Thursday 5 July 2012

Reactions to an FT article on Cyprus

I returned from a consulting trip to Istanbul this evening to read what must be one of the worse articles ever published in the Financial Times.

My critique of the article, Cyprus juggles EU and Russian support, is based purely on facts, and I hope it will be interpreted by the readers of this blog as such.

The article makes its bias clear from the first two paragraphs: 

If European leaders hoped Cyprus would use its turn at the helm of the EU’s rotating presidency to signal a break from its longtime benefactors in Moscow, the country’s Russian-educated communist president made clear on Thursday they would be disappointed.

A week after becoming the fifth eurozone country to seek a bailout from Brussels, Demetris Christofias said his government would continue to seek rescue loans from the Kremlin – in essence, playing one potential creditor off the other.

While Cyprus has requested European Union support, no offer has been made yet. A “Troika” evaluation mission to Nicosia started this week, but the complete package will not be defined for some weeks to come.

Given that neither Russia nor the Troika are “bidding” to lend money to Cyprus, I fail to see how this amounts to playing one creditor off against the other.

Cyprus is following multiple courses of action to redress its urgent financial problems, which mainly involve bank recapitalisation. As a sovereign country, it has every right and indeed the responsibility to do so.

The German bilateral relationship with Russia is far stronger in terms of trade, investment and gas (see for instance former Chancellor Gerhard Schroder’s chairmanship of North Stream). If we apply the author’s logic to Germany, should we understand that Germany too needs to separate itself from “longtime benefactors in Moscow?”

It’s also worthwhile noting that there are far more Cypriots studying and working in the UK than in Russia, and far more British citizens living and visiting Cyprus each year than Russians. Britain maintains two sovereign military bases in the Republic of Cyprus with 3,500 troops stationed there. I therefore have to question the systematic attempt to demonize Russia in this article, or for that matter, the Cypriot relationship with Russia.

The author also misstates the facts of Cyprus’s relationship with Turkey:

Cyprus has not only blocked progress on Turkey’s membership of the EU but it has prevented the EU from working more closely with Nato to co-ordinate European defence policies.

This statement is both factually wrong and misleading:

·    It is wrong in that the Cypriot veto over Turkey’s membership in the European Defence Agency has prompted Turkey’s veto of EU coordination with NATO. Cyprus is not blocking EU coordination with NATO—Turkey is. This is an elementary fact which should have been checked prior to publication.

·    It is misleading because it fails to mention that via the Ankara Declaration, Turkey neither recognises the Republic of Cyprus, nor has it opened its ports and airports to Cypriot ships or airplanes. This is what has prompted Cyprus to veto Turkish membership in the EDA, but has also prompted the European Union to freeze negotiations on 8 chapters of the Acquis communautaire.

·    It fails to include the fact that Nicholas Sarkozy and Angela Merkel have both called for an alternative membership status for Turkey, and that this too has played a negative political role in Turkey’s EU accession process.

The German Foreign Ministry does a far better job of explaining the current status of Turkey’s accession negotiations:

When a large number of Central and Eastern European countries joined the EU in 2004, it became necessary to include them in the EU-Turkish customs union. To that end, the Ankara Protocol, an additional protocol to the Ankara Agreement, was signed on 29 July 2005. Turkey issued a declaration expressing its continuing non-recognition of the Republic of Cyprus and explicitly excluding Cyprus from the customs union. The European Union issued a counter-declaration rejecting this interpretation and thus re establishing the obligation to include the Republic of Cyprus without exception. Turkey is nonetheless still failing to uphold the free movement of goods created within the customs union in the form of free access to Turkish territory for Cypriot ships, aircraft and heavy goods vehicles. The Council of the European Union has repeatedly criticized this treaty violation, deciding in December 2006 on a partial suspension of accession negotiations. Until the Cyprus conflict is resolved and Turkey implements the Ankara Protocol without discrimination, eight chapters in the negotiations will remain unopened and no chapter will be closed. Because of the continuing lack of progress on the implementation of the Ankara Protocol, the Council has renewed this decision annually since 2006.

In reference to President Christofias’ comments on Turkey, it fails to mention that these occur in the backdrop of Turkish threats against Cypriot oil and gas exploration or the Turkish intention to freeze relations with the EU over the Cypriot presidency.

I bring up these facts solely to illustrate the full picture—not to justify the political decisions on any side which has led Turkey and Cyprus into this regrettable situation.

