average Cypriot taxpayer. This is because there are relatively few
taxpayers for the huge balance sheets the Cypriot banks manage. In
addition, banking activity in Cyprus was not focused exclusively on
foreigners. It also facilitated domestic enterprises and households. The
size of borrowing by the private sector in Cyprus was overwhelming. At
the end of 2007, corporate debt stood at 96.9% of GDP and went up to
139.2% in 2012, while household debt at 101.4% of GDP and went up to
134.8% at the end of 2012. Hence, the financial sector vulnerability easily
morphs into an overwhelming financial risk once a negative financial
shock occurs, like it did in early 2013.

10 We use data from ECB and HBA.

http://www.hba.gr/4Statistika/UplPDFs/eubankingstructures2007en.pdf
http://www.hba.gr/4Statistika/UplPDFs/eubankingstructures2008en.pdf
11 http://www.imf.org/external/np/ms/2010/070510.htm.
14

3.2. Additional post-2007 risks

After 2007, an abrupt regime shift occurred both in the rate of economic
growth and in economic policy. The international financial crisis and the
subsequent euro area crisis had a profound negative impact on Cyprus.
While the earlier vulnerabilities continued (i.e., the current account
continued the earlier worsening trend, while the banking sector and
private leverage kept growing), over the next five years from early 2008 to
late 2012, the average growth fell to 0.2% and the annual average
unemployment increased to 11.8% in 2012 vs. a multi-year low of 3.7% in
2008. Moreover, fiscal policy became extremely expansionary to a degree
that was not justified as a natural countercyclical policy response to the
stress caused by the economic crisis (Hardouvelis (2016)). 12
The new 2008 AKEL government of President Christofias seems to have
followed a reckless expansionary fiscal policy, while it did very little to
address the earlier vulnerabilities. Figure 2 tracks the primary fiscal
balance from 2004 to 2016 as well as the debt-to-GDP ratio. The switch
from a primary surplus of 6.0% of GDP in 2007 to a primary deficit of 3.1%
in 2009 is quite striking. This deficit continued in the following years,
raising the public debt-to-GDP ratio from 44.7% in 2008 to 79.3%in 2012. 13
A second new risk was the sudden drop in investment activity. From 2007
to 2012, the ratio of investment to GDP dropped from over 20% to just over
10%. This drop cannot be blamed entirely on the real estate sector. It still
persists today, and may negatively affect the supply side of the economy
for many years into the future.
The financial sector also became more vulnerable. The rapid deterioration
in the macro outlook of Greece resulted in increasing NPLs for banks. In
December 2011, the domestic banks’ direct loan exposure to Greece
amounted to €21.8bn or 126% of Cypriot GDP. The ratio of NPLs from
their Greek operations worsened to 42% of their loan portfolio. More
importantly, Cypriot banks suffered huge losses to their holdings of Greek
government bonds. The PSI severely hit the capital base of the two main
leading banking institutions, Cyprus Popular Bank (CPB) and Bank of

12 Hardouvelis (2016, pp. 235-236) compares all EU 27 countries and shows that given its
cyclically adjusted primary fiscal balance of 2007 of +5.5% of GDP, Cyprus in 2009 ought
to have had a cyclically adjusted primary surplus of +1.7% of GDP. Instead, it had a
deficit of -3.9% of GDP. Cyprus fell in the ranking by 23 places among the 27 countries,
indicating a switch to enormous fiscal laxity from 2007 to 2009.
13 Including the €1.9bn capital injection to Laiki Bank by the State in June 2012.
 15

Cyprus (BOC). The European Commission estimates that the PSI cost
Cypriot banks €4.5bn or 20% of GDP.14

FIGURE 2
The fiscal position of Cyprus 2000-2015
120% 8%
General Government
Primary Balance (Right, %
100% of GDP) 6%
Gross Public Debt (Left
Axis, % of GDP)
80% 4%

60% 2%

40% 0%

20% -2%

0% -4%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Note: ESA2010 terms, not including bank recapitalization costs.

Source: Cystat.

Markets for a long time were comfortable in holding Cypriot Government

Bonds (CGBs) with yields that were smaller than even the corresponding
Irish ones. Then the discussions on a prospective PSI in Greece slowly
pushed yields up in May and June of 2011. And suddenly, the Mari
accident in July 2011 – which destroyed over half of the power supply of
Cyprus, brought an immediate recession and alerted everybody to the
possible risks in Cyprus. Cypriot yields increased further. The rating
agencies also began downgrading Cyprus and by January 13, 2012,
Standard & Poor’s had bought its rating down to below investment grade.
The others followed soon, with Fitch being the last to grade Cyprus below
investment grade on June 25, 2012.

14 EU Commission,European Economy, Occasional Papers 101, Macroeconomic Imbalances-

Cyprus, July 2012.
16

3.3. The 2013-2016 economic adjustment program

Cyprus went through a long process before agreeing to a rescue program.
It first applied for rescue in June 2012 but signed up an eventual program
in March 2013. In the mean time Cyprus held the Presidency of the
European Union and went through Presidential elections. Table 1 presents
the chronology of events before and after the rescue program.
A major feature of the rescue program was the bail-in of depositors and the
profound restructuring of the domestically supervised part of the banking
sector. The program was designed to downsize the domestically
supervised sector. Immediate actions took place, including the resolution
of CBP (Laiki bank) and the sale of Greek branches of Cypriot banks to
Bank of Piraeus. The sector shrank from 750% of GDP15 in 2012 to 420% in
2015. The current size is lower than in other well established hubs and
closer to the EU-average. The bail in of uninsured depositors was deemed
necessary in order to ensure debt sustainability. The total cost of the bail in
came at 9.4bn Euros, most of which was incurred by non-residents.
Subsequently, the conversion of deposits to equity, the additional capital
injections initiatives from private investors and the use of program funds
for the co-operatives, brought the core Tier I capital ratio from 4.5% in Q4-
2012 to 16.5% in Q4-2015.
As part of the conditionality underlying the agreed bailout package,
Cypriot authorities also committed to restrict fiscal policy and implement a
number of policy initiatives with the view of facilitating the process of
internal devaluation and increasing the efficiency of the Cypriot economy.
Indeed, Cyprus has performed an impressive adjustment in 2013-2014,
outperforming initial targets. A general government primary surplus of
2.6% of GDP in cash terms was already achieved in 2014, two years ahead
of schedule vs. a primary deficit of -1.8% in 2013 and -2.9% in 2012.
Accordingly, the general government deficit reached a balanced position in
2015.

