Tuesday 24 October 2017

Three islands, one crisis, three approaches – who fared best?

Clear waters, as at the Green Bay dive site, and year-round mild temperatures continue to drive the tourism sector in Cyprus
Clear waters, as at the Green Bay dive site, and year-round mild temperatures continue to drive the tourism sector in Cyprus
Economic contraction in three island economies.
Dan O'Brien

Dan O'Brien

WHAT happens to economies when banking systems become bloated and then fail? The answer is lots of very bad things. Always. No matter what governments try to do to lessen the impact of financial crashes when they happen, most of the damage is done before the bubble bursts.

Ireland and Iceland illustrate this well. They both had banking crashes in 2008. While one bailed out its banks and the other allowed them to fail, six years on both economies continue to suffer the ill-effects and neither has come close to repairing all the damage done.

Despite many in Ireland claiming that Iceland's way was best, proponents of this view rarely put up evidence to support the position. That is because the evidence does not support it.

As the chart shows, GDP and the domestic economy in both North Atlantic island economies have tracked broadly the same sorry pattern over the past six years. In neither economy has GDP recovered to its pre-crisis levels and both countries' domestic economies are around one-fifth smaller.

But it is the experience of another island economy that offers an even better comparator for Ireland. The case of the Cyprus banking crash is closer to Ireland's because both were/are in monetary union – and both had/have the upsides and downsides of not having an independent currency (as Iceland does).

The decision 14 months ago to impose haircuts on big depositers and bondholders in all crippled banks was just what many people believe should have been done in Ireland. While there was and always will be a strong argument to be made in favour of that option, the state of the Cypriot economy now does not suggest that taking this route is clearly better than the option chosen in Ireland six years ago.

As the chart shows, in the six years to the end of last year, Ireland and Cyprus suffered almost identical declines in both GDP and domestic demand, with the latter being particularly severely affected. Yet they arrived at the same point via very different routes.

The worst of Ireland's economic contraction took place in the first years of the crisis, as the effects of the construction sector's collapse took place. When the shake-out of that industry ended in 2010, the economy began to stabilise.

Cyprus, by contrast, came through the initial post-Lehman Brothers period relatively well, as the chart illustrates, and as a very moderate uptick in unemployment – from 4 per cent to 6 per cent – attests. But the island's connection to Greece proved devastating for its bloated banks.

As Greece went into a tailspin in 2010, Cyprus gradually got sucked into the vortex. By 2011 the economy was being dragged downwards and matters were made worse when Greek sovereign debt was restructured in 2012. As the Cypriot banks were holding large amounts of Greek government paper, the writedown blew a hole in their balance sheets.

From that moment the writing was on the wall and a bailout was inevitable (a point which illustrates that banks are vulnerable to more than their own sovereign's bonds and that another sovereign default would have eurozone-wide implications).

By burning depositers and bondholders, the Cypriot state avoided large direct costs, but the downside of doing so was the closing of the banks for weeks, the on-going (if easing) curtailment of access to bank accounts and the continued imposition of capital controls.

The latter measure (which Iceland also still has in place incidentally) is needed to prevent capital flight. But it is perhaps the most economically damaging consequence of the crisis for Cyprus because capital controls are detrimental for a small open economy embedded in a monetary union and dependent on foreign trade and investment.

Had Ireland imposed haircuts on Anglo depositers in late 2008 there is little doubt that all of the measures Cyprus imposed would have been required, including capital controls. As Ireland is more open than Cyprus in most respects and much more dependent on FDI to power economic growth, the impact of Cyprus or Iceland-style capital controls would have been commensurately greater.

While those who source all of Ireland's ills back to the bank guarantee of September 28 are quite right to highlight its costs, their failure to acknowledge the costs that would have been incurred if it hadn't been introduced results in only a partial picture being painted.

At this juncture – just 14 months since Cyprus's banking crisis reached its zenith – there can only be a partial picture painted of the comparison between Ireland and the Mediterranean economy.

It could be that Cyprus will recover more quickly, but as of now that doesn't look likely. The best that can be said about Cyprus is that the worst appears to be over.

The slump in the economy since the traumatic events of last March, which led to an EU-IMF bailout, has not been as severe as either the EU Commission or IMF economists feared. Many in the business community this columnist spoke to last week were cautiously upbeat and focusing on the growth sectors of the economy, such as tourism and shipping.

But real recovery has yet even to begin. Cyprus is now the only one of the EU's 28 members still in recession. With unemployment at over 17 per cent, the third highest in the EU, the shock to the labour market has been huge. And even with Cyprus's well-functioning jobs market and still relatively high rates of employment (the percentage of adult population at work) it will take many years before all those who want jobs can get them.

And then there is the banking system. Hearing of the slow pace of cleaning up Cypriot banks' balance sheets last week was like reading Troika report after Troika report about Ireland during its years of the bailout. The system is on the life support of central bank 'Emergency Liquidity Assistance'; non-performing loans in the country's financial institutions stand at 40 per cent of all loans and household debt as a percentage of GDP is even higher than Ireland.

Little wonder that in its latest assessment of the on-going bailout, the European Commission warned that "slow resolution of non-performing loans and tight credit conditions could pose considerable risks to the real side of the economy".

None of this augurs well, but it does prove – if proof were needed – that when banks go bad, the consequences are huge and long lasting, no matter what course of action governments then take. Simple narratives such as what the "guarantee did is to blame for everything" may be satisfying, but when it comes to financial crashes they are grossly simplistic.

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