By Alexander Apostolides on March 31, 2013

My second Dukascopy Seminar on what happened in Cyprus and why it is a good time to ivest


Focusing on what happened, why it is now a great time to invest in competitive industries such as Tourism and Pharmaceutics.

Sorry for the lag or the background noise. 

By Alexander Apostolides on March 22, 2013

My first shot of Cyprus if it leave the Euro. Disaster for Cyprus!


Loads of people fail to distinguish that a currency union is not the same as the gold standard or other similar deals when you have a currency. We do not have a currency, we do not even have a domestic economy. This is why:
https://docs.google.com/presentation/d/1Xue3hCYQrd_EWd7FR-_QIoRqvGh8iPV3nro4sWJgyag/edit?usp=sharing

By Alexander Apostolides on March 21, 2013

Η καταστροφή στο Sedan και ο πόλεμος για την τιμή των όπλων: Πως η βουλή μας έφτασε στο χείλος του γκρεμού


Το 1870 η Γάλλια, ενοχλημένη από την εξευτελιστική στάση του Πρώσου Βασιλιά έναντι του Γάλλου πρέσβη, κήρυξε πόλεμο. Η απόφαση της Γαλλίας ήταν περισσότερο για εσωτερική κατανάλωση. Ο αυτοκράτορας Ναπολέοντας ο τρίτος, που δεν ήταν δημοφιλής λόγω της κακής οικονομικής κατάστασης της χώρας, ένιωσε πίεση από τις διαδηλώσεις υπέρ της αποκατάστασης της υπερηφάνειας του γαλλικού έθνους, και θεώρησε ότι θα αποκαθιστούσε το κύρος του προς τους Γάλλους με την κήρυξη του πολέμου. Οι στρατιωτικοί, που γνώριζαν την αληθινή ανισσόροποια δυνάμεων εναντίων της Γαλλίας, μάταια προσπαθούσαν να τον μεταπείσουν. Το διπλωματικό σώμα ήταν επίσης ανήσυχο, αφού διαφαινόταν ότι η στάση της Γαλλίας δεν είχε στήριξη από άλλες σημαντικές Ευρωπαϊκές δυνάμεις, ενώ η Πρωσία είχε κηρύξει στρατιωτική συμμαχία με αλλά Γερμανικά κρατίδια. Ο κόσμος της Γαλλίας δεν γνώριζε την πραγματικότητα. Ο αυτοκράτορας όμως, αν και ήξερε τα προβλήματα που αντιμετώπισε η Γαλλία, δεν ήθελε να δεχτεί επίκριση από τον κόσμο του και κήρυξε πόλεμο.

Το αποτέλεσμα ήταν καταστροφικό για την Γάλλια και το παγκόσμιο. Τα Γαλλικά στρατεύματα ηττηθήκαν και περικυκλώθηκαν στο φρούριο του Sedan. Η πτώση του Sedan είχε τεράστιες συνέπειες. Ακολούθησαν αλλεπάλληλα δείνα για την χώρα – επαναστάσεις, εισβολή, εξευτελιστικοί οικονομικοί οροί και αποζημίωση προς την Πρωσία. Η Πρωσία ενοποίησε την Γερμάνια κάτω από το βασιλικό της θρόνο, αλλάζοντας την ισορροπία δυνάμεων τις Ευρώπης, και έτσι θέτοντας την βάση για τους δυο παγκοσμίους πολέμους που ακολούθησαν.

Βλέποντας την απόφαση της κυπριακής βουλής να καταψηφίζει το μόνο σχέδιο σωτηρίας της Κύπρου κάτω από την πίεση του λαϊκού αναβρασμού μου θύμισε την Γαλλία του 1870. Το σίγουρο είναι ότι το αίσθημα ταπείνωσης είναι δικαιολογημένο: το Eurogroup ζήτησε από την Κύπρο να ανευρεθεί το ποσό του 5.8 δισεκατομμυρίων ευρώ, αγνοώντας το γεγονός ότι ο τραπεζικός μας τομέας είναι σε κρίση κυρίως λόγω την απόφασης του Eurogroup να κουρέψει το Ελληνικό κυβερνητικό χρέος. Όμως το αίσθημα ταπείνωσης θα έπρεπε να περάσει σε μια δεύτερη μοίρα μπροστά στην ανάγκη επιβίωσης της χώρας και την εξυγίανση του κυπριακού τραπεζικού συστήματος.

