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Private debt is the problem

Posted by (Author) on June 6th, 2017 - 12 Comments

Why the economic recovery of Cyprus remains an elusive and distant dream

Cyprus suffers from a developing acute case of what Richard Koo (Koo, 2015) has coined as Balance Sheet Recession. This means that because of the excessive and quite unprecedented levels of private debt (3 to 4 times the size of the country’s GDP) weighing on households and corporations, it is practically impossible for the country to overcome the recessionary effects of the austerity conditions that were imposed since the bail-in in 2013 and which still constitute the core of the Government policy.

To put it as simply as possible, companies and households are overwhelmed by debts which are almost impossible to repay. On the one hand, borrowers are encumbered with ever increasing interest and collaterals on their loans and on the other, income from economic activity is progressively becoming stagnant or decreasing. The twin effect of these is that the country, slowly but surely, is dragged into a long and severe recession. The economy is hence up against conditions of weak domestic demand and mostly, as a result of that, low capital investment.

This situation poses two problems which impede the road to reconstruction and development. One is that, as the margins for dissaving are being exhausted, the conditions for investing in economically viable projects are becoming increasingly worse and secondly, but equally important, given the huge debts burdening the private sector, the ability to repay existing and new loans deteriorate to the point where new loans to stimulate the economy are neither demanded nor are, justifiably to some extent, being offered by the banks. Under normal economic conditions viability is far from a given. But when the lack of local consumer demand and risks encompassing the country, such as the huge public sector debt and the instability in our banking system are factored in, even with a clean slate (where the existing debts are not taken into account) it would be very difficult for other than export oriented projects, such as in tourism, to be viable.

When economic conditions are adverse and the economic agents of the country are burdened with un-repayable loans (most showing negative net worth), then something has to give for economic development to take place and be sustainable. In such grim circumstances, there are only two possible ways forward. Doing nothing and hoping for the best, which is the current economic policy employed by the government, is not one of them. Manison and Savvides (2017) have shown in a recent article published in World Economics Journal that the observed high spending patterns in Cyprus is temporary and the result of dissaving in order to defend/maintain living standards. It is however, inevitable that savings will eventually be exhausted and that forced savings will be needed to pay-down debt, resulting in the full and long-term effects of a balance sheet recession.

The most obvious course of action would be “debt reduction”. Accumulated debt depresses consumer demand and inhibits new investment. Debt reduction (or debt forgiveness), however, is easier said than done. Especially when policymakers adopt the mantra that “a debt is a debt and it is always paid” no matter how big and how long it takes or even how it is paid (such as through the confiscation and liquidation of collaterals). Such a strict adherence to austerity which ignores and totally puts aside the effects of private debt will however inevitably drag the country further into a crisis since the end result of forced debt repayment within a faltering economy is to amplify and prolong the recessionary effects (see Hudson, 2012 and Vague, 2014). Iceland, for example, declared a state of national emergency, broke up and closed most banks and declared the bank debt to foreign entities and bond holders as not repayable in the reigning economic conditions. The result was a recovery in a period of less than three years. Given that Cyprus is in the Eurozone, however, such a course of action may be more difficult, unless of course the country is willing to consider leaving the euro and adopting its own currency.

Without meaning to downplay the negative impact that such a radical recourse would cause, particularly its adverse effects on the balance of payments of the country, in such dire circumstances some control of inflation and devaluation of the currency can do more good than harm. In real terms, the debts to the banks, which are mostly foreign owned, will fall significantly, thereby lowering the hurdle of repayment and having a similar effect as debt reduction on Cypriot borrowers. Moreover, the assets which are held as collateral by the banks will increase in value relative to outstanding loan balances and therefore give better security coverage for the banks and reduce the need for higher provisions. Despite the adverse effects and initial hardship, it should be noted nevertheless that such a path can potentially lead towards the necessary adjustment for repair and reconstruction of the economy.

Given Cyprus’ position in the Eurozone and its political tight spot, one can understand not following an Icelandic type of solution. But our predicament does not allow us the comfort to do nothing and pretend that everything is fine or even that Cyprus is an economic miracle, as politicians would have us believe. This is why there is a crying need for policies to improve the macroeconomic environment designed carefully to address the balance sheet recession problem and specific private debt issues. The Government should not make the mistake of concentrating all its efforts in reducing the amount and cost of public debt, but rather use fiscal policy to lesson and repair the effects of private debt on the economy. The aim should thus be to stimulate the economy through public and private sector projects carefully selected and financed by creating new business entities (special purpose vehicles) unburdened by existing debts. This would, among other things, entail the creation of a special Development Finance Bank or Agency which will be mandated through legislation to evaluate and vet all major public sector capital expenditure and also ensure that public-private-partnerships are viable and in the public interest (Savvides, 2016).

