Following the 2008 crisis, this conservative reputation was to lead to money flowing into the banks in Cyprus as a 'safe haven'. The problem was that the money arriving has nowhere productive to go, so mirroring what had taken place in other economies (e.g. the US), the money ended up in real estate, fuelling a bubble in real estate prices. However, this flow of money could not all be absorbed in real estate, with the Cyprus banks growing at a rate totally divorced from the wider economy. Due to historical ties, the destination of choice for the inward flow of money was an outwards flow towards Greece:
Before joining the euro, the Central Bank of Cyprus only allowed banks to use up to 30 percent of their foreign deposits to support local lending, a measure designed to prevent sizeable deposits from Greeks and Russians fuelling a bubble.
When Cyprus joined the single European currency, Greek and other euro area deposits were reclassified as domestic, leading to billions more local lending, Pambos Papageorgiou, a member of Cyprus's parliament and a former central bank board member said.
The EBA figures showed 30 percent (11 billion euros) of Bank of Cyprus' total loan book was wrapped up in Greece by December 2010, as was 43 percent (or 19 billion euros) of Laiki's, which was then known as Marfin Popular.There is considerable more detail that could be added, such as the high returns offered by Cypriot banks, but also underlying the high risk speculation is a finger pointing at lax regulation by the central bank:
More striking was the bank's exposure to Greek debt.
At the time, Bank of Cyprus's 2.4 billion euros of Greek debt was enough to wipe out 75 percent of the bank's total capital, while Laiki's 3.4 billion euros exposure outstripped its 3.2 billion euros of total capital.
It seems that, when reflecting on the lead up to the current mess, the factors that drove the crisis forwards are oddly familiar. If looking at the US crisis, floods of money were pouring into the US in the lead up to the crisis, with that money over-spilling into the real estate market, and thus causing a bubble. Just as in the US, the central bank was happy as long as everyone seemed to be getting richer. In both cases, it was a flood of overseas money entering the economy that underpinned the problems (e.g. see here).
Whatever the motive, the Greek exposure defied country risk standards typically applied by central banks; a clause in Cyprus' EU/IMF December memorandum of understanding explicitly requires the banks to have more diversified portfolios of higher credit quality.
"That (the way the exposures were allowed to build) was a problem of supervision," said Papageorgiou, who was a member of the six-man board of directors of the central bank at the time.
The board, which met less than once a month, never knew how much Greek debt the banks were holding, both Papageorgiou and another person with direct knowledge of the situation told Reuters.
There is an important point in this story, and it a point that does not receive enough attention. There is a widespread misconception that the politicians and policy makers are in control of their own economies. However, this is a myth. They may have influence on their own economy, but they do not control it. The problems in Cyprus are derived from excessive capital flows, and just as happened in the US, when faced with a wall of money, the Cypriot banks were not going to turn it away, but find a home for it. Thus there is a real estate boom, and this will then drive the Cyprus economy into apparent growth, as ever more money chases a limited supply of real estate, and paper gains in value of real estate create economic growth, without any real underlying increase in the output of the economy. Instead, the increase in output is simply the result of excess credit appearing in the economy.
The difference in the Cypriot and US examples is that the small size of the economy serves to exagerate the same effect. When the Fed acts, it is acting on an economy which is relatively large in relation to the flows of capital throughout the world, so is more influential. In the case of a small economy like Cyprus, the actions of policy makers are swamped by the influence of that same capital. Similarly, the US real estate market was so large, that it was able to absorb a large amount of capital. In other words, it is a similar process that took place, but with differences in degree of effect. We can see a similar process taking effect in other economies. For example, in New Zealand (population about 6 million), the central bank labours under the illusion that it has some control over the New Zealand economy through interest rates targets.
The New Zealand dollar tumbled almost a cent against the US dollar after the Reserve Bank said interest rates will remain at a record low through this year.The bank also hinted at a cut to the official cash rate if the currency was higher than justified by economic fundamentals.The kiwi fell to 81.66 US cents from 82.60 cents immediately before the statement.
Again, the Christchurch rebuild is undoubtedly a factor, but so is the entry of new credit into the economy. Note that inflation is subdued. If you have currency appreciation, imports become cheaper, and this will help keep inflation in check.
Into this interesting bubble scenario, we have the role of the central bank. The brief fall in the $NZ was probably due to previous speculation that the interest rate would be raised to tame the house price bubble. However, had the central bank increased interest rates, the impact would have been to make New Zealand even more attractive to the carry trade, and thus have the opposite effect to the one intended. The problem is that, in keeping a low interest rate target, there is nothing to pop the bubble in house prices. In other words, until such time as the carry trade winds down, there is nothing that the central bank can do which will tame the house price bubble, with the associated problems that will develop from the bubble.
