The Cypriot financial crisis - Essay Example

Template – Dissertation Plan Chapter Introduction One provisional aim/Topic: The Economic Recession, increased public and private debt contributed to the Cypriot financial crisis. (a) Background area of study: The European economic crisis is an ongoing economic crisis that has made it hard or impossible for some nations in the euro region to re-finance or repay their government debt devoid of the help from third parties. Clerides and Stephanou (2009) noted that Cyprus was considered as a tax haven, thus becoming an epicenter for corruption and money laundering. This made the banking sector to be larger than the nation’s economy. Therefore, when there was an increase in public and private debt, the country went into recession with the economy shrinking by 1.67 % in 2009 (Blundell-Wignall, 2013). This marked the beginning of the Cypriot economic crisis. (b) Focal area of study: The study is going to discuss how economic recession public and private debt contributed to the Cypriot financial crisis. (Blundell-Wignall, 2013). It would also examine the rescue model that was used in Cyprus in the economic crisis, bail out and bail-in of the Cypriot banks imposed by Euro group(Puri, 2013) (Genay and Mei, 2013), and what it could have be done by the government and banks to avoid this situation. It would also provide recommendations to avert the financial crisis. (c) Researchable Context: The study is going to examine how competition and increased public and private debt contributed to the Cypriot financial crisis. It would also examine the rescue model that was used in Cyprus in the economic crisis, bail-in of the Cypriot banks imposed by Euro group, and what it could have be done by the government and banks to avoid this situation. It would also provide recommendations to avert the financial crisis. Rationale for the study: Over the last decade, the Greek government has borrowed greatly from international markets in order to pay for its trade deficits and budget. Investors became nervous that the public debt was soaring high, which drove up Greece’s borrowing costs. With the banking systems in Cyprus were experiencing intense pressure; they amassed €22 billion of Greek private sector debt. This increase in public and private debt reduced economic growth plunging the country into a crisis (Faustman and Kaymak, 2013). This market concerns is what initiated the study to examine how public and private debt contributed to the Cypriot Euro zone crisis. Chapter 2: Literature Review Background literature The Cyprus banking crisis was attributed to Cypriot banks investing heavily in Greek government bonds. The Cyprus banks came under intense financial pressure as the bad ratios escalated. Laiki bank reported that the bank was probably insolvent as early as 2008. This was even before Cyprus plunged into the Eurozone crisis. In 2011, the banks were exposed to an upward haircut of 50 % during the Greek government-debt crisis (Besim and Mullen, 2009). This led to fears that the Cypriot banks were on the verge of collapse. Since the Cyprus banking sector was larger than the total economy, their collapse would mean a collapse of the whole economy. Due to the increase in public and private debt, the state was on the verge of an economic crisis. The Cypriot state was not able to raise liquidity from the markets so as to sustain its financial sector. Clerides (2012) noted that this resulted for the state to request a bailout from the European Union. Since Cyprus plunged into the economic crisis in 2009, the economic growth that was witnessed between 2010 and 2012 was very weak to the level that it failed to attain its pre-2009 levels (Clerides and Stephanou, 2009). With a modest economy and a small population, Cyprus was characterised by a huge offshore banking sector (Lane and Milesi-Ferretti, 2010). There was increased pressure to the banking sector due to the non-performing loans. With a nominal gross domestic product of $24 billion, the banks has accumulated €22 billion of the Greek private sector debt with bank deposits standing at $120 billion.This increase in debt levels was a significant factor that contributed to the Cypriot economic crisis (Zenios, 2013). The Cypriot financial crisis can be linked to the sovereign debt theory. Due to the economic recession, there was an increase in public and private debt. As a result, Cypriot had to suffer in the form of huge debt burden and tax payment. As per the theory, the need of various countries to sell large amount of bonds frequently renders them quite vulnerable to financial crisis (Broner et al., 2013). This vulnerability, therefore, gives incentive to the government to pay the debt to an extent that eliminates the possibilities of such a crisis (Lindsay, 2011). Again, if the recession is a prolonged one, it might provide the required incentive to the government for gambling on certain financial aspects. The government might borrow in order to upkeep the ability to spend smoothly; to simultaneously reduce the required debt margin if the economy recovers; and default, if the recession is found to continue (Harrison, 2013). Therefore, these are the rescue