FACULTY OF INTERNATIONAL BUSINESS AND ECONOMICS

Academy of Economic Studies

SOVEREIGN RISK AND FINANCIAL STABILITY AMONG EUROPEAN UNION COUNTRIES

CASE STUDY: CYPRUS

Prof. Coordinator: Dumitrescu Sorin

Students: Oana Olariu Elida Ioana Pantea Georgiana Petrescu Group: 940, 2nd year

APRIL 2013 BUCHAREST

SOVEREIGN RISK AND FINANCIAL STABILITY AMONG EUROPEAN UNION COUNTRIES

Abstract This paper tries to identify the linkages between the sovereign risk of European Unions countries and the level of financial stability it creates for them. After 2008, when the global financial crisis hit the world, Europe started to suffer a lot and is still healing its wounds. Following the critical situations of Portugal, Spain, Ireland and Greece, the year 2013 is now focusing on the fiscal and sovereign difficulties Cyprus has. Our analysis presents an overview on the major concepts of discussion, meaning sovereign risk and financial stability, concentrating in the second part on the economic conditions of Cyprus. Introduction Generally, when discussing about risk, we think of the probability of occurrence of an unforeseen event which has the effect of modifying results. Under this definition, the likelihood effects can be both positive and negative. In practice, however, we are interested more in negative than positive events, because for positive events the effects will only be quantified, while negative effects should be foreseen and overcome on. When we discuss about a country as a whole, we should be aware of its level of sovereign risk and to what extent is this risk having negative effects on the economy. Generically, as its name implies, sovereign risk is the risk of a government becoming unwilling or unable to meet its loan obligations, or reneging on loans it guarantees(Cooper,1998). Simply put, it is the

probability of loss of international activities as a result of economic, political and social events specific to each country. Losses may materialize into: Opportunities loss due to contract failure; Additional costs involved in requiring debtors to meet their obligations; Real losses materialized in amounts that cannot be recovered. During the late 2000s global crisis, there have been many countries which have faced sovereign risk. This type of risk implies that creditors should take into consideration two important aspects when deciding to lend to a firm from foreign country. First of all, one should consider the quality and implications of sovereign risk in that country and then consider the firm's credit quality. Moreover, as a response to the crisis, many governments significantly increased their borrowing, raising sovereign debt levels simultaneously with declines in tax revenues, higher expenditures and increasing fiscal deficits. This practice initiated a new stage of the crisis, which emerged in 2010, namely the sovereign debt crisis. This appeared first in the euro area (Greece, Portugal, Ireland), before extending in UK and US. As sovereign credit risks rose, the governments could no longer support banks and thus sovereign risk multiplied and increased considerably, boosting bank borrowing costs. As a consequence, in 2010, many countries experienced simultaneously large scale banking overturns, refinancing needs and high sovereign borrowing needs. Relationship between sovereign risk and fiscal stability In the face of financial crisis and global recession, the responses given by policymakers to these events have had considerable, and perhaps long-term, effects on the global economy and financial markets. Having reduced growth prospects and sharply increased public debt in several advanced countries, intensified concerns about sovereign credit and liquidity risk, posing a substantial challenge to banking systems and financial stability.
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Apart from these developments, increased interactions between sovereign debt management and central banking systems also emerged from having low short-term interest rates and large-scale procurements of assets as mechanisms of monetary policy. Therefore, an extensive approach is required in order to identify and measure both direct and indirect sovereign risk connections between the balance sheets of a country and those of other institutions like banks, corporations, households. On one hand, we define financial stability as a situation where the financial system which includes financial intermediaries, markets and market infrastructures is capable of resisting shocks and sorting out financial imbalances. On the other hand, however, sovereign risk is far more than just a pure fiscal risk. The analysis of sovereign risk needs to go well beyond the traditional debt sustainability approach to encompass the complex net of macro-financial interactions. Often, when discussing about sovereign risk, economists referred to the risk to debt sustainability of a country, meaning the probability that debt ratios may cross a certain ceiling. Under this merely macro-financial approach, sovereign risk is defined as solvency risk measured in terms of primary expenditure, stock of nominal debt, and tax revenue. In a debt sustainability analysis approach, which explores the net present value of future debt flows, market and investor factors enter into the equation only through the discount variable. The qualitative characteristics of the composition of the debt stock, through which market expectations operate, are mostly ignored. When focusing on the macro-financial stability challenges that governments face, dependence only on a fiscal approach to sovereign risk is valuable, but becomes too limited. As a consequence, is now well established that, with the evolution of global and domestic capital markets and the interconnections between sovereign and financial sectors balance sheets in advanced economies, the concept of sovereign risk has to open out to cover a much larger array of risk factors.