In other words, the New Zealand economy is in the hands of others. For example, if a large economy such as the US targets 0% interest, this will lead to carry trade activity, and this will impact on other economies such as New Zealand. Whether New Zealand is a carry trade destination is determined by New Zealand interest rates, but they are determined by factors such as the currency, and the current levels of credit entering the economy. Most importantly, there is the speculation of the capital markets, based upon exchange rate risk, and the exchange rate risk is determined in part by the speculation, and this is divorced from the underlying economy of New Zealand, as their own collective actions are determining the value of the currency. For the carry trade, it is all about timing. Getting in early, and getting out before it unwinds is the key. The more new entrants into the carry trade, the higher the currency appreciation, the more profit to be made. However, the credit creates an artificial boom in the economy, which can rapidly turn to bust as credit based growth starts to reach saturation, and the situation unwinds, including currency depreciation. The carry trader needs to get out before this takes place.
Returning to Cyprus, the key difference is that Cyprus is a Euro economy which meant that, in consideration of the size of Cyprus, the state of the economy had no influence whatsoever on the value of the currency. This disassociation between the underlying economy and the currency, and the wall of money being thrown at the economy, means that there was no currency derived time 'to get out' excepting where the Euro area was perceived to be at risk. This and the reputation for being conservative but providing outsize returns, made Cyprus an attractive destination. The key to the outsized returns was, in turn, the result of lax bank regulation. Regulation gave an illusion of stability, but it was no more than this; an illusion. Cyprus had only one means to control the situation, which was central bank regulation. However, just as with the many cases in recent history, when a flood of money enters into an economy, the economy booms, the regulators always seem to look the other way. Whilst things are 'good', they suddenly freeze, and fail to act. We have now seen this so many times that it is becoming sadly comedic. However, the illusion that all is okay due to regulation always remains, and ultimately contributes significantly to the growth of the problem.
However, one element of the Cyprus problem was not derived from central bank regulation, which was the property bubble. It has yet to unwind fully. However, we can see it time and time again; when a flood of money arrives in an economy, with nowhere productive to go, real estate is the destination of choice. This in turn creates a boom, and a boom that, in the end is unsustainable, being derived not from underlying economic growth, but in increased consumption. As Krugman (goodness, am I referencing Krugman?) points out, this led to a 15% of GDP current account deficit in 2008:
- Banking regulators; they fail, fail, fail and fail time and time again when it matters
- Policy makers only have limited influence on an economy, and the degree of that influence is often far less than is perceived. The size of the economy in relation to capital markets determines the influence.
- Carry trade bubbles are self-reinforcing, and even more so when removed from currency risk
- Real estate bubbles are economic weapons of mass destruction, and appear to be primarily derived from carry trade activity
- Developing an oversize financial services industry is fatal.
What we are seeing is a grand experiment, in which economists and policymakers are attempting to structure wealth in economies by fiat. As each lever is pulled, as each policy is enacted, there are ripples through the world economy. Flooding $US into the markets whilst holding interest rates low sees the export of $US popping up and creating bubbles elsewhere. Backstopping the mortgage market sees foreclosures reduced, but at the risk of calling into question (contributing to doubts about) the financial viability of the state. Holding the value of the RMB down leads to greater trade imbalances. Each policy has a consequence, and each policy interacts with the policy pursued by every other government.One of the points that I made all that time ago was that the US crisis that emerged in 2008 was, in part, derived from the Japanese Yen carry trade, which was driven by the Japanese bank printing money. When we look at small economies, such as New Zealand and Cyprus, we can see the policy spill-over from other countries more clearly. Whilst there are some very clear differenced between the two economies, they share a single common characteristic; the policy makers are not in control. Furthermore, it is apparent that, as I long ago suggested, policy makers are resorting to ever more dramatic policies (e.g. QE Infinity in the US), and we will no doubt see this generate even greater instabilities in the global economy, and also in the lever pulling countries. It leaves us with the troubling question of how the global economy might look as these ever more extreme policies generate yet more extreme policy in response? It is a worrying question, but those 'in control' of policy have yet to even recognise their own position in the world economy, let alone think through the answer to this question.
In other words, as each lever is pulled, the consequences defeat the intention of the lever puller. For example, if the trade imbalances destroy the economic stability of the destination of Chinese exports, where will this leave the Chinese economy? The more each state pulls on the levers, the greater the turbulence between each of the economies. The world economy is a dynamic system, such that policy in one country impacts on the economy of another country, which then reacts with its own policy provisions, which then impact upon other countries. It is an endless cycle of reactivity, with each reaction driving further reaction, and developing an increasingly unstable system as each country enacts ever more dramatic policy to counter or ameliorate the effects of the policies of other countries.
Note: Thank you Lemming for the comment that prompted this post. Please accept my apologies for not posting, but I have been working 7 days a week again, and could not face more time in front of the computer. I will try to post more regularly, but my work is consuming me at present.
Note 2: I did think about commenting on the 'haircut' policy, but thought that the question of lack of control was more interesting. I hope you agree.