The Crisis in Cyprus

Cyprus is a small island nation in the Eastern Mediterranean. For much of its history, Cyprus has been a
quiet, sleepy place, basked in hot summers and mild winters. On occasion, however, it has been used
as a strategic naval outpost, first by the Ottoman Empire and later by the British.

Britain would go on to have a strong influence over the institutions and economy of the island during
the 20th century - over 70% of the island's roughly 1 million inhabitants speak English - but the island's
main linguistic, cultural and religious influence continues to be Greek and Turkish. In fact the country
is split into two halves - the Greek Cypriots and the Turkish Cypriots - each claiming to be the
legitimate administrators of the island.

To put matters simply, politics on the island have been complicated over the last 60 years. In 1990, the
Greek half of Cyprus (which for the rest of this paper we will refer to simply as Cyprus unless
otherwise noted) applied for membership into the European Union. Full membership was finally
granted in 2004.1

In 2007, Cyprus also applied to become a member of the European Monetary Union. This would mean
that if accepted, Cyprus would transition to using the Euro Currency, co-ordinate economic policy
decisions with other member countries, work with policy makers at the European Central Bank and
importantly gain access to the international bond markets as an EU Member, which would typically
mean pooled risk and therefore lower government borrowing costs. “Funds raised are in principle lent
back-to-back to the beneficiary country, i.e. with the same coupon, maturity and amount.
Notwithstanding the back-to-back methodology, the debt service of the bond is the obligation of the
European Union, which will ensure that all bond payments are made in a timely manner.”2 In order to
qualify, the government of Cyprus was subjected to a review designed to ensure that its national deficit
was less than 3% of GDP, its national debt was manageable, and that its Central Bank's structure and
policies conformed with European standards.3 Euro Monetary Union membership was approved and
became effective at the start of 2008.

Of course, 2008 was the year that Cyprus' financial troubles started. Before that time, Cyprus' economy
was primarily based on tourism, shipping, and a small financial sector. Inclusion into the Euro had a
significant impact on this sector however. Over the previous decades, Cyprus' banking sector had
quietly developed into a haven for offshore banking activities, due to the country's low tax rate of about
10%. European corporations would then use the Cypriot banking system to direct transactions through
which the companies might gain a tax advantage, in the same way that accounts in the Cayman Islands
are used. With Cyprus' inclusion into the Euro, its banks became seen as a safe, reliable alternatives to
other tax havens and the money began to flow in.

Suddenly Cyprus seemed like an attractive place to invest in real estate or simply deposit large sums of
money. One group who took advantage of this situation were Russian billionaires. Deft operators with a
keen understanding of the importance of keeping large holdings, legitimately or otherwise obtained, out
of sight and out of reach of Russian authorities, these ultra wealthy clients soon became some of the
Cypriot banks' biggest customers. The consequence of all this money coming in was that the banks
were keen to lend it out or to invest it in other profitable assets. Billions of dollars went into mortgage
loans both in Cyprus and to customers of Cypriot banks operating in Greece. Even early in 2008, the
1 http://europa.eu/about-eu/countries/member-countries/cyprus/index_en.htm
2 http://ec.europa.eu/economy_finance/eu_borrower/index_en.htm
3 http://ec.europa.eu/economy_finance/euro/adoption/index_en.htm
overheating of Cyprus' property market was a problem recognized by its Central Bank.4 Another
significant portion of the inflow of deposits was reinvested in sovereign bonds, mainly those of Greece.
These investments would later become the poison pill that nearly killed the Cypriot economy.

Meanwhile, in the US, the markets were in full meltdown mode. It slowly became evident that billions
of dollars worth of mortgage backed securities were not the safe investments that they had been touted
as. A cascade of mortgage defaults meant that payments to bondholders stopped and that the value of
these bonds would need to market significantly lower.

First came Bearn Stearns stock collapse and sale to JP Morgan, then the US government had to
takeover Fannie Mae and Freddie Mac, Merrill Lynch avoided bankruptcy with a sale to Bank of
America, but Lehman Brothers was not so lucky, nor were many of monoline insurance companies. By
late September, the government was persuaded to pledge $700 Billion in relief funds to rescue the
banks. In October the Federal Reserve announced nearly a Trillion dollars of short term loans to banks,
while embarking on a $540 Billion dollar bond-buying spree, in the hopes of injecting good capital into
the market.

Throughout this tumultuous period, Cyprus remained largely unaffected. Cyprus' banks held almost no
exposure to the US mortgage market and seemed healthier than ever. While other banks around the
world were in crisis, Cypriot banks were actually expanding their portfolios, continuing to issue ever
larger numbers of loans and mortgages. At this time, the ratio of outstanding loans as a percentage of
GDP rose to the second highest in Europe. Cypriot banks were also expanding their portfolio of Greek
bonds. As investors raced to the safety of large sovereign bonds, like those of the US, bonds of
periphery countries like Ireland and Greece came under pressure. Of course as bond prices fell, yields
increased, which made them seem like even more attractive investments for Cyprus' banks.

What the Cypriot banks did not expect, however, was the slow contagion that spread from the US
financial crisis. First, European banks in England and Germany that had exposure to the US markets
were impacted, as were large corporations who suddenly faced a shrinking capital market. Before long,
companies were slowly production, hoarding cash and laying off employees. The economy began to
slow, as did tourism, and that's when the knock-on effect began to take hold in Greece.

4 http://ec.europa.eu/economy_finance/een/009/article_6467_en.htm