Given the huge private debt, the risk of a long and enduring recession is very high because of the compelling need for households and corporations to repair their balance sheets. In a recent statement by the Governor of the Central Bank of Cyprus during the presentation of the CBC’s Annual Report, it was admitted for the first time that the non-performing loans problem will need another 10 years to be brought to manageable levels. Judging from the experiences of countries whose private debt was in fact significantly lower than that of Cyprus, such as Japan, the period could be well in excess of 10 years.

What policymakers do not tell us, or perhaps do not even realise themselves, however, is that a long and deep recession will result from doing nothing and staying the course of strict austerity. Rather than staring blissfully down the abyss, the government should stand ready to have in place the institutions and provide for fiscal measures which will mitigate and cushion the deflationary effects of the coming, but very foreseeable, recession. To quote Richard Vague (2014), “Government Debt Isn’t the Problem-Private Debt Is”.


  1. Koo, Richard C (2015) The Escape from Balance Sheet Recession and the Q.E. Trap, Wiley.
  2. Manison, Leslie and Savvides, Savvakis (2017) “Neglect private debt at the economy’s peril”, World Economics Journal, Vol. 18, No. 1, January–March 2017.
  3. Hudson, Michael (2012) “The Road to Debt Deflation, Debt Peonage, and Neo-feudalism”, Working Paper No. 708, Levy Economics Institute of Bard College.
  4. Vague, Richard (2014) The Next Economic Crisis: Why It’s Coming and How to Avoid It, University of Pennsylvania Press.
  5. Savvides, Savvakis (2016) Overcoming private debt (unblocking the loan burdened real economy in Cyprus), The Journal of Private Equity, Fall, Vol. 19, No. 4: pp. 51-59.
  6. Vague, Richard (2014) Government Debt Isn’t the Problem—Private Debt Is,, 9 Sept 2014.

Savvakis C. Savvides is an economist, specialising in economic development and project financing. He is a former senior manager at the Cyprus Development Bank and has been a regular visiting lecturer at Harvard University and more recently at Queen’s University, Canada. Author page:


Categories → Οικονομία

  1. avatar
    Anonymous on June 7, 2017 - (permalink)

    This is a good analysis. a balance sheet recession is now what second year undergraduates are taught in macroeconomics modules. such recessions are longer and deeper than normal business cycle recessions because of deleveraging and the need to reduce debt, which combines with the financial accelerator in reverse mode to dampen demand and depress collateral values. Fiscal policy or external demand are the way out. Austerity is not the answer, butthere needs to be some fiscal space . Catkin and soskice have a good analysis in their textbook macroeconomics, institutions instability and the financial system.
    Unfortunately many economists are still in the 1970s and 1980s and think that public debt is the only Problem.

    • avatar
      Savvakis C Savvides on June 9, 2017 - (permalink)

      I am happy to hear that, finally, sound macro-economics has found its way into the textbooks and in the University Curriculums! One of the reasons I started writing about private debt since the Cyprus bail-in is exactly because as you correctly say, many economists are still thinking that public debt is the only problem.

  2. avatar
    Leslie G Manison on June 8, 2017 - (permalink)

    I would emphasise that it is how productively debt is used whether public or private that is important in determining whether a country achieves sustained economic growth or descends into a financial crisis that usually requires the repair of private sector balance sheets ushering in the onset of a balance sheet recession.
    In the case of Greece the huge amount of Government debt wasted in excessive current and unproductive expenditure was the main problem and required initially fiscal austerity.But in Cyprus it was the squandering of costly bank financial resources (considerable foreign deposits paying high interest rates) in unproductive bank loans reflected in extremely high NPLs that was the most important factor causing the financial crisis of 2012/13 However, the troika prescribed the same corrective medicine as in Greece-that is strict fiscal austerity which the Cyprus MOF overdid from 2013 to 2015- and largely ignored the private debt problem which is still threateningly overhanging the economy.
    As Savvakis and “Anonymous” clearly indicate a balance sheet recession is most likely if and when the private debt mess is being cleaned up. However, failure to act will inevitably lead to worse consequences for the economy which a new Government in 2018 will have to deal with probably by seeking another MOU from a hopefuly-more competent Troika.
    On the issue of the productive issue of debt it is noted that both Cyprus and Luxembourg have approximately the same ratio of private debt to GDP, but the latter employs this debt much more productively on the asset side of the balance sheet and does seem to have a fragile financial state.

  3. avatar
    Observer on June 8, 2017 - (permalink)

    Mr Savvides.
    With respect I can propose a third option concerning the “as-is” analysis you presented in the 2nd and 3rd paragraph:

    Increase of FDI as a percent of GDP.

    Complete reform our economy to be compatible with easy and high added value Foreign Direct Investments. Real Investments though, not re-building a ghost city in limassol and paphos for the known reasons. This means, as a start, to have the state completely pull back from the economic activity in any direct (semi-governmental companies) and indirect way(vertical monopolies from those semi-governmental companies/bureaucracy/political agendas in firms) etc. Lets set the rules and let the private initiatives to act.

