REPORT_Economy_Q2 2012.pdf

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Economic Outlook: Cyprus

S&P estimate Cyprus total financial

requirements over a three-year period

at about11-15bn

Conditions of the Troikas support

package will be of key importance to

Cyprus creditworthiness

Structural challenges to the Cypriot

economy are significant

Unemployment is increasing

Cyprus Economy and Banking

Overview: Key Economic IndicatorsCyprus fell back into recession at the YE2011 after posting threesuccessive quarters of negative growth in the second half of theyear. In the second quarter 2012, Cyprus GDP contracted byapproximately -2,3% year-on-year (YoY). Negative growth rateswere recorded in construction, manufacturing, and electricitysector, as well as in trade and transport. Only the sectors oftourism, banking and services (administration, education,medical/health) recorded positive growth rates in June 2012.

Cyprus has lost access to markets following the succession ofcredit rating downgrades to junk status by the three mainagencies, with yields at the short end of the sovereign curvesurging to 24%. Around 4.4bn in principal will need to berefinanced by end-2013 (circa 21% of GDP) which will prove difficultto roll-over when borrowing costs are in the double digits andwith little to suggest that the economic outlook will improve.

2012 is expected to be a recessionary

year for the local economy

Cyprus became the 5thEuropeanmember state to officially file an

application to join the European

Support Mechanism

Filing for Support

Banking Sector: Cyprus

Table 1: Key Economic Indicators

Over the last two years, raters have downgraded Cyprus severaltimes. Key reasons include the potential write-downs arising fromdomestic banks exposure to the Greek public and private sectors,and delays in the consolidation of public finances. Cypruseconomy is currently suffering from a weakening in the propertyand financial services sectors, leading to a deficit of over 6% ofGDP.

Before the global financial crisis, the budgets dependency onproperty tax receipts had steadily increased. Therefore, when the

domestic property market weakened, government revenuesdropped; yet, expenditures continued to grow. Despite thedeterioration in fiscal performance, the government resistedmoving ahead with key cuts to entitlement expenditures andpublic payrolls (circa 25-27% of government spending).

Dynamics and Expectations

September 2012 Report: Q2 2012

Indicator 2009 2010 2011 2012E

GDP (Real _%) -2.0 1.1 0.6 -1.5/-1.8

HCPI (%) 0.3 2.5 3.5 3.1/3.3

Unemployment (%) 5.4 6.4 7.8 11.7/12.0

Fiscal Balance (% _GDP) -5.9 -5.4 -6.3 -4.1/-4.5

Public Debt (% _GDP) 58.0 60.7 71.7 81.0/84.0

Current Account Bal. (% _GDP) -7.8 -7.8 -10.5 -8.0/-9.0

Note: Additional funds for the banks recapitalisation were not taken into account

Increasing NPLs in Cyprus andGreece

Liquidity and capital concerns

High deposit and loan interest rates

(amongst the highest in Eurozone)

Greek exit and devaluation concerns

Recapitalisation and restructuring

plans (and investigations form CBC)

Sources: IMF (2012), Cyprus National Statistics (2012), CBC (2012), Moodys(2012), Fitch (2012), S&P (2012)


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Following these developments, Cyprus applied forfinancial support from its EU partners, becomingthe 5th member in the European Economic &Monetary Union to do so. Faced with the need tore-capitalise the largest domestic banks, and atesting government debt maturity profile, Cyprusis negotiating a package designed to address itsshort-to-medium term financial obligations.

Standard & Poor (S&P, 2012) estimate Cyprusfinancial requirement over a 3-year period at about11-15bn. This figure was based on the capitalneeds of the domestic banks to meet EuropeanBanking Authority (EBA) requirements, thebudgetary requirements, and the total impact abailout package could have on public finances.

Figure 1: High Real Unemployment

3,7%

5,4%

6,4%

7,8%

11%

0%

2%

4%

6%

8%

10%

12%

2008 2009 2010 2011 2012e

Unemployment

Source: Cyprus National Statistics (2008-11)

By the end of 2012E, the Harmonised Index ofConsumer Prices (HICP) is expected to remain atthe same level as YE2011 (circa 3.3%)

The governments efforts to bring the budgetdeficit down to 2,5% of GDP in 2012, from 6,3% in2011, have not been adequate. Thus, the assumedtarget is most likely to be missed. It is expected

that the budget deficit will be around 4,5% of GDPby year YE2012 (IMF, 2012).