Το τραπεζικό μας σύστημα είναι υπό κατάρρευση, λόγω των κακών χειρισμών της Κύπρου και του Eurogroup. Κακώς υπήρχε η διοχέτευση ρευστότητας προς μια τράπεζα που όλοι γνώριζαν ότι έπρεπε να κλείσει. Αυτή η διοχέτευση ρευστότητας ήταν και ο μοχλός πίεσης που δεν άφησε περιθώρια διαπραγμάτευσης στην κυβέρνηση της Κύπρου. Κακώς δεν υπήρχε η διεκπεραίωση του πόνου που θα πρέπει να υποστεί η Κύπρος προς τους επενδυτές κυβερνητικών ομολόγων. Κακώς αποφασίστηκε το κούρεμα των μικροκαταθετών. Όμως αυτή τη στιγμή η βουλή αποφάσισε ότι η δικαιολογημένη αγανάκτηση του κόσμου είναι πιο σημαντική από την οικονομική επιβίωση της χώρας. Η βουλή συμπεριφέρθηκε σαν τον Ναπολέοντα του 1870. Αν και γνώριζε ότι τέτοια απόφαση φέρνει την Κύπρο στο χείλος μιας άτακτης χρεωκοπίας, η βουλή προτίμησε την ευθυνόφοβη πολιτική εσωτερικής κατανάλωσης.

Το κόστος μιας άτακτης χρεωκοπίας θα είναι δυσβάστακτο. Δεν έχουμε δικό μας νόμισμα και η οικονομία μας είναι απόλυτα συνδεδεμένη με αυτή της Ευρώπης. Σαν αποτέλεσμα η χρεωκοπία και η έξοδος από το ευρώ θα προκαλέσει μια σειρά από βίαιες αλλαγές και στρεβλώσεις. Το κούρεμα των καταθέσεων σε τέτοια περίπτωση θα είναι της τάξης του 50%, και η υποτίμηση του νέου νομίσματος θα αυξήσει την τιμή πρώτον υλών (π.χ. βενζίνης) κατά 30% με 100%. Ο πληθωρισμός θα καταστρέψει την μεσαία τάξη, και το εισόδημα της χώρας θα έχει πληγεί ανεπανόρθωτα, χωρίς να υπάρξει αύξηση των εξαγωγών, αφού η ανταγωνιστικότητα που θα παρείχε μια υποβάθμιση του νέου νομίσματος θα πληγωνόταν από την αύξηση της τιμής της βενζίνης. Τώρα είναι η ώρα για την βουλή να πάρει τις ευθύνες της σοβαρά και να προστατέψει την Κύπρο από τα χειρότερα.  

By Euronomist on March 20, 2013

A Plan to Save Cyprus

After considering the current situation in Cyprus we have can up with the following plan. It was written by Euronomist, but Apostolides comments are seen  in brackets:

Instead of haircutting the depositors, use their funds as loans, i.e. hold them for 3-5 years until the economy starts growing again (if the natural gas investment starts earlier then we are looking at 2-3 years tops). During that time the deposits will receive interest (lower than the given market rate) which depositors will be able to use freely. Our understanding is that most of the domestic money is in the form of term deposits; having the amount sitting at the bank or utilized by the government will make no difference to ordinary citizens. In this way, those who have taken out loans on existing deposits will not be gravely affected and in addition this would allow citizens to proceed with their everyday occupations.(Apostolides: people must know that if we leave the Euro this is what will happen, and at much worse rates and conditions that what is described here. In Argentina the Corralon forced deposits into peso denominated bonds.  )