packages applied by sovereign countries like, Europe, thereby affecting all other countries including Cyprus. Thus, the sovereign debt theory can be linked to the crisis of Cyprus (Nee, 2013). The policies that were adapted by the European Union and International Monetary fund for lowering the borrowing cost as well as the default penalties had actively encouraged the government of Eurozone to gamble with redemption (Charalambous, 2013). These policies of the sovereign countries had resulted in downfall of the entire Euro zone and have affected the small island of Cyprus as well. The other sub-topics include: what triggered the immediate crisis, how the financial crisis would have global implications, and justification of the rescue plan for Cyprus. Focal Literature My investigation mechanism would be based on a theoretical framework. The paper outlines the results of the factors that contributed to the Cypriot economic crisis; economic recession and increased private and public debt. The paper then goes ahead to propose an analytical framework of how the crisis could be avoided drawing on the theories; prospect theory and the revenue based finance theory. Applying the revenue based finance theory; one will be able to ascertain how economic recession, increased public and private debt contributed to the Cypriot economic crisis. It outlines that a fixed-rate national debt can actually be replaced by a revenue-based financial instrument. Basing on the theory, most investors are always willing to agree to lower returns in the short-term in exchange for the prospect of a higher payout later (Faustman and Kaymak, 2013). Although Cyprus had been experiencing rising living standards before the commencement of the economic crisis in 2012, serious problems surfaced in the Cypriot banking sector as early as 2011. Cyprus borrowing costs slowly increased due to its exposure to the Greek debt (Theophanous, 2013). Furthermore, the public debt that was owed by the foreigners increased thus making the economy unsustainable thus creating the crisis. High public debt is very detrimental to economic growth. The easy credit conditions during the 2002–2008 period encouraged high-risk lending and borrowing practices. This later resulted to increased bad debts from the private and public sector. Although high private debt is more detrimental to growth than high public debt (Puri, 2013), excessive sovereign debt reduces growth only when the corporate and household sectors are heavily indebted too. The damaging effect of high private debt becomes evident in the busts that follow credit-driven booms. Those households that have borrowed too much in connection to their income reduce their spending. The overleveraged firms shun investing and concentrate on shrinking their balance-sheets. As bad debts wear down their capital, banks become more hesitant to give somebody a loan. These unfavourable trends reinforce each other, increasing the overall drag on economic growth. On June 2012, the Cypriot government requested a bailout from the European Financial Stability Facility citing hardships in supporting its banking sector from the Greek debt exposure (Pasarides, 2012). On March 2013, the EC, Eurogroup, IMF, and European Central Babk agreed on a €10 billion deal with Cyprus (Puri, 2013). As part of the deal, there would be a 6.7 % one-off bank deposit levy up to €100,000 and 9.9 percent for higher deposits which was announced on all domestic bank accounts. The bailout package comprised of the following conditions: recapitalisation of the whole financial sector while accepting a closure of the Laiki Bank (Genay and Mei, 2013), privatization programme, the Cypriot financial institutions were to implement an anti-money laundering framework. Fiscal consolidation in order to reduce the Cypriot governmental budget deficit, and lastly, structural reforms which would restore competitiveness and macroeconomic imbalances (Theophanous, 2013, p.10-21). The Eurozone crisis could have been avoided, provided the government had intervened beforehand. Lack of government intervention had also led to the Cyprus crisis. If the government had taken the right steps to arrest this crisis, then the failure of several Cyprus banks would not have taken place. They should have taken early steps by increasing the rate of interest on borrowings. This would have resulted in prevention of large amount of loans and debts taken by the banks of the country (Braga and Vincelette, 2011). The excessive tax burden would have also reduced with intercession of the government. The theories that can be linked to the Cypriot financial crisis are the revenue based finance theory. The theory suggests that the existing debt of a country can easily be replaced by the shares of earnings of their own economy (Chorafas, 2013). This is the best way of managing the financial obligation, which can prevent any financial crisis of the country in future. Following this remedy, might help the countries to even decrease the cost of their borrowings in future. Therefore, the adaptation of this theory by the government of Cyprus might have helped it to overcome the debt burden (Harrison, A., 2013). Moreover, the study will