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OPINION

The Outlook for the Cyprus Economy

The Outlook for the Cyprus Economy

The March 2013 EU bailout terms for Cyprus were a reminder of the need for businesses to geographically diversify revenue streams and exposure tied to their local economic environment. With this in mind, MeritKapital applied to operate a branch in the Latvian capital, Riga,under the single passport directive and CySEC recently approved its application.


Latvia went through its own banking crisis in 2008, when it received a €7.5 billion bailout from the IMF and the EU. It has since recovered economically, much aided by the growth of the regional economy as well as by its adherence to the imposed austerity measures. With a GDP of €22.3 billion, it will adopt the euro on 1January 2014 and it is being forecast to have the fastest GDP growth in the eurozone of 4.1% for 2014.


The outlook of the Cyprus economy could also be deemed to be for slow recovery.


First, S&P recently upgraded it by a notch to B- from CCC+. Its sovereign debt yields have substantially come down with the issues maturing in 2014 and 2020 currently at 9.8% and 8.27% respectively, from 24.5% and 13.8% in mid-July.


Second, although its economy has been very much tied to Greece's, due to its banking sector's Greek loan book and Greek sovereign debt exposure, it is now less linked as that exposure has been fully divested. However, cultural and other economic similarities still make current macro figures from Greece a relevant case study to forecast the future trends in Cyprus:
 
• an upgrade of the government debt by S&P from B- to B with a stable outlook
• a drop in sovereign yields (10Y dropped from a high of 30% in June 2012 to 8.6% at time of writing),
• expectations that the primary budget surplus will bemaintained this year,
• debt to GDP levels that are forecast to decrease to 156.9% in 2014 vs. 170.3% in 2013
• and GDP growth that is expected to turn positive to 1.8% in 2015 vs. -0.4% in 2014
 
The small Cypriot economy should prove quite versatile and should reverse sooner following the imposed austerity measures that proved effective in Greece.


Third, the financial services sector of Cyprus, excluding the banks with imposed capital controls, contributes decently towards total GDP. This pool is predominantly comprised of some banks which operate without capital controls (solely for nonresident UBOs), professional services firms, investment firms and FX companies. Additionally, tourism revenues are significant, with CTO figures estimating a 13% input to total GDP for 2012, excluding multiplier effects in other sectors of the economy. 


For the above-mentioned banks, key figures to note are that their financial results for 2013 appear promising, especially as they are in an advantageous position vis-à-vis their peers.


On the professional services front, which deals with international clients, we performed an independent survey on a selected group of the larger market players and although they noted a slowdown in sales for 2013 of around 10-20%, they stated that the core of their client portfolio remains steady. This is largely due to Cyprus maintaining its status as an optimal tax jurisdiction in the EU and also due to the strong client vs. service provider relationship which is not easily transferable.


Moreover, the general consensus is that it is unlikely that another round of such ‘bail-in’ measures will be undertaken unless the situation with Bank of Cyprus deteriorates substantially.


Regarding the FX and investment firm industries, the sector continues to prosper having a solely international client base and having felt immaterial impact from the March banking bailout terms. Some of the top ten global FX companies are based in Cyprus as well as the top ten Russian investment firms, as measured by total sales.  


The latest statistics from the tourism industry noted a slight decrease in tourist arrivals for the period January to November 2013 of 2.5% while total revenue recorded a growth of 8% from the beginning of the year. The revenue increase from British and Russian visitors has compensated for a reduction in that of Greeks, Germans and Belgians.


Fourth, there is an expectation of an increase of FDI into Cyprus driven by international investors seeking opportunities in the real estate sector and other viable businesses that are strapped for cash in the credit crunch that followed the bail-in.


Fifth, there have been other OTC transactions that have spurred some liquidity into the market. MeritKapital was the first broker on the island to sell a Bank of Cyprus'bailed in' deposit to a large US hedge fund. Also, there has been some M&A activity in the hotel industry, whereby 'bailed in' deposits were partially or wholly swapped for outstanding debts, within the same bank, of the targeted investment. MeritKapital is in advanced discussions for numerous other 'deposit' deals. An increase in all such OTC transactions and further innovative solutions should ease the ensuing credit crunch. 


Last, the natural gas reserves off Cyprus’s southern shore are a significant factor to consider in the island's economic recovery. The Aphrodite gas field, which was discovered in 2011, is estimated to contain around 4 trillion cubic feet (tcf)of gas, the majority of which could be exported to satisfy the energy needs of Asia and Europe. However, the construction of an offshore LNG plant and added transportation costs would only make economic sense at 5 tcf.  If some agreement is reached for this LNG plant to liquefy the excess gas of neighbouring Israeli fields, then the pricing will start to make financial sense. A latest positive finding is the recent statement by US-based Noble Energy, which disclosed recently that the same gas field may – based on exploratory drilling – also hold between 1.2-1.4 billion barrels of oil. This is very encouraging as the time and cost to drill and extract oil is much less than that for natural gas which transpires into a more viable project.


Nevertheless serious challenges remain. Despite improving operating income ratios, the viability of BOC continues to be uncertain. Non-performing loans (NPLs) have increased to 47% in Q3 from 38% in Q2. As a comparison, the Greek-based banks have average NPLs of 30-35%, and provisions per NPL reduced to 37% in Q3 from 42% in Q2. This demonstrates that Greek banks have already restructured their loans, repossessed assets and are subsequently managing them. The NPL figures for BOC still considerably lag behind these parameters. 


Second, the credit controls that continue to exist are sapping credit liquidity in the local economy and jeopardizing the viability of previously healthy companies.


Third, although the international clientele has largely remained intact from the portfolios of service providers, it is questionable whether this period has served as a study timeframe for clients to measure their options for ulterior solutions that may be affected in time.


Fourth, the lack of foreclosure laws prevents a correction in real estate prices to ignite activity in the industry. Although the Troika encourages imminent legislative amendments the problem remains outstanding. 


Last, Iceland underwent a similar banking crisis in 2008, whereby an oversized banking sector and excessive risk taking led to the collapse of the island's three main banks. As in Cyprus, the Icelandic banks lured foreign deposits with attractive yields and then lent flexibly to foreign borrowers. With the collapse of Lehman and a freeze in the credit markets, the noted banks collapsed. Iceland then imposed capital controls which prevent the exchange of the local currency; their respective lifting date remains undetermined. Its economy has just turned to growth of 3% this year and could borrow from the open markets only in 2011. Moreover, its businesses are suffering as FDI is discouraged by the capital controls.   


Professor Benoit Mandelbrot advised to “diversify as broadly as you can – far more than the experts tell you to”. There have been some encouraging developments that draw a stable economic outlook for Cyprus. However, the apportion of capital and efforts across other geographical markets, such as Latvia, forms a stepping stone towards a prudent risk management. 

 

Persella Ioannides is Executive Director and Head of Investment Advice at MeritKapital.

 

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