15 This number includes also the Greek operations of the Cypriot banks, which may not be
reflected in the ECB data.
 17

TABLE 1
Time line of the Crisis in Cyprus
Jan 1st, 2008 Cyprus enters EMU
Feb 17th, 2008 First Round of Presidential Elections in Cyprus
Feb 24th, 2008 Run off round between DISY candidate Kasoulidis and AKEL candidate Christofias. Christofias elected
President with 53.36% of the vote
Jan 13th, 2011 Moody’s places Cyprus on negative watch for the first time
Jan 17th, 2011 Fitch places Cyprus on negative watch for the first time
Feb 24th, 2011 Moody’s downgrade to A2
Mar 30th, 2011 S&P downgrade to A-
May 16th, 2011 Moody’s places Cyprus on negative watch again
May 31st, 2011 First Fitch downgrade to A-
July 11th, 2011 Ammunitions explosions in Naval Base Mari. 50% of the power generation capacity is destroyed
July 27th, 2011 Moody’s downgrade to Baa1
Oct 27th, 2011 EU leaders summit decision on 50% haircut on Greek public debt
Aug 10th, 2011 Fitch downgrade to BBB
Nov 4th, 2011 Moody’s downgrade to Baa3
Dec 16th, 2011 Fitch places Cyprus on negative watch again
Jan 13th, 2012 S&P downgrade to BB+, the first rating agency to rank Cyprus below investment grade
Jan 27th, 2012 Fitch downgrade to BBB-
Mar 13th, 2012 Moody’s downgrade to below investment grade (Ba1)
May 3th, 2012 Panicos Dimitriades took office as the new Central Bank governor to replace Orphanides
Jun 13th, 2012 Moody’s downgrade to Ba3
Jun 25th, 2012 FITCH downgrade to BB+, below investment grade
Jun 25th, 2012 Cyprus application to ESM
Jul 1st, 2012 Begins Cyprus Presidency of the European Union Council
Jul 25th, 2012 Troika submitted the terms of the bail-out program for Cyprus. The Cypriot government expressed
disagreement over those terms and continued negotiations with Troika
Sep27th, 2012 Central Bank of Cyprus commissions PIMCO to carry out the an independent due diligence exercise
18

Nov16th,2012 Moody’s downgrade to B3

Nov21st, 2012 FITCH downgrade to BB-
Nov22nd, 2012 Statement on the European Commission website on behalf of Troika claims progress towards agreement on
key policies of a macroeconomic adjustment program
Nov 30th, 2012 Christofias administration announced agreement reached with Troika on bail-out terms with only the financial
sector package pending
Dec 13th, 2012 Euro-Group statement took notice of the progress made at the staff level
Jan 10th, 2013 Moody’s downgrade to Caa3
Jan 25th, 2013 FITCH downgrade to B
Feb 17th, 2013 First Round of Presidential Elections in Cyprus
Feb 24th, 2013 Run off round between DISY candidate Anastasiades and AKEL candidate Mallas. Anastasiades elected
President with 57.48% of the vote
Feb 28th, 2013 Anastasiades administration is sworn in
Mar 15-16th,2013 First Euro-Group: agreement to impose a levy on all (insured &uninsured) depositors (6.7%<100,000
9.9>100,000 to collect €5.8bn) in all banks- Capital controls imposed
Mar 19th,2013 Parliament rejects the bank levy bill, part of the bail-out agreement conditionalities, with a majority of 36 MPs
against, 19MPs abstained, 1 absent
Mar25th,2013 Second Euro-Group: agreement to bail-in the uninsured depositors of Laiki and Bank of Cyprus only, resolve
Laiki and fold the good bank into Bank of Cyprus. Program money will not be utilized to recapitalize the
domestic banking sector except for a provision of 1.5bn for Co-operative sector.
Mar 26th,2013 Fitch places Cyprus on negative watch again
Apr 2-3rd,2013 Michalis Sarris resigns from the post of Minister of Finance; Harris Georgiades appointed Minister.
Apr 24th,2013 ESM Board of Directors grants stability support to Cyprus
May 13th,2013 ESM disbursement of €2bn in cash
Jun 3th,2013 FITCH downgrade to B-
Jun 26th,2013 ESM disbursement of €1bn in cash
Jun 28th,2013 Interim report of the Independent Commission on the future of the Cypriot banking sector
Jul 9th-15th, 2013 ESM disbursement of €600mn & €100mn in cash
Jul 30th, 2013 Bank of Cyprus exit from resolution status, recapitalized with 47.5% conversion of uninsured deposits to equity
July 31th, 2013 Staff teams from the Troika visited Nicosia during July 17-31 for the 1st quarterly review
Aug 8th, 2013 Ministry of Finance announcement on a capital restrictions roadmap removal in agreement with official lenders
 19