    On the other hand, what you are proposing is just a hard reset of the consumer growth model of the past decade, which led to a respectable level of iiving standard but with the known results which sadly are completely ignored by most of Cypriot economists.

    The very high level of private debt happened exactly because the households in order to reach to this respectable level of life they used to borrow more than they could ever possibly repay , sometimes even in the best case scenario. Furthermore, companies made all the wrong investments and now they are paying for it . I understand that many companies in cyprus cannot make any new investments thus the economic activity will be moderate for the next years.

    Well, the only alternative are FDIs that could give concrete jobs and align cyprus with global value chains so we can enjoy a sustainable higher level of living standard.

  4. avatar
    E. Z. on June 9, 2017 - (permalink)

    So, if I understood the argument that the author makes, is that the solution, to increase growth, is to increase government spending to stimulate the economy. Just the conventional Keynesian economics. Obviously, the first question is where is the money coming from? Borrow? Thus, increasing the debt even more to an unsustainable level as is the case in Greece. The second alternative is to increase taxes which will have the negative impact of reducing consumer spending and hence lowering economic growth. But the biggest impediment for greater economic growth rates is the ineffective and inefficient public sector. Funds that can be invested in improving productivity are wasted in supporting a bloated public sector.

    • avatar
      Savvakis C Savvides on June 11, 2017 - (permalink)

      As Les very correctly points out in his comment above “it is how productively debt is used whether public or private that is important”. Indeed, this is why it is considered imperative that a professional and independent institution which determines and confirms the viability of projects (whether public or private-public partnerships) is needed. During a balance sheet recession the money that goes to repay the loans do not find their way back into the economy. This in effect is what brings about the recession. In Cyprus with such a huge debt, the payment of interest only is enough to drag us into a long and deep recession. Especially, as seems to be the case, we simply stand by and hope that this will go away like a bad cold.

    • avatar
      Anonymous on June 13, 2017 - (permalink)

      Fiscal policy is the best answer when there is some fiscal space, when public debt is not already too high. External demand stimulus is a possible alternative. The other alternative is monetary policy, e.g. Low interest rates, but when they are so low they cannot go below zero, then it’s unconventional monetary policy, e.g. Quantitative easing, which is what the ECB somewhat belatedly tried to do in the eurozone.

      It’s not Keynesian economics that got European countries into high public debt. It’s governments bailing out big banks that were failing and the reduction of borrowing costs in the periphery following the introduction of the Euro. Cyprus has elements of both.

  5. avatar
    Leslie G Manison on June 9, 2017 - (permalink)

    I meant to say that Luxembourg does NOT seem to have a fragile financial state.

  6. avatar
    kaitanou on June 11, 2017 - (permalink)

    I was wondering would a major reduction in interest on loans and deposits be sufficient to rectify or improve the situation.

    • avatar
      Savvakis C Savvides on June 11, 2017 - (permalink)

      It would help but I don’t think it would be anywhere near enough. Moreover, there is the issue of loss of income by the banks and an increased likelihood for new recapitalisation.

  7. avatar
    Lefteris on June 14, 2017 - (permalink)

    For the past 6 — 7 years this has been the best way forward for Cyprus, yet nobody is willing to consider it.

    Οι κυβερνήσεις θα μπορούσαν να βοηθήσουν τις τράπεζες της ευρωζώνης να μειώσουν το τεράστιο απόθεμα «κόκκινων δανείων», στηρίζοντας τις επονομαζόμενες «bad banks» που θα μπορούσαν να αγοράσουν τα μη εξυπηρετούμενα δάνεια, δήλωσε ο αντιπρόεδρος της Ευρωπαϊκής Κεντρικής Τράπεζας, Βίτορ Κονστάνσιο.

    Καθώς η αγορά «κόκκινων δανείων»  της ευρωζώνης είναι μικρή και με περιορισμένη ρευστότητα, οι bad banks ή οι εταιρείες asset management  θα μπορούσαν να διορθώσουν τις αστοχίες της αγοράς αγοράζοντας δάνεια στην μακροπρόθεσμη οικονομική τους αξία, αντί της σχετικά πιεσμένης αγοραίας αξίας τους, δήλωσε ο κ. Κονστάνσιο, όπως μεταδίδει το Reuters.

    «Υπάρχει ένα κοινό στοιχείο σε αυτού του τύπου τις εταιρείες asset management: η κρατική στήριξη», δήλωσε. «Βάζοντας κεφάλαια και χρηματοδοτικές εγγυήσεις, οι κυβερνήσεις μπορούν να σηματοδοτήσουν την προσήλωσή τους σε διαρθρωτικές μεταρρυθμίσεις και να φέρουν πιο μπροστά τα σχετικά οφέλη», σημείωσε.

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