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Repair of Private Sector Balance Sheets Needed for Sustained and Inclusive Economic Growth

Posted by (Guest Contributor) on January 17th, 2017 - 10 Comments

In most euro area countries the recovery of the real economies from the financial crisis has been weak despite the pursuit of easy monetary policies. And even in economies such as Cyprus where there has been a recent revival of economic growth, the essential conditions and policies for sustaining growth hardly exist (see Manison and Savvides “Towards Sustainable Growth—Rebuilding the Foundations of the Cyprus Economy”  At the same time there is growing evidence including  the recent Eurosystem’s Household Finance and Consumption Survey (HFCS) that the benefits of growth are being distributed unevenly among EU countries providing greater relative wealth and income gains to the richer households in the wealthier nations. Indeed, instead of achieving the prime policy aim of convergence recent policies are producing divergence among EU countries.

In response to the persistence of deflation and high unemployment in the euro area the ECB in early 2015 embarked on a policy of quantitative easing in providing liquidity to banks in exchange for euro area bonds aimed at boosting demand in euro area economies. With lower nominal interest rates, the demand for loans, particularly to finance investment projects by Non-Financial Corporations (NFCs), was supposed to be raised significantly. But in most euro area economies including Cyprus levels of private and public investment have remained depressed and along with relatively low inputs into research and innovation the growth potential of the euro area is being diminished.

Unfortunately, policy-makers in Europe, especially the Eurogroup, have focused their policies too much on restoring or maintaining government debt sustainability through repairing government balance sheets by harsh and mostly inappropriate fiscal austerity and on strengthening the balance sheets of banks per se with little consideration given to the macroeconomic repercussions of their policies. Much  less attention has been paid to the urgent need to restore the balance sheets of private sector corporations and households to positions where they can contribute to economic growth.

The repair of the balance sheets of private sector entities should entail addressing the  private debt problem that burden NFCs and households, especially in the program and financially distressed countries of Europe. Indeed a recent paper by Savvakis Savvides and I (see Manison and Savvides “Neglect Private Debt at the Economy’s Peril”, stresses  that the heavy indebtedness of the private sector is the most important factor hindering the sustained growth of  a number of euro area economies. This is particularly the case in Cyprus where the ratio of private debt to GDP was over 350% in mid-2016, the highest level in the EU. It was pointed out that even when banks have sufficient loanable resources, as seems to be the current situation in Cyprus, they are reluctant to lend to debt-laden and defaulting customers and/or are unwilling, or simply, are not capable of properly assessing and gauging the risks of financing potential investment projects. Moreover, with most NFCs in Cyprus loaded with excessive debt and having virtually no equity, such businesses are not well-placed to undertake new bank-financed investments.

Accordingly, the balance sheets of NFCs require substantial repair in particular in order to be in a position to obtain the bank credit and equity required to finance viable investment projects. However, reducing the NPLs of NFCs per se is hardly a solution as a significant number of these enterprises have to be reconstructed financially so as to have the capacity to undertake investments to generate growth. In this respect, productive debt restructuring solutions such as exchanging debt for minority bank equity participation and special project financing arrangements would seem to be required. But in a situation as in Cyprus where many NFCs during the financial boom prior to 2013 having obtained loans from many different banks, the putting together of productive debt restructuring solutions and effecting adequate project financing arrangements for many enterprises would appear to be tasks stretching beyond  the capabilities of individual banks.

Hence, it has been argued repeatedly by Savvakis Savvides and I that an independent institution like the Irish Development Agency be created in Cyprus to pave the way in arranging the reconstruction of and project financing for indebted enterprises and for assisting in channelling capital into viable investment projects. With its operations, this new institution would be closely involved in formulating solutions for repairing the balance sheets of  NFCs, a process seen as essential for setting the  stage for a significant increase in the bank and equity  financing of productive investments.