Sep 5th, 2013 IMF appoints a resident representative in Cyprus

Sep 10th,2013 General Meeting of the new shareholders in Bank of Cyprus convenes to elect a new Board of Directors
Sep 12th,2013 Cyprus and Russia agreement on the restructuring of the 2011 bilateral €5bn loan
Sep 16th,2013 IMF Completes First Review Under EFF Arrangement and Approves €84.7 Million Disbursement
Sep 27th,2013 ESM disbursement of 1.5bn in floating rate notes
Nov 7th,2013 Staff teams from the Troika visited Nicosia during October 29-November 7 for the 2nd quarterly review
Dec15th-19th,2013 ESM disbursement of 350mn &100mn in cash
Dec20th,2013 IMF Completes Second Review Under EFF Arrangement for Cyprus and Approves €83.5 mn Disbursement
Feb 11th,2014 Staff teams from the Troika visited Nicosia during January 29-February 11 for the 3rd quarterly review
Mar10th-11th, 2014 Panicos Dimitriades resigns from Governor-Chrystalla Georghadji announced as successor
Mar 28th, 2014 IMF Completes Third Review Under the EFF and Approves €83.3mn Disbursement
Apr4th,2014 ESM disbursement of 150mn in cash
Apr 25th,2014 S&P upgrade to B
May 17th,2014 Staff teams from the Troika visited Nicosia during May 6-17 for the 4th quarterly review
Jun 30th,2014 IMF Completes Fourth Review Under the EFF for Cyprus and Approves €84mn Disbursement
Jul 25th,2014 Staff teams from the Troika visited Nicosia during July 15-24 for the 5th quarterly review
Jul 29th,2014 Successful €1bn rights issue of Bank of Cyprus with the participation of EBRD and Wilbur Ross
Sept 6th,2014 The Parliament endorsed the foreclosure bills with a majority of 47 votes and 7 against
Oct 24th,2014 S&P upgrade to B+
Oct 25th,2014 IMF Executive Board Concludes the 2014 annual Article IV Consultation with Cyprus
Oct 26th,2014 Announcement of the comprehensive SSM assessment results of four systemic Cyprus banks
Nov 14th,2014 Moody’s downgrade to B3
Feb 6th,2015 Staff teams from the Troika visited Nicosia during January 27-February 6 for the quarterly review (no staff
level agreement was reached given the suspension of an effective application of the foreclosures framework)
Apr 06th,2015 Full lift of capital controls
Apr 18th,2015 The Parliament endorsed the insolvency framework bills with a majority of 33 votes and 23 against
Apr 26th,2015 Election of Mustafa Akinci in the post of Turkish-Cypriot leader
May 20th, 2015 Based on the recent Troika visit in the island staff-level agreement has been reached on policies that could serve
as a basis for completion of the pending reviews.
Jun 19th,2015 IMF Completes Fifth, Sixth & Seventh Reviews of Cyprus’ EFF and Approves €278.4 mn Disbursement
Jul 27th,2015 Staff teams from the Troika visited Nicosia during July 14-24 for the 8th quarterly review
20

Aug 15th,2015 CYSTAT announced the flash estimate of Q2-2015 which showed the second positive QoQ growth
Sep8th,2015 S&P upgrade to BB-
Sep23rd,2015 IMF Completes Eighth Review of Cyprus’ EFF and Approves €126mn Disbursement
Sep 25th,2015 S&P upgrade to BB-
Oct10th,2015 ESM disbursement of €500mn in cash
Oct23th,2015 FITCH upgrade to B+
Nov15th,2015 Moody’s upgrade to B1
Nov16th,2015 Staff teams from the Troika visited Nicosia during November 3-13 for the 9th quarterly review
Jan27th,2016 IMF Completes Ninth Review of Cyprus’ EFF and Approves €126.3mn Disbursement
Mar7th, 2016 Ministry of Finance asks IMF for the early termination of EFF arrangement & Euro-Group supports Cyprus
graduation from the economic adjustment program. The last prior action of the completion of the review
(CYTA corporatization) was not satisfied
May22nd, 2016 Parliamentary elections: The ruling right-wing party DHSY gained 37.6% (18 seats), the main opposition left-
wing party AKEL gained 25.7% (16 seats), and DHKO gained 14.5% (9 seats)
Sep16th, 2016 S&P upgrade to BB
Oct21st, 2016 FITCH upgrade to BB-
 21

Cyprus has made the fastest come-back to international markets among

other Euro Area program countries, tapping the markets three times (June
2014, April 2015 and October 2015). This is due to its enhanced credibility.
Since March 2013, Cyprus completed successfully nine reviews according
to the IMF disbursement schedule and seven reviews according to the ESM
schedule.16 Cyprus ended up borrowing only about €7.3bn out of a total
€10bn available under the program. The ESM disbursed a total of €6.3bn,
complemented by another €1bn by the IMF. Cyprus’ graduation from the
program was finalized in the Eurogroup of March 7, 2016. The Eurogroup
praised the authorities for the high degree of ownership and their
important achievements and approved their decision to exit the economic
adjustment program. 17 Later on, Cyprus also graduated from its IMF
program as well.
Macroeconomic outcomes came out better than expected in the initial and
revised program forecasts. The recession of 2013-2014 turned out milder
than expected. The cumulative output losses amounted to 8.3ppts vs.
13.5ppts in the program. The full year contraction of 2013 came at -5.4% vs.
-8.7% in the initial program forecast. The full year contraction of 2014 came
at -2.5% vs. an initial forecast of -4.8% (in May 2013). The rebound of 2015
also surprised to the upside. The initial program forecast stood at +1.1% in
2015 and then official lenders even revised it downwards in the next
reviews: In the 4th review in May2014, the forecast of 2015 had been
lowered to +0.4%). In year 2015, GDP growth posted the first positive
growth reading after a three year recession. GDP growth expanded by
+1.6% YoY, compared to -2.5% YoY in 2014, -5.9% YoY in 2013 and -2.4%
YoY in 2012.
A large part of the better than expected performance stems from the fact
that the wealth effect of the bail-in and the spill-over effects to the domestic
economy were widely overestimated. From a demand point of view,
private consumption remained resilient as both consumers and corporates
used part of their precautionary savings to smooth out consumption plus
the bail-in affected primarily foreigners. On the supply side, economic
activity in the sectors of tourism and professional services remained

16 The last ESM review (the 8th) is not considered to have been completed successfully.
17http://www.esm.europa.eu/pdf/2016-03

