Repair of Private Sector Balance Sheets Needed for Sustained and Inclusive Economic Growth
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” http://ssrn.com/abstract=2784802). 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”, https://ssrn.com/abstract=2886345) 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 www.paecon.net/PAEReview/issue58/Koo58.pdf) 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.