Generally, sovereign risk factors are: Demographics and education: birth rate, population pyramid, the share of urban

population in total population of a country, quality of life (GDP / capita), life expectancy; Production and trade structure: nominal and real GDP, the share of imports and exports in

GDP, export and import volumes by geographic region; Dynamics of the private sector: the rate of creation of new enterprise, privatization and

methods used, the share of private sector in the national economy; Macroeconomic policy: monetary policy objectives, price stability, the degree of central

bank independence, the evolution of the exchange rate; Investment and trade policy: measures to control imports, customs duties, export

subsidies, foreign investment policy, control over repatriation of profits, interest and dividends; Banking system: analysis of loans by type of institutions and sectors, lending policies, the

degree of central bank intervention, prudential regulations and banking supervision, capital market development and the degree of interconnection with international markets; External debt: debt strategy, major types of borrowers debt (private / public), net and

gross external debt; State policy: the degree of consensus on economic policy, the corruption and

bureaucracy, the size of the armed forces, military and economic agreements; International position: foreign policy goals and strategies, membership in international

organizations, relations with the IMF and the main industrialized countries: USA, EU, Japan. With the global crisis accelerating rapidly after 2008, the euro area launched support programs and also broadcasted some ambitious fiscal reforms among countries that faced the greatest sovereign difficulties, in order to keep under control the economic chaos that was about to erupt. Nonetheless, sovereign risks remained high as markets continued to center on public debt burdens, weak growth dynamics and linkages to the banking system. The policymakers became aware that they should both improve the process of fiscal sustainability and also attenuate the connections between sovereign risk and financial systems. They expected this attitude to help reduce the sovereign debt risk which compromised the financial stability of countries.

Economic and fiscal instability in Europe As a consequence of the rising private and government debt levels, to which is added a wave of downgrading of government debt in some European states, investors feared the influences of the sovereign debt crisis from the late 2009. The impact of the European debt crisis may be huge and we know that economic growth, inflation and foreign exchanges are and will be affected on a long term basis. Thus, today is a lot of uncertainty about the economic and fiscal policies that Europe and the rest of the world will adopt. It is possible that some risk scenarios are more plausible than others and the final outcome is uncertain. A method by which sovereign debt in several euro areas and other advanced countries may no longer be regarded as having zero credit risk is to create credible plans in order to restore long-term fiscal sustainability. We can characterize the global financial crisis by severe turbulence in the global financial system, large cumulative losses in economic output, and a sharp deterioration in advanced economies general government fiscal balances and public debt levels. Regarding the public debt levels in the advanced economies, between the end of 2007 and the end of 2011, rose by 30 percentage points of these economies combined GDP. The predictions from the IMF forecast are that this overall debt ratio will peak at around 110 % of GDP in the course of 2013. Causes of the crisis varied by country. For example in Greece, high public sector wage and pension commitments increased the debt. In some countries, private debts arising from a property bubble were transferred to sovereign debt as a result of banking system bailouts and government responses to slowing economies post-bubble. Another factor that contributed to the crisis and harmed the ability of European leaders to respond was the structure of Eurozone as a monetary union, but without fiscal union. Also the European banks own a significant amount of sovereign debt.