Repairing the balance sheets of households, which include the business wealth of self-employed persons, is also an urgent task for policy-makers, particularly in Cyprus where the gross debt to income ratio is extremely high ( just under 200% in 2015) and is well above that of all other EU members except the Netherlands and Denmark. Around half of the household debt in Cyprus comprises NPLs, a non-significant part of which arises from borrowers delaying or not servicing their debts even though they have the ability to do so. With widespread tax evasion and strategic defaulting of debt obligations by the business elite and professionals of Cyprus households, the country exhibits the hallmarks of a failing state and the Cyprus authorities as well as bank directors and managers must exercise initiative and courage in dealing with this state-undermining problem.

Notwithstanding, there are a great number of less wealthy households who do not have the financial capacity to punctually service their debts. While debt restructuring through lengthening repayment periods would help households meet their new debt commitments in a number cases, policy efforts should be directed most importantly to raising their ability to repay debt through increasing their disposable incomes. This will require the sustaining of a healthy rate of economic growth and the greater distribution of the real GDP gains to less wealthy and lower and middle income households, that is, in achieving so-called more inclusive growth. Increasing the distribution of disposable incomes to such households could be accomplished by restructuring personal income tax rates in favour of lower and middle-income earners.  Furthermore, as the actual inequalities in the distribution of household disposable incomes and in net wealth in Cyprus are greatly exacerbated by the large tax evasion of higher income earners, especially by self-employed professionals, it is paramount  that the Government as indicated above becomes much more serious in stepping up its efforts to combat tax evasion.

But the bottom-line issue is how can economic growth be generated and be sustained at a healthy rate? In the Cyprus context this will require raising the current level of domestic demand to complement rising external demand.  However, it should be stressed that the repair of private sector balance sheets will obviously be associated with the increased repayment of debt, a process that will require higher saving and/or use of existing saving balances leading to a sizable reduction in private domestic demand. Accordingly, to counter weaker private demand and the onset of a “balance sheet recession”, as outlined by Richard Koo, (see and to create investment opportunities the Government will need to take the lead and boost its outlays on productive investments financed mainly by EU funds designated for priority projects and programs and to combine as well with the private sector via Public Private Partnerships (PPPs). A redistribution of incomes toward households with a higher propensity to consume should help also to raise domestic demand. In addition it will be important that Cyprus takes advantage of the strong increase in foreign demand for its tourism services by investing in expanding and renovating its accommodation capacity for tourists so as to sustain externally-propelled economic growth.

Leslie G. Manison is an economist, specialising in macroeconomic policy analysis and international financial relations. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus Ministry of Finance, and a former senior advisor in the Central Bank of Cyprus.

Categories → Οικονομία

  1. avatar
    xyz on January 18, 2017 - (permalink)

    This is indeed an excellent and innovative policy paper, though not an unconditional one. A detailed set of conditions should be established for implementing the policy suggestions, without burdening further the public sector. In the same context, an additional policy dimension that might be incorporated is the possibility for retrieving the past practice of adopting a medium-term Development Plan or a Priorities Policy Framework setting priority sectors matched with pertinent incentives & actions. In this way your policy suggestion that “the Government will need to take the lead and boost its outlays on productive investments financed mainly by EU funds designated for priority projects and programs and to combine as well with the private sector …” will gain more clarity and become realistically doable.
    Keep it up.

  2. avatar
    Thinkingaloud on January 19, 2017 - (permalink)