use the prospect theory. It takes into consideration the alternatives that come with uncertain outcomes. This model is actually descriptive by nature and tries to represent real-life choices other than not optimal decisions. The prospect theory would outline the decisions that were arrived at during the crisis. Context The study would be based on banking sector which was the focal point of the factors that led to the economic crisis; economic recession and increased public and private debt. Laiki Bank and Bank of Cyprus, the two largest banks of a country held 37.9% of all Cypriot deposits (Zenios, 2013). So when they experienced an increase in debt levels both private and public, they could not sustain the economy plunging the country into an economic crisis. In 2011, the banks were exposed to an upward haircut of 50% during the Greek government –debt crisis(Besim and Mullen,2009) All the bank deposits were to be levied in Cyprus in order to recapitalize the Bank of Cyprus and Laiki Bank. Although Cyprus had been experiencing rising living standards before the commencement of the economic crisis in 2012, serious problems surfaced in the Cypriot banking sector as early as 2011. Cyprus borrowing costs slowly increased due to its exposure to the Greek debt (Theophanous, 2013). Furthermore, the public debt that was owed by the foreigners increased thus making the economy unsustainable thus creating the crisis. High public debt is very detrimental to economic growth. According to Blundell-Wignall (2013), sliding economic recession was a significant factor that led to the Cypriot financial crisis. The banking sector was too big with regard to the total economy, and with the two big banks attracting foreign deposits, this created sliding a risk to the economy if the banks collapsed. The economic rescue model that was used in Cypriot financial crisis was cutting its budget, privatizing state assets, and implementing structural reforms. Cyprus agreed to cut its oversized banking sector and inflicting huge losses on wealthy depositors in the troubled banks in order to secure a 10 billion euro bailout. Puri (2013) added that most wealthy individuals were utilizing Cyprus as a tax haven. This is why the banking crisis further aggravated public and private debt. The European banks owned big amount of sovereign debt, such that concerns relating to solvency of banking systems are negatively reinforcing The bailout was from European Central Bank, IMF and European Commission; organisations which saved the Cyprus’ banking system from collapse by giving them a €10 billion loan. Faustmann and Kaymak (2013) noted that of the €10billion bailout, €4.1billion was to be spent on debt liabilities. The bail-ins of the Cypriot banks imposed by Euro group was that a decision was arrived at to levy all the bank deposits in Cyprus in order to recapitalize the Bank of Cyprus and Laiki Bank. A huge haircut was imposed on the uninsured deposits that were more that 100,000 Euros. (Genay and Mei, 2013).Therefore, these marketing concerns are what initiated the study to examine how economic recession imbalances in the economy and public and private debt contributed to the Cypriot economic crisis For Cypriot financial crisis, the global economy as well as the Cyprus government should be blamed to a large extent. The government should have forecasted the crisis, but had failed to notice various consequences of the global recession on the country. In addition, there was lack of transparency in the banking sector. All these contributed to failure and bankruptcy of numerous banks in Cyprus. Therefore, the government of Cyprus had a single source of recovery, by cashing in from the huge deposits of oil they had. It was left with the only choice of having a partnership based on oil with either Russia or Turkey so as to overcome this problem. These problems should have been better handled by the government of Cyprus in the form of measures taken for market diversification, structural reform and social policy. These could have boosted the economic recovery of Cyprus in a relatively short time span (Bulmer and Lequesne, 2013). 3 Provisional Research Questions What effect did sliding economic recession have on the Cypriot financial crisis? What effect did increased public and private debt have on the Cypriot financial crisis? What economic rescue model was used in Cyprus? What was the bail-ins of the Cypriot banks imposed by Euro group? Chapter 3: Methodology Design approach, stance & why The research uses qualitative research methodology (Nenty, 2009). The methods used to gather qualitative data included open-ended questions, observation, reviewing documents, personal interviews. These were the main primary data collection tools. The secondary data would be collected by reviewing the Cypriot financial reports from the government and other financial institutions. Interviews were used because they are designed to elicit-depth insights and comprehension of the participant’s motivations and perceptions. The open-ended questions collected information on how a reducing public debt and economic recession made Cyprus to succumb to the effects of the Eurozone crisis. The people to be