The most important driver of recent developments in global financial markets remained the sovereign risk perceptions. In the past 12 months, a huge number of additional downgrades of sovereign risk took place including negative actions as regards the debt issued by formerly AAA-rated countries, thus it can be observed that the risk continued to materialize to a significant extent. Another, yet exceptional, manifestation of the materialization of sovereign risk was the restructuring of Greeces sovereign debt in March 2012, which took the form of a debt exchange with private creditors. The sovereign risk ratings downgrades were concentrated on a number of peripheral Eurozone countries, where serious internal and/ or external imbalances and resulting weak economic growth were perceived to compound the difficulties of rising public debt and the related challenges of restoring the debt to more sustainable levels. Spreading the tensions on sovereign bond markets to the larger southern European countries, namely Italy and Spain, was the main development during that period under review. This spreading of the sovereign debt crisis contributed to a highly correlated surge in the risk premiums for sovereign and bank debt, attesting to the persistence of strong links between sovereign risk perceptions and bank funding conditions in the euro area. By using the issues of secured bonds, such as covered bonds, banks responded to the drying up of unsecured bond funding. Because the link between sovereign risk and bank funding is so persistent, it increases the risk of acceleration in bank deleveraging strategies, including through cuts in bank credit. Many European banks are currently engaged in processes aimed to reduce their total assets and risk-weighted assets and increase solvency ratios, but developments so far suggests that most of the asset sales or rundowns focused on non-core assets or non-core lending activities, in particular those denominated in non-euro area currencies (US dollar) and/or attracting higher risk weights (asset-based finance and project finance).

In some peripheral euro area countries lending to the domestic private sector has been tightened significantly, increasing the possibility that deleveraging forces may be felt in varying degrees in banking systems across the euro area. Led by strong domestic credit growth, in some countries like Spain and Ireland where the total assets of the banking sector expanded up to 2007, deleveraging to unwind previous credit excesses may be unavoidable being likely to take the form of both tight credit conditions and write-offs of non-performing assets.

CASE STUDY: CYPRUS Introduction Cyprus, which is an island country located in the Eastern Mediterranean Sea, is now suffering a lot from the domino effect of negative consequences in the global economy. The Cypriot economy contracted by 1.67% in 2009 mainly because the fall in the tourist and shipping sectors, thus following in the footsteps of US mortgage crisis in 2008. Cyprus entered into a recession because it experienced a continuous rising of unemployment and from 2010 to 2012 due to the fact that the economic growth of the country weakened, the Cypriot prospects for recovery were not considerable. The outbreak of the Cypriot financial crisis is marked by the year 2012. The crisis involves the exposure of Cypriot banks to the Greek Debt Crisis, the downgrading of the Cypriot economy to junk status by international rating agencies, the consequential inability to refund its state expenses from the international markets and the reluctance of the government to restructure the troubled Cypriot financial sector. In exchange for Cyprus agreeing to close one of its largest banks, the Cyprus Popular Bank on 25 March 2013, a bailout consisting 10 billion euros were offered, levying all