Next, depositors will receive bank shares at the rate of 1.5 share per 1 euro held by the government. (Apostolides: the real sticking point is IMF, but you have the ECB as an ally who want to put this to bed quickly) Banks should be recapitalized by the state, although the shares should be made out in the names of the depositors whose deposits have been used (ordinary shares rather than preferred since preferred is debt which does not assist too much in capital adequacy ratios). Through this, the banks' equity will be increased, meaning that the capital adequacy ratios targets will be fulfilled. The ECB will have no reason to shut the ELA, especially since the amount needed to recapitalise the banks will be much less after such a deal. As banks' share capital represents only the face value of the shares, the money given to the banks may be used two-fold:

1. Bring liquidity to the market thus boosting the economy
2. Rolling-over government debt, which will be decreased given that the deficit is expected to be less than 3% this year. (Apostolides: The deficit will now balloon to over 5%, but the difference in financing can be made up by restructuring all government debt). If the interest rate on the government debt is reduced to 1-2% (or less) and a long maturity is used, although the burden will be increased the interest payments will be significantly lower. Let us not forget that the current Russian loan has been issued with a 4,5% interest rate and it is highly unlikely that any new agreement will mean a lower rate. Lowering the interest rate by half will mean an additional reduction to the government budget.

If the government wishes, it can also give the depositors the rights to long-term bonds, with their rates dependent on the natural gas revenues.

Imposting capital constraints on transfers to foreign banks and withdrawals will be suitable as a mechanism to avoid bank runs from foreign investors. No solution can occur without imposing severe capital control regulations. In case anyone has not heard, these regulations are in fact legal in the European Union. We cannot emphasize it more: with no capital controls there is no solution for the island.

What we would propose is no cash withdrawals larger than 3,000-4,000 euros and not being able to transfer more than 5% (or 5,000 whichever is larger) of an account balance outside Cyprus unless it is payment of invoice (although the invoices should be carefully studied). Transfers between domestic banks and check issuance for deposit may take be issued for any account.

In addition, there should be a restructuring of bank loans, increasing their duration while simultaneously decreasing both the lending as well as the deposits interest rate. This will allow for lower installments over a longer time-frame which will mean that NPL's will be reduced significantly, both increasing bank profits and the capital adequacy ratios.

Although there have been some talks about leaving the euro, we are largely unsure of the consequences of a Eurozone exit (which will not be a controlled one). However, we commit to study the subject with more detail and come back with an answer.

P.S. Gas-linked bonds may be used as sweeteners only. Otherwise it would be mere speculation.

Authors:
-Euronomist
-Alexander Apostolides

By Alexander Apostolides on March 16, 2013

What are governments defaults and how they are managed? Could Cyprus do it?


I have been asked to explain on how government defaults take place.
Government defaults are very unpredictable events, and so they are hard for economics to predict or model.

I think only history can be a very rough guide: Defaults that work go something like this (based on 1932 Greece or 1931 UK). I define a good default one that lead to recovery of GDP within 18 months. 

a) You stop paying international creditors (so the 1.3 bn in june becomes less threatening). You put capital controls and close borders for 2 days. You convert all deposits to new currency and notes and coins in banks (do not even need to print currency - you an stamp all euros).

 b) The hard part: You need to Balance your current account (imports/ exports) and your government account (the hardest as deficit will be 0 - but you have no interest payments). Both of these will be a rude shock to GDP, much harder and ruder than any bailout/austerity package. But some argue it is a one shot game, rather than a prolonged period of austerity. 

However it is interesting to note that all Eurozone countries eliminated a large part of their currency reserves when joining the Euro (they became Euros). Thus you would need to start from the beggining, maybe keeping a current account surplus.

 c) A mixture of inflation and growth will ensure - the key is you do not know how much of each before the default! 

Inflation will arise: I do think inflation will be bad, and you will have fuel shortage as well. After some time J curve effect will make your exports very competitive. However it is important to remember that inflation transfers income from to those who own supermarkets to those who shop there. All the big Greek families with famous names became super rich when the exit from the gold standard took place. It is also true that inflation destroys the middle class. In that case savings will be hurt, perhaps far more than the 6.75% that were now subjected by the memorandum. Some argue however, than you can stop this cycle of inflation by correctly issuing your currency - ending fiat currency and only backing it on assets. 

d) The new currency needs to be backed on something: I would back it on the assets of the troubled banks and not have fiat circulation i.e. all circulation of pounds will equal the assets of the banks and the government. If you did that today those assets should be more than Euros in circulation. This should not reduce the money supply. If this process is done correctly (see UK in 1931) you might stabilize and your new currency will trade to around 30% below euro. 