interviewed included: 4-5senior managers at Laiki Bank and Cyprus Banks, 2-3 financial analysts, and 4-5 members of Parliament of Cyprus who had passed the legislation on haircut deposits. The senior managers would provide information on how the economic crisis affected their business. They would also ascertain the importance of the bailouts and bail- in haircut policy. The members of parliament would provide information on why they passed the policy and what solution might have been adopted to resolve the issue. The Financial analysts would provide professional information on the economic crisis. There is sufficient data on the measures that the government should have taken, but had failed to do so. There are also certain quantitative data related to GDP of Cyprus as well as few macroeconomic data, covering the dissertation plan. These data are taken from relevant academic literature, containing fresh viewpoints and realistic information from various authors (Nee, 2013). These will help to justify the plan efficiently. These data are extensively taken from the government professionals, where they stated the need to curb this financial crisis along with the immediate steps that could have taken at that point in time. Therefore, qualitative and quantitative data are taken from authentic sources and will depict a true picture of the Cypriot financial crisis. This empirical research employed exploratory research since it focused on “why” or “what caused” the economic crisis phenomena to occur (Jaworski et. al., 2008). The research study explains why economic recession and increased public and private debt contributed to the Cypriot financial crisis. The research study uses conative and cognitive models of qualitative research. This qualitative research employs these models through grounded theory, ethnography and phenomenology. For instance, observation in qualitative research is the central data collection method in ethnography, whilst in phenomenology it would be utilized to determine areas of “lived experience” that would be explored during in‐depth interviews. The grounded theory gives explicit, sequential guidelines for conducting qualitative research as well as streamlining and integrating data collection and analysis. This article uses three theoretical approaches commonly used by qualitative researchers in business and marketing domains: interactionism, critical theory, and phenomenology. Data collection/analysis methods The analysis draws out patterns from insights and concepts since sampling is theoretical. A descriptive analysis on how economic recession led to the Cypriot economic crisis, as well as how public and private debt contributed to the Cypriot economic crisis will be done. The descriptive component reported what was found, using diagrams, maps, charts, tables, graphs or other illustrations where appropriate. In the year 2009, economy of Cyprus had shrunk by 1.67%. There was a large fall in the shipping and tourism sector, which resulted into unemployment. The economic growth in 2010 and 2011 had failed to attain that in 2009 (Chorafas, 2013). In 2011, commercial property declined by 30% and non-performing loans rose to 6.1%, thereby increasing pressure on the banking system. The nominal GDP was €19.5 billion; but unfortunately, the debt taken by the banks from the private sector of Greece was €22 billion, which also included $60 billion taken from the business corporation of Russia and the deposits from banks was $120 billion (Braga and Vincelette, 2011). The percentage of debt to GDP of Cyprus since 1999 is higher than that of Euro zone. The following analysis helps to show the position of Cyprus before the financial crisis and the way it got affected after the Euro zone recession. The data regarding the GDP and the debts taken later on by the banks of Cyprus will help to depict the financial downfall that the country faced after the recession. The research project will use logical analysis since it provides an outline of generalized causation and logical reasoning process. This analysis uses flow charts and diagrams to pictorially represent these, in addition to written descriptions. For instance, data on labour market and competition levels between Cyprus and other EU nations. Therefore, this analysis component will interpret the findings and consider the implications for the research question addressed. Bibliography Besim, M., and Mullen, F. 2009. Cyprus in the Global Financial Crisis: How Lack of Banking Sophistication Proved an Advantage. South European Society and Politics, 14 (1), 87-101. Blundell-Wignall, A. 2013. The banking crisis: Lessons from Cyprus. Organisation for Economic Cooperation and Development (295), 32-60. Braga, C. and Vincelette, G., 2011. Sovereign debt and the financial crisis: Will this time be different? Washington, DC: World Bank Publications. Broner, F., Erce, A., Martin, A. and Ventura, J., 2013. Sovereign debt markets in turbulent times: Creditor discrimination and crowding-out. Washington, DC: International Monetary Fund. Bulmer, S. and Lequesne, C., 2013. The member states of the European union. Oxford: Oxford University Press. 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