Public debt was at 71,7% of GDP by the YE2011,from 60,7% of GDP at the YE2010. The public debt

is projected to reach 81-84% of GDP by YE2012(excl. funds for the recapitalisation of domesticbanks).

For 1H2012, tourist arrivals reached approx.900.000. Tourist arrivals in July 2012 reached371.453 having a 3,5% YoY increase. Proceeds fromtourism over the period from January to June2012, reached 646mn.

The outlook for 2013 remains uncertain. The needfor further austerity measures to reduce thebudget deficit and continuing uncertainty arelikely to affect consumer and investor confidence,leading to consecutive year of recession. Amedium-to-long-term positive prospect for Cyprus,concerns the exploitation of major offshore gasreserves, which, if managed well, could provide animportant boost to the countrys long-termgrowth potential, even if the full benefits will most

likely take a decade to realise (Fitch, 2012).

CYPRUSECONOMYANDBANKINGDYNAMICSANDEXPECTATIONS

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Report:Q22012

Pessimistic OutlookGDP is forecast to contract by 1,5%-1,8% in 2012, asthe current government propose to intensify itsausterity measures (many of these are expectedto be imposed by the Troika), and uncertainty overthe banking sector, negatively affecting domesticdemand. The high likelihood of wage cuts in boththe public and banking sector, casts a heavyshadow over consumer spending.

Deteriorating trends in the local labour market will

negatively affect the economy. Unemployment hita record of 11,5% in the 2Q2012, beaten only bythat of Spain and Greece. This rapid increase,which is likely to continue, will have a negativeimpact on consumer confidence.

Figure 2: Cyprus Fiscal Balance

3,7%

5,4%6,4%

7,8%

-4.5%

-8%

-6%

-4%

-2%

0%

2%

2008 2009 2010 2011 2012e

Fiscal balance (%_GDP)

Sources: Cyprus National Statistics (2008-11), IMF (2012)


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Contingent liabilities from Cyprus two largestdomestic banks, i.e. Bank of Cyprus (BoC) andCyprus Popular Bank (CPB, formerly Marfin), are inthe process of crystallising on Cyprus balancesheet. Both banks (~40% of total domestic lending)posted significant losses after write-downs ontheir Greek Government Bonds (GGBs) holdings.At the YE2011, BoC held GGBs with a nominal valueof ~2bn and CPB ~3.1bn. After a 75% impairment,BoC and CPB are estimated to need a total of2.3bn to raise Core Tier 1 capital adequacy to 9%(EBA regulatory limit). To raise capital, both bankssold subsidiaries, issued rights (underwritten bythe government in CPBs case) and convertedeligible securities into equity. However, recentfigures suggest that BoC fell ~700mn short of thetarget, and CPB ~1.8bn (government support has

already been provided and approved by EU,c.1.8bn), together totaling a capital need ofapprox. 2.5bn. If one provides additional creditlosses in 2012 and 2013 of 2.2bn, the totalrecapitalisation cost to 4.7-5.0bn or 30-40% ofGDP (S&P, 2012).

In Fitchs (2012) opinion, Cypriot banks will requiresubstantial injections of capital in order to secureconfidence in their financial viability. They argue

that the scope for further capital-raising from theprivate sector is limited and thus assume that thecapital will have to be provided by the Cypriotgovernment. With the fiscal cost of bank support,government debt is likely to exceed 100%.

While some improvement in capital could beachieved via further divestments/ disposals andretained earnings, analysts expect the main costof injecting equity into the system will most

probably fall to the government.

As of March 2012, non-performing loans (NPLs) inGreece were nearly 16% and banks continue toprovision 300 basis points on their loan portfolios.Therefore, analysts suggest that Cypriot banks areat risk from extensive deterioration in theperformance of their Greek loans. Losses on theseloans could push capital adequacy further belowthe 9% regulatory minimum.

Acceleration in NPLs formation in 2012, and theexpectation of continued severe asset-qualitypressure from the weak operating environmentsin Cyprus and Greece will lead to higher loan lossprovisions. Moreover, the weakening funding andliquidity positions, which are the result of depositoutflows which in turn have triggered anincreased reliance on Central Bank (e.g. CPB has

~9 billion of ECB funding while BOC has ~3,5billion). Analysts expect that declining businessvolumes in Cyprus will pressure pre-provisionprofitability, thereby weakening internal lossabsorption capacity.

