Geographies in Depth

Lessons from Cyprus that did not make it to Greece

Anil Ari
PhD Candidate, University of Cambridge
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With Greece in the spotlight, little attention has been paid to the other Mediterranean country striving to get back on its feet after a painful bailout in 2013 (Buchheit and Gulati 2013, Wyplosz 2013). After gradual relaxations over the past two years, Cyprus abolished the last vestiges of its capital controls in April of this year. The news is that, so far, there is no sign of any major capital outflows.

Although this is encouraging, the effects of the recent banking and fiscal crisis are still evident. Recent estimates show that one in two loans are non-performing, with this ratio being even higher for household loans. While overall growth has turned positive, it has the symptoms of a creditless recovery. The reluctance of banks to grant new loans results in growth that is concentrated in sectors that are less dependent on loans, such as tourism and non-financial services (Claessens et al. 2009, IMF 2015).

Cyprus’s financial sector experienced rapid growth during the last decade due to a large inflow of international deposits. At the same time, high demand in the property market (driven by the expansion of domestic credit) caused house prices to skyrocket. At the outburst of the Global Crisis, this period of expansion came to an end leaving the island’s real estate market in tatters and its banking sector with accumulated financial liabilities amounting to 750% of GDP. Moreover, the large exposure of the banking sector to Greece left the country in an even more vulnerable state, with the restructuring of Greek bonds costing its two largest banks the equivalent of 25% of GDP. Cyprus Popular Bank, the island’s second largest, needed a capital injection of €1.8 billion in order to meet its capital requirements in 2012.

Raising money was difficult for Cyprus, which had already lost market access after the government’s credit rating was downgraded to ‘junk’ in 2012. The left-wing government at the time, in an attempt to avoid the harsh austerity measures that would accompany a European bailout, examined the option of obtaining a bilateral loan from Russia or China. In 2011, a €2.5 billion loan was obtained from Russia and used for refinancing the debt in that year. Nevertheless, Cyprus applied for a bailout from the EFSF/ESM in late June 2012. Despite the urgent need for money, an agreement on a bailout plan was not reached until a year later, after a right-wing party came into power.

We believe that there are important lessons from the Cypriot experience that could have been beneficial for Greece in its recent attempt to seal a bailout deal. Even though it may be too late for Greece, these lessons can be important for countries in need of financial assistance in the future.

Debtor countries hardly benefit from a lengthy negotiation process

The first lesson that can be drawn from the recent evolution of events in Cyprus is:

  • Extending the negotiations is likely to create damage vastly in excess of any potential gain from ex post concessions by the creditor.

Deposit outflows are clearly one of the major sources of damage resulting from increased uncertainty as negotiations drag on and no agreement is reached.

Figure 1. Total deposits of non-MFIs held with MFIs

corsetti fig1 10 aug

Source: Bank of Cyprus.

Figure 1 shows the value of total deposits of non-monetary financial institutions held within monetary financial institutions in Cyprus from January 2011 until today. The figure clearly highlights the extent of withdrawals between December 2012 and March 2013 while negotiations were ongoing. Amid leakages of information and rumours of a possible ‘bail-in’, depositors took drastic action to protect their money. During this period of rapid withdrawals, the need for liquidity was met by Emergency Liquidity Assistance (ELA) provided by the ECB.

The major problems are now evident. First, periods of increased deposit outflows are accompanied by drastic changes in the composition of financial liabilities in the banking system. The average size of deposits shrinks significantly and is replaced by ELA, which needs to be paid back. This not only increases the financial obligations of the banks, but also reduces the basis for a potential bail-in. As a result, bank restructuring is much more difficult.

Second, the anticipation of a potential default creates macroeconomic costs that are significant and comparable to the ex post costs of a default itself (see e.g. and Corsetti et al. 2013). Uncertainty weighs on economic activity directly and indirectly, via an increase in the cost of borrowing, reflecting country risk. This is exactly what happened in Cyprus.

Certainly, after the drastic decrease in deposits and with the economy slowly collapsing, the debtor country’s bargaining position relative to the creditors weakens. It comes as no surprise that the final bailout plan can be worse than a plan agreed on earlier.

Risk of contagion (at high frequency) abates with lengthy negotiations

At first, the agreement between the European institutions and governments was for the Cypriot bail-in money to be raised by taxing both large and small deposits. This could have triggered a major shift in expectations with depositors all across Europe withdrawing their money. However, outside of Cyprus, its effect was limited.

One possible explanation for the limited contagion of the Cypriot bail-in is that Eurozone policymakers were effective in convincing their citizens that the events in small distant countries would not be repeated elsewhere in the union.

Admittedly, the case of Cyprus was viewed by the international community as special because of its reputation as a tax haven attracting large sums of ‘black’ Russian money. Animosity against Russian oligarchs in Europe created international support for part of the Cyprus bailout money to be raised ‘in-house’ by a tax on deposits.

Yet, each crisis country is unique in its own way and Cyprus was indeed the third bailout recipient, after Ireland and Greece, to be declared as a special case by European officials (Reuters 2012, WSJ 2012).