I honestly have to question how an article with such visible bias, and with such a one-sided view of the situation, can be published in the Financial Times, particularly coming at the beginning of the Cypriot EU Presidency.

I've had the enormous privilege of working over the years in all three countries: Greece, Cyprus, and Turkey. Through my work, I've interacted with thousands of business owners and managers in this time, as well as journalists, NGO members, government officials, and many others. 

Like many others, I believe that Greece, Turkey and Cyprus have more to gain from working together constructively and peacefully rather than engendering a permanent state of military and political aggression. Geographic reality, together with our shared culture and our tremendous economic synergies and potential should make that obvious to anyone.

What should also be obvious are that while there are serious problems on all sides of the political equation, well-meaning partners could solve these if we would put aside the vested interests, stereotypes, political posturing and the bitter memories of the past, and concentrate on our shared—and inevitable—future.

This would require a rational, post-nationalistic approach to policy, which I believe citizens in all three countries are ready for, and indeed would welcome. I have particular hopes that the positive impacts of globalisation and mobility, and the common interests of younger generations will one day make this vision a reality.

Unfortunately, articles like this do more to encourage misconceptions and hostility than to present an accurate and objective picture of current affairs.

A list of sources follows for anyone interested in a more complete picture of the political situation between Cyprus and Turkey.

© Philip Ammerman, 2012

Turkey rejects EU Cyprus Proposals (Hurriyet Daily News)

EU Enlargement: Turkey. (Germany Ministry of Foreign Affairs)

Nord Stream AG (Wikipedia)

Monday 2 July 2012

The Futility of ESM Bail-outs of the Private Banking System

Friday’s announcement that the European leaders of the Eurozone agreed to use the European Stability Mechanism (ESM) to recapitalise Spanish, Italian and other banks was met with euphoria.

Under the preliminary agreement, the ESM will be able to use part of its EUR 500 billion credit reserves to participate in bank recapitalisation, subject to certain conditions which include the development of a pan-European banking regulator under the European Central Bank (ECB) as well as a wider national commitment to an austerity / balanced budget programme.

Several commentators have already remarked that the agreement lacks detail. I will go a step further and argue that the dual mechanism of European banking regulation plus bank recapitalisation will fail to prevent future situation equivalent to that where Spanish banks need recapitalisation. While the recapitalisation may take place and provide momentary relief for the "zombie banking system", the root causes of the problem remain, while regulatory compliance will prove impossible to implement. 

The reasons for this are based in two salient facts: recent history, and regulatory operations. If we look at the emerging market debt crisis of 1982; the US savings and loan crisis of 1987; the east Asian currency crisis of 1997-1998; the boom and bust of 1999-2000; the mortgage/property crash of 2007-2008; and the sovereign debt crash of 2009 and onwards, we readily see that these crises were caused by an excess of capital chasing outsized returns from a relatively few real investment opportunities.

This search for outsized returns is possible either at the early stage of the boom, or by taking on massive leverage, or by finding gullible investors, or by illegal activity. Or a combination. But the longer a boom continues, the more difficult it becomes to regularly earn high returns. Market saturation results; the good opportunities are taken; competition lowers margins for everyone. As a result, bubbles burst.

In each of the cases mentioned, the initial investments and subsequent credit or investment booms were entirely legal. There was nothing inherently illegal, for instance, about stocks being valued at 200 times earnings. Similarly, there was nothing illegal about adjustable rate mortgages, or sovereign loans to Greece.

The problems occurred when too many institutions starting throwing too much money at too few opportunities. This is a common factor in most boom-bust cycles, but it has usually has little to do with regulation.

This is not to say there were regulatory failings: there were many, and these have been widely documented after each crash. 

But during the boom, a common factor is that the power to regulate loses its political acceptability in inverse proportion to the outsized profits being made.

Let’s look at the Spanish bank recapitalisation as a case study. Spanish banks are currently in dire need of recapitalisation primarily because the Spanish property market boomed in the 1990s through to about 2005. This investment boom was very well known and widely reported. See The Economist’s survey of Spain in June 2004 as an example:  

The first problems for the new government are the demand for housing, which is such a large component of general economic growth, and the supply of labour, which also drives growth, though by boosting jobs, not productivity. Spain made a start on 700,000 houses last year, four times as many as Britain. Even so, prices for new Spanish houses rose 18.5% and for existing ones 16.7%. The boom continues, fuelled partly by foreigners drawn to Spain by the thought of a house in a sunny part of the euro area, partly by share-shy Spaniards looking for an investment. The upshot is that though 3m-4m houses stand empty and a similar number are used as secondary residences, many young Spaniards cannot afford even the smallest flat, and thousands of workers turn down job offers that involve moving house because they cannot find a house to move to. At the same time household indebtedness has risen sharply (nearly half of the average family's disposable income goes on servicing housing debt), while some 40% of Spanish capital stock is in nothing more productive than property.