07%20Eurogroup%20statement%20on%20CY.pdf
The Eurogroup also noted that the last prior action of the last program review with respect
to the approval from the parliament of the corporatization of CYTA-the telecom public
utility-has not been satisfied. Yet this did not preclude Cyprus’ graduation from the
program.
 22

relatively resilient as both of them are less credit dependent but also more
extroverted and internationally competitive.
4. Crisis in Greece and Cyprus: A revealing comparison
4.1. Differences prior to the rescue package
Our earlier discussion revealed important differences between the two
countries in the factors which led to their respective crises. The first major
difference was the much larger fiscal and competitiveness imbalances in
Greece. This is shown in Figure 3, which depicts the original EMU
countries plus Cyprus, and illustrates the average fiscal (horizontal axis)
and current account (vertical axis) balances over the period from 1999,
when EMU was created, to 2009, before the start of the Greek and EMU
crisis. In both the internal and the external imbalance dimension, Greece
was a clear outlier among all EMU countries and carried double the
respective deficits of Cyprus.18 It follows that the required macroeconomic
corrections for Greece were twice as big, which naturally led to a much
worse recession.
FIGURE 3
Imbalances across the Euro Area
Current Account Balance % GDP, avg. 1999-2009

15
Twin Surpluses

10 LU

5 NL FI
DE BE
AT FR EA
0 IT
IE

-5 SP
CY

GR PT y = 1.48x + 2.535
-10 Twin Deficits
R² = 0.5096

-15
-8 -6 -4 -2 0 2 4
General Government Balance% GDP, avg. 1999-2009

Source: International Monetary Fund.

18 The crisis in Cyprus started three years later in 2012, hence the figure does not include
the large Cypriot fiscal deficits of that period. Yet, still those deficits were small in
comparison to the historical Greek ones.
 23

Table 2 presents in greater detail certain economic statistics that

characterized each country prior to its respective crisis. The table presents
three fiscal statistics (primary balance, general government balance, and
gross public debt), three competitiveness statistics (current account, Doing
Business indicator, and real effective exchange rate), and two financial
sector statistics (private sector indebtness and bank assets). Cyprus’ initial
conditions were better than those of Greece, except for the financial sector.
Differences in the financial sector present the second major difference
between the two countries. Cyprus was initially hit primarily by a banking
crisis, which was the result of the large indebtness of the private sector and
an oversized banking sector. In Greece, a banking crisis came much later as
a consequence of the earlier fiscal and competitiveness crisis and was
caused by the PSI and two waves of bank deposit withdrawals by the
population. In Cyprus, the banking crisis was felt immediately by the
population and its impact was abrupt. Yet, rectifying the problems of the
financial sector in Cyprus didn’t necessitate a large fiscal austerity, which
otherwise would have caused a bigger recession and may have led to
population unrest.
A third difference relates to the timing of the crisis, as the crisis in Cyprus
came three years after the crisis erupted in Greece. This difference in
timing had major implications. First, during the time interval between the
two countries’ crisis eruptions, Europe managed to develop adequate
defense mechanisms to protect the member states from an unwelcome
negative shock in any individual state or outside the Union. It created the
European Stability Mechanism and had empowered it with funds and
discretion to act. It had also employed a new architecture in fiscal matters
and had begun the process of a banking union. When the crisis erupted in
Cyprus, Europe was not worried about a possible contagion, the way it
had worried three year earlier when Greece entered a crisis phase. Thus it
could experiment with a bail-in process without having to worry about
possible irreversible negative consequences on the rest of EMU.
Second, the external economic environment was also different when the
crisis occurred in Cyprus. Europe had already recovered from the
international crisis, the recession was a somewhat distant memory and
sentiment was rising. Back in 2009, Europe was not yet over the
international crisis.
24

TABLE 2
Initial Conditions prior to the Crisis
Greece Cyprus
(April-May2010 (March2013)
or 2009) or 2012)
Primary Balance19
-10.3% -2.9%
(% of GDP)
General Government20
Balance -15.2% -5.8%
(% of GDP)
Gross Public Debt
126.7% 79.3%
(% of GDP)
Current Account21
-12.3% -6.0%
Balance (% of GDP)
Doing Business Distance
62.44
to Frontier22 69.1
(2010)
(best = 100)
REER
123.0 110.2
(ULC total economy
(2010Q1) (2013Q1)
deflated, 1999Q1=100)
Private Sector
Indebtness 116.8% 328.3%
(% of GDP)
Banks assets
212.7% 750%
(% of GDP)
Notes: Seven of the eight statistics above refer to full years 2009 for Greece and 2012
for Cyprus. The eighth statistic, the real effective exchange rate (REER), refers to the
end of the respective quarters 2010Q1 and 2013Q1. The most recent Doing Business
data for Greece and Cyprus are from Doing Business 2017. The earliest comparable
Doing Business series available for Greece are dated in 2010. In the Private Sector
Indebtness statistic, the numerator refers to the stock of liabilities (loans plus debt
securities) held by the non-financial corporate sector and households on an non-
consolidated basis, i.e. taking into account transactions within the same sector. The
GDP levels in the denominator of the last two financial sector statistics refer to 2009
for Greece and 2012 for Cyprus.
Source: Eurostat, ECB, National Authorities, World Bank Doing Business.

19 & 18 Without banking sector recapitalization costs (the Laiki Bank Recapitalization Bond of
2012).

