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Cyprus' banking revamp underpins economic reboot

Wednesday - 7/3/2013, 8:34am  ET

A man leaves a branch of Bank of Cyprus in central Nicosia, Cyprus, Tuesday, July 2, 2013. Moody's Investors Service said that it considers Cyprus to have defaulted after the debt-stricken island country swapped some local bonds for longer-term bonds. Cyprus negotiated a 23 billion euro ($30 billion) bailout with those entities in March. To get the money, Cyprus had to agree to cut spending and restructure its banking system. (AP Photo/Petros Karadjias)

MENELAOS HADJICOSTIS
Associated Press

NICOSIA, Cyprus (AP) -- It's been just over 100 days since its financial rescue and Cyprus is struggling to cope with life under the terms of its international bailout.

The country's shell-shocked banking system is still reeling from a punishing restructuring while harsh capital controls at the banks are holding back spending. All of which is hitting Cyprus' fragile economy, which is projected to shrink by more than 9 percent this year while unemployment is expected to soar. At the same time, international ratings agencies are warning that the country has defaulted on its debts.

To keep its government going and the country's financial sector from imploding, Cyprus in March negotiated a 23 billion euro ($30 billion) financial rescue package with its euro partners and the International Monetary Fund. In order to receive a 10 billion euro ($13 billion) bailout loan, Cyprus had to raise the remaining 13 billion euros ($17 billion). To do that, it had break up its second-largest bank, Laiki, and impose heavy losses on depositors with over 100,000 euros sitting in it and the largest lender, the Bank of Cyprus.

Further sapping trust in Cyprus' banking system are the strict restrictions on money withdrawals and transfers that were imposed to prevent a run.

Cyprus' president, finance minister and central bank governor met with European Central Bank President Mario Draghi Wednesday with the aim getting the country's banking system moving again.

Analysts warn an economic rebound won't happen until the country has a healthy banking sector doing what it's supposed to be doing -- loaning people money to start businesses, buy homes and invest.

Here is a look at how Cyprus is trying to deal with its biggest problems:

BANKING AND CAPITAL CONTROLS

On top the agenda at the meeting with Draghi were the problems at the country's largest lender, the Bank of Cyprus. The country's president, Nicos Anastasiades, last month warned the country's international creditors that bank's cash reserves were running dangerously low.

This cash crunch arose because, under the terms of the country's bailout, Bank of Cyprus was forced to shoulder billions in debt when it merged with parts of the now defunct Laiki, the country's second largest lender. The debt, amounting to EUR9 billion ($12 billion) euro, is ECB emergency funding that Laiki had racked up.

Anastasiades has warned that Bank of Cyprus' debt burden is hampering the bank from bolstering its coffers, which in turn is stopping it from obtaining its own emergency cash from the ECB -- a problem that could undermine the country's rescue package.

An ECB statement issued after the Cypriot delegation's meeting with Draghi said that both sides agreed that a priority is to wrap up Bank of Cyprus' restructuring soon. The statement said that talks would continue once an assessment of the bank's good and bad assets is completed sometime in the second half of July.

To prevent a run on the country's banks after the terms of the bailout were revealed, Cyprus authorities imposed in March a series of harsh capital controls, such as a daily cash withdrawal limit of 300 euros and a ban on opening new accounts. There is no end in sight for these controls. The authorities say they will remain in place until trust is restored in the banking sector and the risk of a mass deposit flight has sufficiently subsided.

But even with capital controls in place, banks have lost some 7.8 billion euros in deposits since the March bailout agreement, according to Cyprus Central Bank figures. These outflows are mainly due to ordinary business activity -- the rules do allow payments abroad, while foreign banks doing business in Cyprus are control-free. While money is going out of the country, not much is coming back in. Deposits stood at 55.9 billion euros at the end of May, a far cry from the 72.4 billion -- much of it from Russian and other foreign investors -- in May of last year.

The controls are a key obstacle to stimulating a moribund economy, analysts say. Property sales have slumped precipitously because banks aren't loaning money, while the cash crunch has seen the country's small and medium-sized business sector shrink by about 30 percent, says Cyprus Chamber of Commerce and Industry General Secretary Marios Tsiakkis.

Economist Theodore Panayotou, director of the Cyprus International Institute of Management (CIIM) and a former Harvard professor, argues that lifting the controls as soon as possible is the best option in order get money injected back into the economy again.

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