uninsured deposits there, and possibly around 40% of uninsured deposits in the Bank of Cyprus (the Island's largest commercial bank), many held by wealthy citizens of other countries, significantly Russia. Political conditions Since 1974, when Turkish troops had invaded the island driving thousands of Greek Cypriots from their homes in the northern towns, Cyprus has been divided by a U.N.-controlled zone known as the "Green Line," a border that was completely sealed off until a decade ago. Even though it has partially opened, those who lost their homes in the north during the brief conflict that year still long to permanently return. But a negotiated settlement to the conflict has remained elusive since the invasion, even as the partition has been the top issue on the island for decades.
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Cyprus political risk outlook has worsened since Dervish Eroglu was elected president of the Turkish Republic of Northern Cyprus in April 2010. Reunification talks of the south and north of the country have since reached deadlock and prospects for a permanent peace settlement on the divided island have receded due to unfavourable political conditions on both sides. Political stability decreased further after a junior coalition partner left the government and a Supreme Court ruling weakened the presidents position. The delicate political environment in this crisis period is hardly helping any matters. Domestically, the landslide victory for the pro-bailout conservative Democratic Rally (Disy) party candidate Nicos Anastasiades at the presidential election in February 2013 had been interpreted as resolution-friendly. Anastasiades is more amenable to the types of structural reforms required to steer the country out of its present mess than his Communist predecessor, who rejected privatization of state-owned enterprises. To instill confidence in the international community, the new cabinet contains many respected economists and business-minded figures.However, with control of only 28 of 56 parliamentary seats, the government, comprising Disy and the Democratic Party (Diko), does not have a majority to legislate. On balance, to ensure that Cyprus becomes a country that survived the crisis, Political Risk Service (PRS) Group believes that policymakers may still reach a solution convenient to all parties. By doing this, the euro will stabilize long-term and confidence will be slowly restored. Economic Environment Cyprus economy is slowly recovering from the negative shocks of the past two years, hence the effects of the financial crisis on the country were not as severe as on other Mediterranean ones. The most important matter is the decisive implementation of the preliminary agreement on a support program for Cyprus by the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), which was drawn up after negotiations with the Government and the Central Bank of Cyprus (CBC).

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This program aims to achieve consolidation, restructuring and recapitalization of the banking sector, consolidation of public finances and implementation of the structural reforms required according to the agreed timetables. These measures will lay the foundations for the gradual recovery of the economy in the medium term and ensure sustainable growth in the longer term. Cyprus gave up all monetary policy instruments by entering the euro-zone in 2008, thus monetary policy is managed and interest rates are now set by the ECB. Another modification is that the economic policy is now limited to fiscal policy and structural economic reforms which must be in accordance with EU regulations Financial environment In comparison with countries that have been severely affected by the financial crisis, namely Greece, Spain and to a lesser extent, Italy, Cyprus was not that harshly hit. Even so, the financial supervision system from Cyprus still got to maintain certain stability and escaped from the total downfall of the banking system, without any financial governmental help. However, their main purpose still remains the reduction of governmental deficit. As it can be seen in the table above, the budget deficit rose rapidly in 2008-2009, from 0.9% to 6.1%. This was the year that the crisis deepened mostly and took its effect on the governmental expenditure. The deficit continued to increase until 2011, and since then, as Cypriot government struggles to save the country from going bankrupt, it can be noticed an important decrease of deficit by 2.1%.

Budget deficit (% of GDP)

7 6 5 4 3 2 1.2 1 0 2006 2007 2008 2009 2010 2011 2012 0.9 3.5 6.1 5.3 4.2 6.3

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Regarding the banking system, statistics show that during the first nine months of 2012, all lending rates in Cyprus remained at higher levels compared with the corresponding period of 2011, although at the end of the third quarter of 2012 some categories recorded a slight decrease. This decrease was mainly due to developments that influenced the economic activity on national and international level. The major development was the ongoing financial uncertainty in Greece and the exposure of domestic financial institutions to Greek bonds and loans in Greece. On the domestic market, there were some factors that contributed to the increase in the governments cost of borrowing from the international markets: the continuously downgraded Cypriot government bonds and the resulting downgrades of domestic banks by the rating agencies, and the negative outlook for the economy. Therefore, Cyprus was excluded from the international markets in May 2011, and as a result of that, the government continued to turn to domestic credit institutions for borrowing, thus limiting the available liquidity. Moreover, the competition between domestic monetary and financial institutions to attract deposits by offering new higher interest bearing deposit products in an attempt to meet capital challenges and increase their liquidity, inhibited possible reduction in lending rates for the future. Economic indicators The economic indicators show exactly what the actual situation in Cyprus is and to a certain extent, what the future preserves for this country. Therefore, regarding the GDP, the emphasis is put on starting with 2008, when it abruptly fell from 3.6% to -1.7%. The year 2008 marked the entrance of Cyprus in the euro-zone. Besides the advantages of having a common currency, such as positive growth, higher employment etc., for the moment the country had to adjust to differences of currency. Even though, in 2010 the economy started to show signs of a slight recovery, the financial crisis prevailed, as the real growth rate started to decline sharply again in 2012. It seems that the prospect of any growth in Cyprus has now evaporated.