    The need for immediate and substantial debt reduction across NFCs (households) in Cyprus goes without saying.
    In Cyprus, the banks that colluded for years (offering exactly the same products with the exact same terms and contracts forcing the borrowers to accept clauses for personal guarantees among other onesided terms) have to step up to the task and start offering the people the breathing space they need. My personal experience was that because I had difficulties meeting my payments on my loans (not excessive loans but ones that were definitely impaired with a near 60% immediate drop in our household income overnight) the bank raised the interest rates and is now demanding more and more resulting in my household now carrying a debt that is nowhere near what it was and becoming unsustainable even if our household income rises to what it once was (still at about 40% down).
    So how do the banks, expect borrowers to meet their debt payments, when themselves are inflating their own problems? In turn, my spending has been largely reduced and thus businesses (especially small businesses) are not receiving what they should be receiving to remain in business and meet their loan payments resulting in higher interests (and loans) on that front too. The scenario is not fictional. It is real, but what we see is all academics and govt officials talking theory and policy recommendations that the Central Bank and the government has never actually acted upon. Meanwhile, whatever I had saved for the future has disappeared (stocks on CSE, savings that were taken by the bank to not even make a dent to my debt, bank bonds, etc) leaving us with little to hope for. The government is only implementing policies that help specific sectors (developers, lawyers, bankers) and the rest of the people and businesses are really struggling.
    Hold the banks accountable for all the s**t they have created, and FORCE them to wipe clean debt loads and personal guarantees from people who have nothing more to give them and allow them to restart. The banks should accept the collaterals they signed on as full and final repayment of the debts. End of story! If the bank inflated the debt loan with increased interest rates, extra charges, etc , it is not the borrowers fault as it is not their fault that the property values have dropped. The banks were reporting record profits when the property valuations were on the rise but now refuse to accept the harsh reality of reduced valuations. The bank refused to accept my property (in a debt asset swap) when it was still at a much higher value than my loan at the time and now the loan has nearly doubled. The value of the property has not dropped further but the bank now demands much more. Was that their plan right from the start because they have me signed personal guarantees? In some cases I am sure it was. Oh, and good luck sorting things out if you have loans in two or three banks (most of us do). (NOT overleveraged but just two or three banks because when you created a family, your wife or husband had a loan in another bank so you ended up as a household banking with two banks).
    * I am always using personalized examples as I think it is easier for all readers to relate and understand than to talk about policies and theories.

    • avatar
      Savvakis C Savvides on January 21, 2017 - (permalink)


      I totally sympathise with what you are saying. The banks in general, but those in Cyprus in particular, have been giving out loans without a proper assessment of repayment capability and credit risk. The Central Bank and misguided Government policy encouraged the influx of huge foreign deposits which the banks had to position in income generating assets (loans) in the local economy (and even to use it to expand abroad in hostile and unmanageable environments).

      If the banks were to do proper repayment and risk assessment (assuming they knew how) in giving out the huge surpluses of deposits they have assembled, they would in all probability be only capable to position a very small fraction of these deposits into income generating loans. This is simply because an Economy cannot grow 300% and more in a few years. There are just not enough such economically viable projects to be financed.

      So, the banks basically shoved down the throats of unsuspecting customers (households and companies) loans taking as security collaterals (fixed and floating charges), the personal guarantees of borrowers and even of those in their immediate environment and any other undertakings they could persuade the “customer” to give them in order to secure their ability to collect on the loan and interest.

      If this was the setting of a crime scene, and in a sense it was, there would be two guilty parties, the borrower for accepting such loan and terms and the lender who irresponsibly gave loans which could not be repaid. But I guess this is the weakness of our current system, where banks can demand and claim their security in full in the law of contract without having to suffer from their negligence and irresponsibility for practicing imprudent banking.

      • avatar
        Thinkingaloud on January 24, 2017 - (permalink)