21BPM6 definition.
22World Bank (Doing Business, Distance to Frontier definition): The distance to frontier
score aids in assessing the absolute level of regulatory performance and how it improves
over time. This measure shows the distance of each economy to the “frontier,” which
represents the best performance observed on each of the indicators across all economies in
the Doing Business sample since 2005. This allows users both to see the gap between a
particular economy’s performance and the best performance at any point in time and to
assess the absolute change in the economy’s regulatory environment over time as
measured by Doing Business. An economy’s distance to frontier is reflected on a scale
from 0 to 100, where 0 represents the lowest performance and 100 represents the frontier
 25

Both previous reasons made Cyprus worse off relative to Greece. But there
is also a third reason that made Cyprus better off. The difference in timing
benefited Cyprus in the sense of being knowledgeable about the potential
consequences of different responses to the crisis. Cyprus had the benefit of
hindsight, observing Greece and then Ireland and Portugal enter a crisis
and responding to it. Each of these countries had a different policy
response with their populations behaving differently. The Irish did not
strike as much against the austerity measures as the Portuguese or the
Greeks did, for example. Cypriots could observe and learn from the
different experiences.
Next to timing, a fourth difference originates from the type of political
parties that ran the two countries prior to their respective crises. Greece up
to September 2009 was run by New Democracy, a center-right conservative
party, whereas Cyprus was run by AKEL, a leftist communist party. The
economic consequences of this difference may not have been major,
however. A closer look at their respective economic policies prior to the
crisis reveals important similarities. They both followed expansionary
fiscal policies and generated huge budget and current account deficits,
which naturally aggravated the pre-existing domestic macroeconomic
imbalances.
A fifth important difference between the two countries relates to the speed
of concluding the negotiations for designing the rescue package. Greece
applied for a rescue package in April 2010 by a relatively new government
and within a month it had signed the MoU and the loan money was
flowing into the country. In the case of Cyprus, the negotiations for the
eventual rescue package prolonged for eight months and in the mean time
presidential elections took place and a change of President occurred.
Cyprus paid a huge penalty for that delay, as it ended up absorbing a
surprising eventual bail-in.
A final sixth difference prior to the rescue package is in the relationship
between the government and the central bank. In Greece there was
unanimity between the Prime Minister and the Central Bank governor
about the required policy responses. This was not the case in Cyprus.
President Christofias did not renew the appointment of Governor
Orphanides in May 2012 and later tried to cast the banks as the villain,
thus aggravating the country’s vulnerabilities.
Overall, prior to the rescue package, it seems Greece had tougher domestic
initial conditions, while Cyprus faced a more acrimonious external
environment and a less robust financial sector. Cyprus was also slow to
come to terms with the details of the rescue package.
26

4.2. Differences in policy responses

Policy responses to the crisis also varied between the two countries both
from the lenders’ and the borrowers’ perspective. In the beginning of the
crisis, Cyprus faced more aggressive lenders than did Greece, yet it
responded to its crisis more quickly and effectively.
Let us first examine the lenders’ perspective. Here lies a major difference.
Lenders imposed a bail-in on Cyprus in March 2013, whereas three years
earlier, in May 2010, they had bailed-out Greece without even any prior
bond haircut. A major argument for the Cypriot bank bail-in was the
savings to the Cypriot state and future tax payers. Europeans insisted that
Cypriot bank stakeholders be bailed-in in order to clean up the bank
balance sheets with own resources, thus saving future Cypriot tax payers a
debt burden of €4.9bn or approximately 25% of annual pre-crisis Cypriot
GDP of 2012. On the other hand, the bail-in costs were primarily allocated
to non-residents, hence softening the negative impact on domestic
consumption.
Let us now turn to the policy responses of domestic politicians in the two
countries. First, when it comes to program ownership, most Cypriot
political parties signed up to the program. Their differences in economic
policy were relatively minor.23 This political agreement – which contrasts
to what happened in Greece - filtered through to the population and,
unlike in Greece, society was not split into two groups, for or against the
MoU. Thus the political and social tensions were relatively moderate
despite the painful decisions. Cypriots showed great adaptability and
willingness to compromise their living standards thanks also to the
dramatic episodes in their post-war history, which may have shaped a
certain population psychology of sticking to each other at times of
adversity.
In Greece, the major political parties failed to agree on a minimum
common denominator. As a consequence, the Greek population remained
uneducated about the pre-existing economic imbalances. Most Greeks
never understood the true causes of the crisis, and many of them perceived
the MoU itself as the cause of their suffering, not that the MoU was there to
fix the economy, which itself had caused their troubles. This misconception
continues even today by many.

23 The Presidential political system in Cyprus also helps in reaching a more balanced and
consensus point of view. The President can decide on the execution of the economic
program and then try to find a majority coalition in the Parliament for the various
components of the program. The President can thus push a compromise solution among
the different political parties. The same compromise is harder to accomplish in the Greek
parliamentary system.
 27

Second, Cyprus has a relative well-functioning government sector and

high administrative capacity to carry out structural reforms. The
institutional and administrative capacity of Cyprus is very close to the EU
average, which implies that the executive body is in a relative favorable
position to carry out the necessary structural reforms. Table 3
corroborates this by presenting indices published by world-renowned
institutions on the quality of institutions. 24
TABLE 3
Quality of Institutions
Cyprus EA-18 Greece
1.Corruption Perceptions Index
2013 (0-100) 63.0 64.7 40.0
2. Rule of Law
2012 (score -2,5 to 2,5) 1.07 1.23 0.39
3.Government Effectiveness
2012 (score -2,5 to 2,5) 1.38 1.24 0.31
Source: World Bank, Transparency International, World Bank.

Third, in Cyprus the program was executed remarkably well, and in the
words of a representative of the lenders, “almost like a clock”
(Hardouvelis and Gkionis (2016)). The authorities showed commitment to
the program conditionalities and established a strong track record of
timely and continued policy implementation. The quantitative targets were
met ahead of time and by a wide margin. Thus three years after the MoU,
the country had gained credibility, capital controls were lifted and the
country graduated from the program.
In Greece, the opposite happened. Politicians tried to avoid delivering on
what they had signed, fearing the political cost. The lenders gradually
became increasingly dissatisfied and began micro-managing the reform
process. For example, the second MoU is relatively voluminous and a lot
more detailed than the first MoU. And after the third rescue program of
2015, lenders put a tighter auditing grip to ensure complacency and avert
the back-tracking of earlier reforms.
Fourth, in Cyprus the package of fiscal measures in 2013-2014 was decided
and legislated upfront, which minimized uncertainties. In addition, the
fiscal adjustment was front-loaded, splitting the burden almost equally
between revenue enhancing and expenditure spending cuts, thus, making
the policy mix of the measures balanced. As the initial IMF MoU25 & EU