A second possible explanation for the absence of drastic international deposit withdrawals after a bail-in, leads us to a second lesson:

  • Risk of contagion to other European countries is reduced (although not necessarily eliminated) as lengthy negotiations become the status quo for bailout agreements to be reached.

We believe that, paradoxically, this may have something to do with the formation of beliefs that any future bail-in will be preceded by a long period of negotiations which will grant depositors time to withdraw their deposits. In the short run, the emergence of such beliefs may prevent the financial turmoil in the crisis country from spreading to the rest of the Eurozone. This weakens the bargaining power of the debtor countries relative to the creditors.

Even though deposits in other Eurozone countries may not be drastically affected immediately after a bail-in, households and firms are put on alert and ready to withdraw their deposits if their country is put on the spotlight. This exacerbates the potential for future instability in the monetary union.

At this point it is worth mentioning the potential role of ELA in sustaining these beliefs. During the period of negotiations for a bailout plan, the ECB continued supplying Cypriot banks with ELA. Hence, if the general belief is that ELA will be supplied during future negotiations then it can be seen as a kind of temporary deposit insurance, creating a window for preserving the nominal value of the assets in the domestic banking system. This is paradoxical, as the ELA was established to provide emergency liquidity to banks with unexpectedly high deposit outflows.

Closing banks and imposing capital controls are steps that cannot be easily undone

In order to prevent a coordinated deposit outflow, Cypriot banks remained closed for two weeks starting on the day of the agreement and capital controls remained in place for the next two years – in sharp contrast with early statements by policymakers predicting a return to full integration in a matter of weeks.

Experience from the imposition of capital controls in Cyprus leads us to a third lesson.

  • Despite the politicians’ expectations and promises, closing the banks and imposing capital controls is not a step that can be easily undone. It is like going on methadone – once on it, it takes a long time for the detox process to be completed. And this medicine does not come free from serious side effects.

The immediate effect of capital controls is to bring the economy to a standstill with virtually no new lending or investment. The result is a sharp drop in economic activity and a significant aggravation of non-performing loans, since firms and households lose access to the sources of revenues and credit they need to service their loans.

The rise in non-performing loans may in turn exacerbate the collateral gap. In the case of Cyprus, a fall in the value of collaterals was well underway after the housing market bust in 2008. The anticipation that banks will seize the collaterals for their non-performing loans led to a classic fire-sale which further reduced the market value of properties.

In January 2015, the Central Bank of Cyprus announced that the size of the collateral gap was about €15 billion. This gap between the value of loans and collaterals can have detrimental effects for the borrowers who can end up with an outstanding loan much larger than the value of their properties. On the other hand the banks face increased risk since in the event of a default they will not be able to recover the full value of the loan from the collateral.


The experience of Cyprus shows that the handling of negotiations, by both the debtor countries and their creditors, can have serious effects for the economy and the eventual bailout deal. In its attempt to secure more favourable bailout terms, the government of the debtor country might actually worsen their country’s position and end up with a significantly worse deal. Furthermore, the imposition of capital controls has side-effects that need to be carefully examined before creating circumstances that require them.

Whether or not the Cyprus experience was pondered by the Greek government and the EU institutions, the same pattern was repeated in the case of Greece. Negotiations were stretched over a long period of time and banks were closed with capital controls imposed perhaps under the impression that these measures would be temporary.  The Greek government was admittedly surprised to see the lack of contagion to other Eurozone countries and the drastic deterioration in economic activity in the country.

Even though the situation in Greece is very different from Cyprus, the recent records add supporting evidence for the three lessons discussed above. We hope that, in the case of any country finding itself in similar circumstances, these lessons will be somehow useful and help contain unnecessary economic distress.


Buchheit, L C and M Gulati (2013) “Walking back from Cyprus”, March 20.

Claessens, S M, A Kose and M E Terrones (2009) “A recovery without credit: Possible, but … ”, May 22

Corsetti, G, K Kuester, A Meier and G J Müller (2013) “Sovereign risk, fiscal policy, and macroeconomic stability”, Economic Journal, Royal Economic Society, vol. 0, F99-F132, 02.

IMF (2015) ‘‘Cyprus steps toward sustainable growth”, IMF Survey Magazine: IMF Survey Interview, June 23.

Reuters (2012), “Merkel says Greece is special case, needs PSI”, 9 January.

WSJ (2012) “Kenny, Merkel say Ireland’s bank debt special case”, 22 October.

Wyplosz, C (2013) “Cyprus: The next blunder”, 18 March.

This article is published in collaboration with Vox EU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Anil Ari is a PhD Candidate, University of Cambridge. Giancarlo Corsetti is a Professor of Macroeconomics, University of Cambridge and Programme Director, CEPR. Andria Lysiotou is a PhD student at the Faculty of Economics, University of Cambridge.

Image: Tourists are silhouetted against the parliament where the flags of Greece, Cyprus and the EU are fluttering in Athens, Greece. REUTERS/Yannis Behrakis

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