This single paragraph summarises everything wrong with the Spanish economy at the time.

Remember that in the mid-1990s, the whole objective of economic development in Spain under standard EU procedures was to attract domestic and foreign investment and promote economic growth. One of the main beneficiaries of the Spanish property boom was British and German vacationers, and speculators. Some of the main sources of capital for property development in Spain came from British and German banks.

The problem was—and remains—that nothing about the Spanish real estate boom was illegal, or even unsustainable, unless financers, customers and regulators were to have taken a much longer-term, conservative view.

So let’s assume the impossible: that a long-term, “economically rational” or conservative view prevailed among public policy makers, bankers, developers and customers. What could have regulators done to stem the property rush? There are several classic policies, ranging from requiring a greater deposit ratio for mortgages, to increasing a transaction tax on frequent sales of homes in order to avoid “flipping” or other speculation.

All these tools exist. But experience shows us that applying them is nearly impossible.

Now let’s fast-forward to the ESM and the ECB. Thus far, the European Central Bank has been placed in a nearly-impossible task of maintaining a Euro-wide inflation target while providing liquidity to European banks. Along the way, it has purchased over EUR 200 bln in sovereign debt, which it is not supposed to do, and also lent over EUR 1 trillion to European banks under LTRO, not counting additional loans previous to LTRO.

What exactly is this ECB bank regulator supposed to do in the next boom? Order Spanish banks to stop lending for property development? Insist via the Eurozone economic planning committee that Spanish property taxes should rise by 10% to discourage speculation? Force Spanish banks to increase the deposit ratios to 40% of mortgage loans?

Does anyone realistically see this happening?

Most Eurozone countries, including Germany, have been in breach of the Maastricht criteria since their inception. These criteria underpin the European convergence criteria, and therefore the basis of European monetary policy. Let’s remember what these criteria are:  

1.  Inflation no higher than 1.5% of the average three best performing member states in the EU
2.  Annual government deficit not more than 3% of GDP
3.  Government debt not more than 60% of GDP
4.  Long-term interest rates not more than 2% higher than the rates of the three lowest-inflation member states. 

These criteria are the real problem in the Eurozone crisis. They impose an inflexible, rigid set of macroeconomic and fiscal standards which are almost impossible to apply in a monetary community of 17 member states, which pack small, service centres such as Ireland, Cyprus and Malta alongside larger economic powers such as Germany or France. They are also impossible to enforce given the lack of a single, elected budgetary and decision-making authority (which is ironically what Germany is trying to develop).

These criteria themselves have fed the economic boom-bust cycle. As countries with weaker government economic planning and weaker enterprises such as Spain, Italy or Greece entered the Eurozone, they saw interest rates fall, leading to a massive credit expansion in both the public and private sectors. This credit expansion was fuelled by lower interest rates, and by the fact that credit was secured not only by normal economic conditions, but by the very convergence policies and infrastructure spending channelled through the European Union (Common Agricultural Policy, Structural Funds, etc.).

The results today are clear: there has been a massive transfer of credit and investment from better-developed capital markets in northern Europe (and Asia and North America) into the southern European countries. This was used for everything from capital investments (hospitals, highways, ports, schools) to private homes to luxury consumption (imports of Porsche Cayennes and Hugo Boss suits).

Eventually, the boom turned into a bust, either in terms of the state-led development model (Greece) or the property / tourism boom (Spain). Now creditors and lenders are left with non-performing loans and deteriorating public and private assets that are rapidly losing their value.

The classic solution in this case is a debt restructuring and work-out. It is not a EUR 100 billion recapitalisation in exchange for “better regulation”, which will be politically impossible to implement.

The sooner Greece, Spain and other countries (including the UK and Germany) come to terms with re-pricing asset values and their associated debt service assumption, and restructure these loans contracts, the sooner the crisis will end and “normal” growth will resume. Until the next bubble, of course.

© Philip Ammerman, 2012

Philip Ammerman is Managing Partner of Navigator Consulting Group and European Consulting Network. He works in the field of investment management and due diligence in Europe, the former Soviet Union, and the Middle East.