24 The Government Effectiveness Index, the Corruption Perception Index and the Rule of
Law, World Bank & Transparency International.
25 Page 19, http://www.imf.org/external/pubs/ft/scr/2013/cr13125.pdf
28

Commission program26 states: “The total package of 6.8ppts of GDP was split
between 3 ppts expenditure cuts and 3.8ppts in revenue enhancing measures.”
Cypriots also resisted the enormous pressure to drastically increase their
corporate tax rate, and thus kept their international comparative tax
advantage.
In Greece, the inability to come to terms with economic reality resulted in
three consecutive rescue programs covering the period from 2010 to 2018,
with the third program being self-induced and completely unnecessary.
The disastrous policy of the first half of 2015 brought a new recession and
reduced asset values further. It caused a huge loss to the State from the
collapse in bank stock prices. Since 2015, the Greek government also
resorted to over taxing households and businesses, hence stifling away any
incentives for work and investment. Since 2015, the Greek policy reaction
has been diametrically opposite from the Cypriot experience.
4.3. A different economic trajectory following the outbreak of the crisis
This section compares the evolution of the respective economies after the
beginning of the rescue package. Based on the earlier discussion on the
initial conditions prevailing prior to the crisis and the different policy
responses in the two countries, it ought not to come as a surprise that the
economy’s negative trajectory after the outbreak of the crisis was much
more benign in Cyprus.
Figure 4 sets as date 0 the quarter before the agreement of a rescue
package. It then shows the evolution of real GDP in the following quarters.
For Greece, quarter 0 is defined to be the first quarter of 2010. For Cyprus,
quarter 0 is the last quarter of 2012. At quarter 0, for both countries the
level of real GDP is set to be 100.
Figure 4 shows that the depth and length of the recession in Cyprus were
much smaller than in Greece. In Cyprus, the lowest point of the recession
occurred 10 quarters (2.5 years) after the rescue, when the GDP level was
at 90.5% the original GDP level, and then a recovery began. In Greece, a
recovery began much later, after 15 quarters and at a much worse GDP
point, at 78% of the original level. Moreover, subsequently, the recovery
was stopped short by a new phase of the crisis. The figure shows that
Greek crisis Phase II currently costs over 6 percentage points of 2012-GDP,
or about €14bn per annum.
Figure 5 presents a similar story about the rate of unemployment. It shows
the change in unemployment relative to date 0, which is the quarter before

26 Table 4, Page 47: contains the consolidation measures in 2012-2014

http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/pdf/ocp1
49_en.pdf
 29

the rescue package as in Figure 4. In Cyprus, unemployment went up by 5

percentage points and then, after 11 quarters, began declining. By mid
2016, it is almost back to where it started. However, in Greece
unemployment went up by over 16 percentage points and began declining
much later, after 14 quarters.
FIGURE 4
The Evolution of Real GDP after the Crisis Outbreak
100 GREECE
GDP Greece & Cyprus (2010Q1=100)

CYPRUS
95 (2012Q2=100)

GREECE
90 (Autumn
Forecasts 2014)
-9.5% from T0 in 10 Quarters
85

80

-22.0% from T0 in 15 Quarters

75
T0

T+10
T+11
T+12
T+13
T+14
T+15
T+16
T+17
T+18
T+19
T+20
T+21
T+22
T+23
T+24
T+25
T+3
T+1
T+2

T+4
T+5
T+6
T+7
T+8
T+9

Source: Eurostat, Eurobank research.

FIGURE 5
The Evolution of Unemployment after the Crisis Outbreak
20
ppts Cumulative Change in Unemployment Rate Greece vs. Cyprus

15

10
ppts

GREECE 2010Q1=0

CYPRUS 2012Q2=0
5

0
T0

T+10
T+11
T+12
T+13
T+14
T+15
T+16
T+17
T+18
T+19
T+20
T+21
T+22
T+23
T+24
T+25
T+1
T+2
T+3
T+4
T+5
T+6
T+7
T+8
T+9

Source: Eurostat, Eurobank research.

 30

4.4 Different perceptions about the crisis and the country abilities to
withstand it
Turning to how markets perceive the crisis, Figure 6 presents Greek and
Cypriot yield spreads vis-à-vis Germany.27 Financial markets became more
aware of the Cypriot economic problem after the Mari accident in July 2011
and the simultaneous discussions on the Private Sector Involvement (PSI)
for Greek bonds, which began in the summer of 2011. The figure also
shows that the Cypriot spreads grew higher than the Greek spreads from
the summer of 2012 to the end of 2014, essentially during the time of the
Cypriot crisis. When Greek crisis Phase II began, the Greek spreads
overtook the Cypriot ones for a second time. Another interesting feature is
the more or less continuous decline of the Cypriot spreads since July 2013.
This is not the case with the Greek spreads, which peaked for a second
time in the summer of 2015 and remain stuck at high levels by 2016Q4,
around 700-900 bps.
FIGURE 6
Interest Rate Spreads over Germany
4000
SPREADS GREECE VS GERMANY
3500
SPREADS CYPRUS VS GERMANY
3000

2500

2000
bps

1500

1000

500

0
Apr-10

Apr-11

Apr-12

Apr-13

Apr-14

Apr-15

Apr-16
Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16
Oct-15
Oct-10

Oct-11

Oct-12

Oct-13

Oct-14

Oct-16
Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Source: Bloomberg.

27 Figure 6 portrays the evolution of the sovereign spreads of the ten year generic
Greek government bond vis-à-vis the German one. The same graph also
includes the spread of the long-term Cypriot bond of initial ten-year maturity,
the last one issued by the Cypriot government in 2010 before the country was
cut off from the international financial markets vis-à-vis a German government
bond with maturity date very close to that of the Cypriot bond.
 31

Next, it is also interesting to see how the population, households and

businesses reflected on the crisis. Figure 7 presents the index of economic
sentiment in the Euro Area, in Greece and in Cyprus from early 2007 to the
present. It is clear that sentiment in Cyprus follows much more closely the
ups and downs of the overall sentiment in the Euro Area than the
corresponding sentiment in Greece does. In Greece, there was decoupling
from Euro Area sentiment from the fall of 2009 until the fall of 2012, and
then again during phase II of its crisis from January 2015 on. By contrast
the sentiment in Cyprus shows similar ups and downs as in the Euro Area,
even during the Cypriot crisis in 2013.