Even so that does mean 30% increase in fuel prices however, making all domestic production more expensive. Thus the export increase effect perhaps muted. I disagree with the analysis that a country like Cyprus does not seek to gain with a devaluation: although the effect could be negative or positive, it is clear that at least three sectors will become competitive:
1) the tourism sector will be very competitive to tourists holding Euros 
2) The universities / education sector will offer a 40% cheaper tuition/accommodation costs than UK 
3) the existing business services will be able to take on back office outsourcing work from their UK and European organizations, as the cost of a chartered accountant will be much lower.

This default is not a panacea. It is harsh and wrong decisions can make it much more painful.
The first is that there are  Common problems/mistakes on defaults: 

1) Governments wait too long to leave to default. It becomes obvious to all and subject to speculation and hoarding of currency. Leaving sooner is better. This is something that politicians seem to resist. The UK only left the gold standard quickly when the central governor had a nervous breakdown, creating a lack of communication. In short government never leave a currency union (or other for of currency link) early enough

 2) Governments usually print money rather than balance the books. Austerity before hand makes governments not balance their books, with large problems of inflation arising. This is because common sense macroeconomic stability is not followed after a default as people want a break from austerity 

3) Litigation can stop a re-entry into the markets. As Argentina has discovered a default without the agreement of all creditors can stop your economy coming back in the international arena. This is the case in Cyprus which has British law bonds, although experts thing that this just makes renegotiation of bond difficult but not impossible 


First memorandum deal makes a second memorandum almost a certainty.



First memorandum deal makes a second memorandum almost a certainty.

It took a while to get around the news this morning. The main issue is the immediate haircutting of all deposits of all Cypriot banks (although oddly Greek depositors are excluded!). What does that mean for the economy of Cyprus:

A) Macroeconomic Instability

The news this morning initiated what looked like a bank run: the Eurogroup must not have known that the Co-op societies are open on Saturday, and people patiently waited in queue to remove their deposits only to be turned away. This made everything worse: we seem to have a bank run, which I think the government promise of this being a “one-off” raid on personal deposits will not stem.

How bad is the bank run? According to government sources, the last two months saw 11 billion euros was removed from the Cypriot deposit system within the last few weeks. This week is not going to be any better. I am assuming that at best there will just be an additional 11 billion loss of deposits for the banking system this following months. This means that banks will need liquidity assistance; as a result the Emergency Liquidity Assistance (ELA) of the ECB is bound to continue.  

What is the effect of this loss of deposits? Let remember the Axiom of economics that links the monetary economy with the real economy:
Ms*V= P*Q
or Money supply times velocity equals price times quantity (P*Q is also called nominal GDP).

The removal of deposits led to a reduction of the money supply. As a result there is a brutal negative shock to the money supply, coupled with reduction of velocity as companies and individuals with loans that are attached to deposits battle it out with the banks. As prices in Cyprus are relatively stable then it means that quantity (output) will decline. This makes the scenario for a recession of -2.4% very unlikely (my prediction is -5% GDP). As the recession will be worse than predicted, then neither the government revenue/expenditure stream we agreed on the troika, nor the PIMCO report on the banks’ capitalisation needs, will be accurate. As a result we need a larger bailout à A second bailout is coming

  1. B)  mortal blow for Cyprus as international financial centre?

If one agrees with my logic of a second bailout then we need to think what that means for Cyprus’ position as an international financial centre.

Some foreign depositors woke up with the news that they have lost money in the unthinkable way. Clever depositors might have thought they were safe by reducing their accounts to several accounts of 100,000 euro tranches, the limit guaranteed by deposit insurance, or by moving them to the better run banks. However these did not help them; they woke up to hear a 6.75% haircut on their deposits under 100,000, which includes all financial institutions, even banks that avoided the mess and were run efficiently.