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GDP-real growth rate(%)

6 5 4 5 3 2 1 0 -1 -2 -3 2000 5.1 4 2.1 1.9 1 0.5 4.2 3.9 4.1 3.6

-1.7 2002 2004 2006 2008 2010

-2.3 2012

Apart from a booming tourism sector largely untouched, until now, by the countrys problems, most other areas of economic activity, including construction, manufacturing and most other types of services activities are struggling with poor export markets, fiscal consolidation and tightened credit availability as banks deleverage. This is weighing heavily on confidence and crimping private consumption and investment. Another economic indicator that emphasizes the Cypriot financial crisis, yet, of an extreme importance is the inflation rate. The table below shows a similar trend as the real growth rate does. Therefore, in 2008, the year of euro-zone accession, the inflation rate decreases from 4.4 to 0.2 in 2009. Many economists think that the primary effect of the currency union is that of reduced inflation, with all the other beneficial consequences.

4.9 5 3.9 4 3 1.9 2 1 0 2000 2.8 1.9

Inflation rate
4.4 3.3 2 2.2 2.6 2.1 3.4

0.2 2002 2004 2006 2008 2010 2012

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The unemployment rate in Cyprus has a continuous negative evolution since 2008, as shown in the table below, from 3.6% in 2008 to 8.0% in 2012. The predictions for the following period are expected to be 16% or more by 2014, further fuelling social tensions and emigration.

Unemployment rate (%)

9.0 7.9 8.0 7.0 6.0 4.9 5.0 4.0 3.0 2000 3.8 3.6 4.1 4.5 5.2 4.6 3.9 3.6 5.4 6.4 8.0

2002

2004

2006

2008

2010

2012

Conclusions The Cyprus economy as well as the euro area as a whole are facing an extremely difficult time. The adverse international economic developments, particularly the fiscal crisis which hit the Greek economy, inevitably affected the Cyprus economy, through the banking system. The consequences of the haircut on Greek debt have created immediate needs for the efficient recapitalization of the banking sector, which will help bring the economy back to a healthy and sustainable growth path. This is a necessary condition for the sector to regain its role as an engine of growth for Cyprus businesses and households. In parallel to the efforts to address the recent challenges faced by the banking sector, the Central Bank of Cyprus also supports the Ministry of Finances efforts for fiscal consolidation. The increase in public debt emphasizes the need for fiscal consolidation, especially when taking into account the likelihood of state funding in order to finance a domestic bank which could increase the public debt by up to ten percentage points.

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The implementation of the Fiscal Framework agreed by the leaders of the euro area is an important step towards the recovery of fiscal balances. At the same time, making the right choice of expenditure cuts and revenues is of particular importance under the current circumstances. For example, the containment of public spending should be achieved mainly by cutting current, nonproductive expenditure, which will not undermine growth. Moreover, fiscal consolidation must be accompanied by structural changes which will increase competition in the labor and product markets and assist in restoring our credibility as well as creating a favorable environment for growth. Otherwise, adopting the wrong type of austerity measures will reinforce the vicious circle between the reduction in economic activity and increasing fiscal deficits. During such difficult economic conditions for the country, it is important to have a consensus among all the intended parties so that the current challenges can be successfully faced, thus ensuring that the economy regains its healthy growth path.

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