FIGURE 7
Index of Economic Sentiment
120

EA
110

100

90

80

Greece
70
Cyprus
Cyprus Euro Area Greece
60
Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Jan-15

Jan-16
Jul-07

Jul-08

Jul-09

Jul-10

Jul-11

Jul-12

Jul-13

Jul-14

Jul-15

Jul-16

Source: European Commission.

4.5. Different behavior regarding the possibility of capital controls

One of the consequences of the crisis on both countries was the imposition
of capital controls. Yet capital controls were anticipated in Greece but came
as a complete surprise in Cyprus. Figure 8 shows the behavior of deposits
before and after the imposition of capital controls. The difference between
the two countries is striking. Deposits fell in Greece before the imposition
of capital controls. In Cyprus they remained almost intact before the
imposition of capital controls and then fell after the imposition of capital
controls (when also some uninsured deposits were transformed into
32

stocks). On the graph, T0 is defined to be the date on which capital

controls were imposed in each country. For Cyprus it is March 27, 2013
and for Greece June 28, 2015.28 Over the period December 2014 to June
2015, Greece experienced a bank-run in slow motion. In Cyprus, the sharp
decline of private sector deposits in Q2 & Q3 2013 was mainly due to the
bail-in & the ensuing economic slowdown.

FIGURE 8
Private Sector Deposits before and after the Imposition of Capital Controls
(in million euros), (T0=imposition of capital controls)
75,000 175,000
Greek
70,000 parliamentary elections 170,000
Jan15 T0: Capital Controls
65,000 Cyprus: Mar13 165,000
Greece: Jun15
60,000 160,000

55,000 Greek 155,000

parliamentary elections
50,000 Jun12 Cyprus 150,000
finalization of bail-in
45,000 terms 145,000
Jul13
40,000 140,000
Cyprus
35,000 135,000
application to ESM/IMF
Jun12
30,000 Greek Banks Recap Greece 130,000
Cyprus 2nd Review
Dec15
25,000 Presidential Elections begins Oct16 125,000
Feb13
Greece
20,000 1st Review 120,000
Greek Elections
Sep15 Jun16
15,000 115,000
T-36 T-32 T-28 T-24 T-20 T-16 T-12 T-8 T-4 T0 T+4 T+8 T+12 T+16 T+20 T+24 T+28
CYPRUS (Left Axis, Th. Euros) GREECE (Right Axis, Th. Euros)

Source: Central Bank of Cyprus, Bank of Greece, Eurobank Research.

Figure 9 portrays the change in sentiment before and after the imposition
of capital controls. Here the differences between the two countries are not
as striking as in Figure 8. The imposition of capital controls decreased
economic sentiment in both countries, which subsequently recovered.

28 In Cyprus, capital controls were imposed on the last day after a two-week bank holiday
after public announcements of the decisions of the Euro group on the restructuring of the
banking sector without program funding. In Greece capital controls were imposed
concurrently with a bank holiday. They aimed at averting a bank-run after the lengthy
multi-month antagonistic negotiations between the government and the international
lenders had collapsed.
 33

FIGURE 9
Economic Sentiment Indicator before and after the imposition of Capital Controls
(T0= capital controls)
115

Greek Elections
110 T0: Imposition of capital controls
Cyprus: Mar13 Greece
Greece: Jun15 2nd Review
105 begins Oct16
Greece
100 Greek Banks Recap 1st Review
Prior Actions Jun16
Dec15
95

EU parliament elections
90 May14

85

80

Cyprus
75 Application to ESM/IMF Cyprus
Jun12 Presidential Elections Cyprus
70 Feb13 Greek Elections Troika Reviews
Sep15 July13-Nov13-Feb14-May14

65
T-18 T-16 T-14 T-12 T-10 T-8 T-6 T-4 T-2 T0 T+2 T+4 T+6 T+8 T+10T+12T+14T+16T+18
CYPRUS GREECE

Source: European Commission, Eurobank Research.

4.6. Two major risks confront both countries today

Today Cyprus and Greece face different challenges, yet they do share a
common short-term super-risk factor, the issue of bad loans. In both
countries, the rate of non-performing loans (using the EBA definition of
non-performing exposures (NPEs)) is extremely high, at 49% in Cyprus
and 47% in Greece. This rate sets both countries apart from all other
European countries, since the next observed worst rate is less than half, in
Slovenia 20%and in Portugal 19%. Figure 10 provides a cross-country
comparison of non-performing loans as of March 2016. 29 As of March 2016,
problematic loans stood at 145% of GDP in Cyprus. The relevant ratio in
Greece in December 2015 stood at 61.4% of GDP.
NPLs have begun a declining trend in Cyprus but not so in Greece. In
Cyprus, NPEs in absolute levels- began declining in 2015Q2. The formation

29 https://www.eba.europa.eu/documents/10180/1360107/EBA+Report+on+NPLs.pdf
34

of new NPLs stopped as the economy started growing, while thanks to the
new laws some of the past non-performing borrowers began settling their
accounts. As a result, the level of NPEs has declined to €24.7bn in July 2016
down from a peak of €27.8bn in April 2015. Yet, the ratio is still at very
high levels mirroring the ongoing deleveraging which impacts the size of
total loans in the denominator of the ratio. The NPL reduction is a good
piece of news, yet it is too early to be able to say the risk is definitely going
down.
FIGURE 10
Non-Performing loans as of March 2016
(% of total loans)

60%

50%

40%

30%

20%

10%
European Union

0%
RO

DK

DE
BG

BE

LV

EE

LU
GR

MT

ES
LT
SI

AT

SK

GB
PT

FR
CY

PL
IT

CZ

NL

NO
IE

HU

HR

SE
FI

Note: Data provided by EBA on non‐performing loans and forborne loans for total on‐
balance loans and advances per country of origin of the bank (March 2016). These
NPL ratios relate only to exposures qualifying as loans, and do not include debt
securities or off‐balance sheet exposures. For EU banks, the NPL ratio per March
2016 was 5.7% on average.
Source: European Banking Authority.