The confidence to the banking sector is shaken. Quickly as the negative shock ripples through the economy there will be a realisation that a second bailout will be needed. The local and foreign depositor will ask himself “Is this the last time there will be a deposit haircut or will
my deposits be affected in a second bailout?”
No one can answer that question with any credibility anymore. After all, the President of Cyprus had committed while being a presidential candidate to never accept a deposit haircut. No one knows what the Europeans will ask next time. Thinking backwards the depositor will not be lured or committed to stay in Cyprus, regardless of the competitiveness of the Cypriot business services sector, which is one of the best in the world.

    C)  The moral of the story is that politics need to listen to basic economic principles
The basis of any successful capitalist economy is the protection of the right of personal property. This decision to punish all savers equally across all banks, regardless of the bank’s solvency, violates this principle. Note that depositors under 100,000 were insured against losses even if the banks failed, but are now forced to bear the brunt of the banking recapitalization. Thus the majority of depositors and shareholders of the two major banks actually had an incentive to let the two major bank fail, as they would not have their deposits haircutted.

This matters: when the right of personal property is violated the whole capitalist system, or institutions, that underlie the correct running of an economy, are threatened. And when such basic principles are disturbed, neither does the IMD, the Eurogroup of the EU commission can estimate the repercussions for Little Cyprus, but also for the Eurozone as a whole. 

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By Alexander Apostolides on March 13, 2013

My Second Interview with “Inside Outside“, for the Istanbul based community radio Açık Radyo

As I said before I like when Ekrem Eddy Guzeldere interviews people: he lets the person talk and really listens to the answers. He interviewed me after the Cypriot election and I am still very hopeful  about how things will turn out, but that was before the negotiations started. Things look tougher now but i am still optimistic, especially for Cyprus peace negotiations. 

By Alexander Apostolides on March 06, 2013

Efficient Taxation 101: The locust tax of Cyprus

A revolution, like the one that affected Egypt, usually leads to a collapse of the basic functions of the state. This is not surprising: as revenues collapse, the state will focus to maintaining the very basic economic functions, such as keeping Cairo ticking. The countryside will come second: people are mainly in the cities, and they are the ones that can "make or break" the new, post revolutionary regime. The Jacobins understood that well during the French revolution: they managed to takeover the revolutionary government by tapping into the anger of the Parisians, and maintained it their power by keeping Paris as happy as possible.

The effects of the neglect of rural Egypt are materialising in scary, biblical ways. Locust swarms are now making their way through Egypt, re-energised due to the neglect of the past two years, as the revolution reduced the ability of the government to react. Locusts are very dangerous to crops, but especially if they reach the critical mass of swarms: when Locusts swarm, there is really no way to stop their march as they raze all flora in their way. With no flora remaining, fauna is also decimated, causing severe environmental damage over large areas. Swarms change locusts both in how they behave but also in how they look, blackening them while making them very aggressive and mobile. Spraying them with pesticide will only knock out thousands at a time, yet millions are relentlessly pushing forwards towards new land in order to feed. Even with modern technology, locusts, when swarming, are near impossible to stop.

Many people might not know this but Cyprus was traditionally part of the locust migration and swarming problem, with millions of locusts consuming vast amounts of carobs and grain. It seems that the phenomenon was seen as most problematic (perhaps because people thought they could stop it) during the 18th and 19th century. Although the phenomenon is in part a response to the environmental conditions (see the National Geographic article linked above), correct prevention can reduce the possibility of swarming occurring in the first place.

It was quickly found out back then Locust swarms can be prevented by capturing the eggs of the locusts in specially made traps. The trigger to swarm arises from overpopulation of swarms due to high rainfall: thus by keeping the population in check through the collections of eggs, the possibility of swarming was reduced. The Ottoman administration of the island introduced sporadic egg capturing campaigns that were successful;  however the problem would re-occur after the campaigns would wind down.

The new British Administration of Cyprus decided to do something about it. It introduced the Locust Prevention Tax of 1881 (Law 12). It aimed to raise revenue in order to create a systematic,  year-on-year effort to destroy the locust prior to swarming. The history of this tax can be seen here.