        Dear Savvakis,
        I believe that this is exactly where the regulator should focus. The penalization of the banks for their ill practices and criminal acts of the past.
        I agree with you that there were two guilty parties but the blame is not equal, and “justice” is not being served equal either. The one party was a massive establishment, equipped with experts and special tools, with access to government and an ability to collude with other similar establishments in the industry to deliver basically identical products. The other party was a business owner, trying his/her best to operate his business, feed the family, put a roof over the family (not talking about the two or three or five roofs) and put the kids through school. The borrower yes is guilty for accepting any odd terms that the bank was demanding and perhaps even guilty of overborrowing but this was often done with the advice of the experts and the special tools of the bank! Meanwhile the borrower had no real choices as the banks offered the exact same product, and the borrower was never allowed early repayment so that a potential refinancing was prohibited. Need we go even further?? The banks accepted the valuations of the “professional” valuators which were inflated because a. the banks liked them inflated, b. the owners/borrowers liked them inflated and c. the valuators liked them inflated (they were and still are compensated on a percentage of the value of the property valued). So it is clear that the system was rigged! The only one carrying the brunt is the borrower! All I am saying is that the banks should accept the collaterals (which they had already accepted as collaterals at 70% of the forced sale value, so effectively at around 50% of the valuation) and write off the rest! Forget personal guarantees, and let people live to fight another day. In cases where the borrowers have taken money and bought property abroad and they are hiding money in banks abroad, the banks know very well who they are and they should swing at them in full force.
        Imprudent banking must stop and it must be penalized! If the contracts of the past were misconstructed or were lopsided to the benefit of the biggest counterparty because the regulator (CBC) was asleep (the false feeling of regulation is more dangerous than no regulation) the contracts should be cancelled or corrected.
        Any good lawyers out there not already representing the banks? (another issue where all the big lawfirms are on the side of the banks because the pool of money there is large)
        In order to solve a problem we must first understand what caused the problem and then take decisive corrective action.

        • avatar
          nag on January 26, 2017 - (permalink)

          Banks here will hardly bear the brunt of the blame, since they are well protected by the political and economic establishment. Just take a look at what banks had to pay to settle lawsuits by the US Department of Justice for Subprime mortgage backed Securities:

          Bank of America: $16.65 billion
          Citigroup: $7 billion
          Deutsch: $7.2 billion
          JP Morgan: $13 billion
          Credit Suisse: $5.3 billion

          Part of this money will be used to compensate investors.

          BOC has written off loans of about €2 billion in the last 3 years (€900 million for 2016-up to September). So it’s not just swapping of loans for property that takes place here, there is a lot of writing off as well (a bail-out of the “bail-in” culprits).

          And it’s not just bank anonymous that is the guilty part. Banks are run by people who managed to squander their customers’ savings on non-viable loans. The Central bank was complicit in covering up bad loans with its infamous NPL formula, so passionately defended by some politicians, former/incumbent officials and their fawns.

  3. avatar
    Leslie G Manison on January 19, 2017 - (permalink)

    To xyz. Thanks for pertinent comments.
    Some of the key conditions required for generating the sustained growth of the Cyprus economy were outlined in the paper co-authored with Savvakis Savvides referred to in paragraph one of my blog above.We argue that one of the important factors hindering investment-led growth is the inadequate capacity/competence of Government institutions in Cyprus.This has meant that a considerable part of the EU funds available for productive investments ( eg.for waste management projects) have not been absorbed and efficiently used.Ministries prepare projects to favour particular tenderers often without proper scrutiny and evaluation by the Directorate for EU Programmes and Coordination. The procedures of the Tenders Review Authority are grossly inefficient and seriously delay project implementation as appeals against the award of a project to a particular tenderer can be unlimited without supporting explanations and are not costly( eg, fee of 17.500 euro for appeal on a 100 million euro project).
    EU funding will help alleviate the burden on the Government finances from public investments; the EIB also stands ready to finance the Governments matching contributions for partly EU-funded projects at very low interest rates.I would argue as well that there is much scope for financing growth-enhancing expenditures of the Government through raising much revenue from a serious effort to combat tax evasion.It is noted that the underground or untaxed economy of Cyprus is close to the largest in the EU being estimated at around 27% of official GDP, even exceeding that of Greece according to some estimates.

  4. avatar
    Costas on January 23, 2017 - (permalink)

    A very interesting article, with a “socialist” flavour, if I may say. I agree with such an idea.
    I sense that in order for such a “redistribution” to be passed into law, the better-off of this country must be convinced that they have more to gain by allowing the less well-off improve their finances, which will then lead to all the common sense positive outcomes: more household spending –> more jobs –> more tax generation –> more government spending –> more foreign direct investment –> more prosperous economy for everyone.
    The theoretical connection is obvious. Whether that is sufficient to motivate law makers to move things forward is to be seen.

