THE DOWNGRADE of the rating of Cyprus by Standard & Poor’s due to the likely difficulties of banks in Cyprus aggravates the problem of the cost of their own borrowing. While the deposits/loans ratio has been fairly supportive of banks hitherto it is arguable whether this will continue to be the case as the deposit base of Cyprus can only grow modestly as the economy remains slack and hot money from deposits from overseas holders is not a sound basis to extend credit for long term.
All this means higher interest margins will be charged by banks in Cyprus or banks will reduce lending or both.
The reason all these developments are negative for the growth of bank credit and economic growth, is that bank lending is the main source of funding for investment in Cyprus, especially the highly desirable development projects which require access, long term and cheaper credit.
If this is not available or is more expensive , and only time will tell, the economy will struggle due to lack of investment capital. The sources of economic growth will remain business services, retail and some growth due to public sector investments which will not be generating jobs and future growth based on an increase in capital stock.
The government has to consider what its response should be very soon. Surely the public finances are the focus of government but the funding of investments cannot be left for later since tax collection is a function of economic growth and this will impact the tax revenues this government so strongly wants to increase.
The government has a number of options. The approval by the ECB of the covered bond legal framework is attributable to the very good work done by the Central Bank of Cyprus. The government should seek to make this law effective s soon as possible. This in itself will not be sufficient since the pricing of such debt will be dependent on the rating these covered bonds will achieve and this will depend on the rating of the sovereign itself.
The government should also put into Law a legal framework for Public Private Partnerships (PPP) which can provide the private sector with the certainty it needs for infrastructure projects. In addition, the government should consider supporting the private sector by offering partial guarantees to sponsors of major projects which have a development feature, create jobs and can be supported by the Commissioner for State Aid. Such support can be in the form of guarantees for loans in exchange for equity or fees. Lastly, the government and political parties should refrain from making the economic environment more difficult for the private sector to decide on long term investments. The more the leader of AKEL talks about taxation, especially profit, the worse it makes matters. Likewise the opposition has to make action its words on the economy and seek to work with the government.