The law aimed to correct a problem of negative externalities in agricultural production:  all persons were negatively affected by the swarming, and yet none was willing to pay more than his private benefit in order to eliminate it. In these situations the government has a very positive role to play in raising the revenue to act and eliminate the negative costs of swarming, thus creating a better market outcome.

The tax was ingeniously planned. Firstly the revenue was placed in an escrow account, completely separate from normal government revenue. This guaranteed that an amount was always available: locust prevention would not be sacrificed in order for other, more popular or immediate government projects. This was done on purpose, as the failure of the Ottomans to control the locust on Cyprus indicated that people (and officials) were willing to divert funds to prevention during and after a swarming event, but quickly diverted resources to other areas after the immediate threat passed, allowing the locust time to recover and regroup. By keeping the locust account separate, the government ensured that investment in prevention was ongoing, allowing for funds to attack the locust exactly when it was the weakest, further reducing the ability of the animals to swarm and become destructive.

Secondly the law was careful in should carry the burden. The Locust tax, collected 1% of agricultural  production, 0.1% of the value of property (since at the time a lot of property were trees and land, directly affected by swarming) and a smaller tax on flocks of sheep and goats. As a result all who would loose out by swarms had to pay, and each paid relative to the possible damage he or she would have if the locusts swarmed. That is why flocks were taxed less: although a swarm would cause losses to a flock by reducing the pasture, their cost would be less than the cost of a person who owned an orchard.

Note that the law has cyclical and non-cyclical elements, providing both flexibility and stability. Output is cyclical to GDP and thus the burden would not overwhelm farmers when their output was low (as they were charged 1% of output). At the same time property and flocks are stock concepts, allowing for stable revenue collection, which is less variable than output. Thus there was a basic amount of tax collected that would not vary much (based on taxing those who owned wealth and stock), and this was topped up according to the economic growth of agricultural sector (by directly taxing output).

The effect of the tax was immediately clear. As the locust was brought under check, the cost of prevention fell rapidly, allowing for a healthy surplus in the escrow account. Rather than stop the tax and have the issue of raising revenue if a future locust swarm issue resurfaced, the government kept the law and separate account, and passed a new law that allowed it to spend the revenues (or earmark future revenues) of the tax on infrastructure projects. The pier in Larnaca and other projects that allowed for the opening of markets were undertaken by the revenue collected by this tax. The prevention of locusts remained a priority, but the fund also allowed government to spend on long term projects based on a predicted revenue stream. It is no surprise that one of the few foreign loans that the British administration was able to procure was based on earmarked revenues of this tax, as the creditors felt safer knowing their interest would not be repaid by the general government revenue: as a result the locust tax enabled the largest infrastructure project to date, the construction of Famagusta harbour and the railway to connect it to Nicosia.

By 1926 the abolition of the Tithe brought the tax to abeyance. The funds in the separate account were depleted, and sure enough the Locust returned in 1948, forcing the government to spend £20,000 on DDT and other highly hazardous chemicals in order to try and counter it. The liberal use of such dangerous chemicals has a huge cost to Cypriot wildlife, which was decimated and has never recovered.

What are the lessons that this tax can provide? Taxation can and should be used to correct market failures (in the case failure to prevent Locust swarming) where the private cost is lower that the social cost to society.    Yet such revenue needs to be protected and not allowed to be put in general government revenue, where short term needs will trump long term development issues. Thus I am all for a tax that would collect revenue for the future infrastructure costs of establishing a local and exported gas network, provided it is kept out of general government revenue.

Secondly, all good taxes need to balance revenue flexibility with revenue stability. A tax that is too flexible (such as VAT) will not be able to sustain government expenditure if the economy suffers a severe recession; likewise a tax that is too rigid (such as property tax) will be far too onerous to the taxpayer when his income contracts. The fact that the above tax combined tax flexibility/stability with varying the burden on the taxpayer according to possible future loss due to locusts was a brilliant idea. Each taxpayer contributed relative to the possible loss he would suffer if locust swarms occurred and  thus prevention was shared not equally but according to who had more to loose, making the tax more bearable.