  5. avatar
    Leslie G Manison on February 25, 2017 - (permalink)

    Agree with “nag” that Cyprus banks have to do more and change their self-serving behaviour if they are going to help the Cyprus economy. NPLs are just a symptom of the poor and unproductive lending behaviour of banks and reducing them per se does not necessarily improve the economic situation and prospects as the CBC and credit-rating agencies ( see Moody’s latest report on Cyprus) say when they point to short-term reductions in NPLs. As ” nag” implies you can decrease NPLs by just writing-off debt, in some cases transferring net wealth to the culprits which in part caused the crisis with their abuse and wasteful use of bank loans.
    Especially for debt of NFCs there is a need to restructure it in a way ( such as debt for equity swaps ) that allow for businesses to continue profitable operations and to undertake productive investments.
    However, with the private indebtedness of Cyprus so huge at around 350% of GDP a considerable amount of the debt will need to be written-off resulting in large losses to the banks, a process that could wipe out their existing capital and reserves.
    But with the balance sheets far from being sound with their poor quality asset portfolio it would seem virtually impossible for Cyprus banks to raise sufficient capital to cover such losses.The listing of the BOC is unlikely to help boost its capital as its share prices since listing have fallen by 12% plus.It would be preferable if a program were introduced that enabled banks to spread their losses from write-offs over a long period, say 15 years, in order for them to survive and hopefully contribute to economic growth with better lending decisions based on competent risk assessments and productive debt restructurings.

  6. avatar
    nag on March 2, 2017 - (permalink)

    Moral hazard is rife in this place. It looks as if some companies/people have become too important to fail. Is it a national security issue or just the web of interdependence? We are setting up the stage for the next catastrophic event if “we” cannot or will not let the free market decide who is competent to stay afloat or not. And what about the rest, are they just collateral damage?

    Here is an excerpt from the recent European Commission’s report on Cyprus:

    “4.6.4. CORRUPTION Trust in the public institutions is undermined by a high perceived level of corruption.(30) Recurrent surveys highlight the perception that patronage, bribery or abuse of power are significant problems in the Cypriot public administration (World Bank, 2015; Transparency International, 2017). 87 % of companies agree that corruption hampers business competition in Cyprus. According to the World Economic Forum, corruption is seen as the third most problematic factor for doing business in Cyprus. The 2016- 2017 Global Competitiveness Report ranked Cyprus 103rd out of 138 countries regarding favouritism in decisions of government officials (Schwab, 2016). This might affect competition in public tenders and efficiency of public procurement. For example, in 2015, 40 % of public procurement procedures involved only a single bidder, while 24 % of procedures did not feature a call for tender, the highest percentage in the EU (European Commission, 2016f). From 2009 to 2015, only 9 % of public tenders were assessed according to the principle of the most economically advantageous tender, resulting in one of the lowest scores in the EU.”

    Swapping of loans with property may help to reduce the stock of NPLs but it also entails risks as banks now have direct exposure in the property market. The procedures on foreclosures are complicated and entangled. They are all waiting (procrastinating) for the property market to recover, but at the same time they are not letting prices to find a level for buyers, feared that banks will need more capital if they do. It’s a catch 22 situation!

    • avatar
      Savvakis C Savvides on March 2, 2017 - (permalink)

      There are many culprits. The banks themselves primarily for lending on the basis of collateral and whatever other undertakings they could lay their hands on (including fixed and floating charges and personal guarantees), the Central Bank for a) allowing huge and dubious deposits from abroad to flow into our banking system and b) in not ensuring that the banks lent prudently and on the basis of sound repayment capability, the politicians, lawyers and accountants to mention just a few, who for their own special interests promoted and pushed for this organised charade (or crime I should say) for years. And last, but probably the least guilty party, the borrowers themselves. Who are guilty for taking up these mostly unproductive loans in terms that are extremely harsh against them. They however, as nag points out, in law and because of the apathy of our Government are probably the only ones who are called to pay (sooner or later) for all the crimes of all the above. As a result, the economy will fall into a deep debt deflation which will make us all poorer while the “saviours” of our banks will be raiding the banks’ and the people’s balance sheets.

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