In Greece, NPLs have not yet stopped growing. They did decline in
2014Q4, but Phase II of the crisis in 2015 caused a resumption of the earlier
upward trend. And the more recent NPL laws continue to have gaps.
Hopefully, if the economy picks up in Greece, few new NPLs will form
and old ones will be restructured. Overall, resolution of the NPL problem
is the hardest challenge for both countries.
 35

A second risk factor both countries face is the low rate of private
investment. The fall in investment preceded the crisis in both countries and
was not entirely due to the real estate sector. It is an issue that has to be
addressed. New investment is necessary for the economy’s ability to
continue producing and achieving high sustainable rates of growth in the
long-run.

5. Concluding remarks: Would future policies differ?

The different economic trajectory of each country necessitates a different
policy prescription. The successful Cypriot exit from its economic
adjustment program in 2016 suggests the best policy for Cyprus is to move
along the earlier policy path, being more aggressive on reforms and with a
better focused growth model. At the other end, the disastrous Greek
experience since early 2015, suggests there is a need for a complete
overhaul of current policies or non-policies. Future policies in the two
countries should therefore differ in focus and perhaps would differ.
The main question in Cyprus is whether or not a real growth rate in the
neighborhood of 3% is achievable over the long-term. For it to happen,
Cyprus needs to safeguard its comparative advantages and its
macroeconomic stability, continue reforming its economy and begin
reversing the earlier fall in investment activity. So far its international
comparative advantages are the low corporate tax rate, the low tax wedge
on labor costs, the low personal tax rate and an efficient state bureaucracy.
Macroeconomic stability prevails at the moment but may easily get off
track, especially if the pension system were not fully reformed. Reforms
ought to continue and for this to happen, the population must own the
reform agenda. And ownership of reforms begins with politicians. During
the crisis, Cypriot politicians managed to agree on a minimal common
denominator. Hopefully this common understanding will continue.
Finally, for sustainable growth, an overall long-term growth strategy is
required, which would emphasize innovation and entrepreneurship and
would readjust the Cypriot economy’s previous dependence away from
the financial sector into new promising sectors like energy or information
technology.
In Greece the policy prescription is more complicated. Greece is still in
recession, so it needs first to reestablish credibility to get out of the current
stagnation mode and be able to access financial markets. Then there is the
problem of debt sustainability, which has to be solved for Greece to gain
access to financial markets. Next, once a cyclical recovery takes hold,
attention has to shift towards factors contributing to long-term growth,
especially the need for a major reversal in the current policy of over-
36

taxation, which is suffocating incentives for work, jacks up the cost of labor
and tanks competitiveness, keeps domestic and foreign investors hesitant
to invest, and restrains economic activity.
In Greece, there is a definite need to focus on the supply side of the
economy, minimize bureaucracy and lower corporate tax rates and thus
boost domestic production and exports at the expense of domestic demand
and imports. In Greece, public and private consumption represent an
overwhelming 20%+70.2% = 92% of GDP, when the corresponding (EA-19)
EMU average is only 20.7%+54.8%=75.5%. This excess demand relative to
the economy’s productive capacity necessitates a future relative shrinkage
in domestic aggregate demand. While consumption ought-not shrink in
absolute terms for otherwise a continuing recession cannot be avoided,
future growth ought to be higher in investment and exports relative to the
growth of consumption.
The flip side of the Greek domestic excess aggregate demand is a very low
domestic savings rate, which is incapable of supporting domestic
investment. Thus FDI is desperately needed and for this to occur, policy
credibility is a necessary condition. So credibility is necessary not only for
the cyclical recovery and the exit from crisis phase II, but also for a
sustainable rate of growth over the long-run. Yet credibility was destroyed
over the last two years in Greece and its reinstatement remains a challenge.
Crisis Phase II and the forces behind it are hard to erase from households’
and enterprises’ memory. Capital controls are still in place, the over-
taxation continues, the unemployment rate is still high, the youth is
immigrating abroad, many companies are registering abroad, and
economic sentiment remains low.30
Despite their large differences, some of the challenges are similar to both
countries. The first such challenge is the high rate of non-performing bank
loans. As a response to the NPL problem, both countries introduced new
stricter laws that govern corporate and personal bankruptcy (insolvency
framework), foreclosures and moral hazard.31Those laws aim to provide

30 In the midst of Greek crisis Phase II, European lenders seemed to have abandoned
hopes of a quick Greek reinstatement to normality and thus never seriously challenged
the coalition government for a rational economic policy path. They allowed them to
generate fiscal savings exclusively from taxation, something they had never allowed
earlier governments to do prior to 2015. The other lender, the IMF, apparently sensed
the trouble with the new Greek political leaders early on and thus has refrained from
giving any new loan money at all, insisting on the continuation of reforms, the overhaul
of the pension system and on a big fiscal break on the part of Europeans, which would
come in the form of lower future primary surpluses and a more generous relief in the
present value of public debt.
31 To facilitate the restructuring of troubled loans, banks have put in place restructuring
units. However, a state-backed asset-management company (AMC) was not created in
 37

adequate incentives for voluntary debt restructuring negotiations, as well

as measures to facilitate the creation of a distressed debt market to enhance
the quick reduction or transfer of NPLs. Hopefully a growing economy
will also help reduce the problem gradually.
A second common challenge originates from the low rate of investment
activity in both countries. The decline in investment predates both
countries’ economic crisis. It needs to be addressed with active policies,
something that is missing from the current policy debate. After all, a
higher rate of investment is a necessary condition for persistent long–term
balanced growth.

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