Banking Outlook

Figure 3: NPLs - Major Cypriot Banks (2Q12)

It is expected that a Greek exit and devaluationwould lead to a large and rapid increase in NPLs.This would leave the Cypriot banking system inneed of substantial sovereign re-cap, leading to asignificant increase in government debt. Asmentioned above, financing for this would need tocome from external sources. Without financialsupport, problems could be compounded by adeposit run, including by non-resident depositors.

Source: Banks financial presentations (2Q2012)

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S&P (July 2012) estimate the total of Cypriot bankclaims on Greek private-sector borrowers at 22bn(120% of estimated 2012 GDP). The vast majority ofthis loan book rests on the balance sheets of BoCand CPB. S&P expect that Greek output willcontract by a further 7% in 2012, suggesting thatGreek borrowers will struggle to repay their loans

to Cypriot banks as income decline, consumptionwithers, and unemployment increases.

Credit Loss Estimates


Report:Q22012

15.8

14.2

22.3

5

7

9

11

13

15

1719

21

23

25

Hellenic BoC CPB

Reported NPLs (2Q12)


4/4 2012 Copyright by LEAF Research

ECB Research on Deposit and Loan Rates in CyprusCustomer deposits account for approx. 70% of the major banks assets and 78% of their total funding as at1Q12, while liquid assets are relatively high at 19% of total assets. Cypriot banks also have relatively lowloan-to-deposit ratios at around 95%, compared with other European systems (Moodys, 2012).

ECB figures indicate a substantial increase in deposit rates as a result of the strong competition forretaining existing deposits and attracting new ones. The liquidity problems in the banking sector lead to agradual increase in the cost of borrowing for banks, creating dependence on ECB funding. According tonew ECB data, interest rates for new deposits in Cyprus stood at 4.41% in July from 4.33% in June and 4.11%in July 2011. Cyprus and Greece have the highest deposit rates in the euro area, where the averagedeposit rates for deposits up to one year increased to 2.80% from 2.72%. Unlike Greece, deposits inCypriot banking system seem to resist the turmoil caused by the accession to the mechanism. Accordingto Central Bank figures, deposits in the domestic system in July 2012 fell to 70.6 billion from 70.8 billionin June 2012 and 71.4 billion in July 2011.

As for mortgage rates in Cyprus, these fell to 5.51% in July from 5.74% in June and 5.46% in July 2011. This isthe first decline since February. In the Eurozone, the mortgage rate dropped to 3.58% from 3.66%. In

Greece, it decreased to 3.42% from 3.72%. Business loans in Cyprus decreased to 6.61% from 6.66% in Juneand 6.65% in 2011. In the euro area, business loans slightly decreased to 3.53% from 3.60% in June.

Deposit and Loan Rates

For more information please contact:Pavlos LoizouMRICSLead Consultant

M +357 99 450 329E [email protected] www.leafresearch.com

Independent Investigation Commissioned by CBCThe Central Bank of Cyprus decided to commission Alvarez and Marsal (A&M) to carry out an

independent investigation into the circumstances that have led two banks within the Republic of Cyprusto seek state support. CPB has already been nationalised by 84% and based on current data it needssupport of 2.5 billion. BoC asked for support of 0.5 billion (announce that deficit to meet EBA capitalrequirements is 0.7bn). The Central Bank of Cyprus anticipates that the investigation will provide clarityand comprehension regarding the current financial stress in the Republic and guide remediation tostrengthen the stability of the banking sector.

Central Bank of Cyprus (CBC) Investigations

Interest Rates in Eurozone, July 2012 Deposits (1)Loans

Housing Business

Eurozone 2.80 3,58 3,53

Germany 1,38 3,10 3,51

Greece 4,82 3,42 6,01

Cyprus 4,41 5,51 6,61

Malta 2,15 3,54 4,47Portugal 3,07 4,70 4,81

Spain 3,34 3,67 2,50

(1) Deposits up to 1-year

Leaf Research Ltd Information herein has been obtained from sourcesbelieved to be reliable. While we do not doubt its accuracy, we have notverified it and make no guarantee, warranty or representation about it.

It is your responsibility to independently confirm its accuracy andcompleteness. Any projections, opinions, assumptions or estimates usedare for example only and do not represent the current or futureperformance of the market.

Disclaimer 2012 Leaf Research Ltd

Source: ECB (2012)


Report:Q22012

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