Since the banking crisis of 2013, the economy of Cyprus has shown impressive resilience and improvement. From negative growth rates, we now have significant and positive growth.
From budget deficits, we now have significant primary and budget surpluses. From sky-rocketing unemployment levels, we now have levels that are close to full employment. The banking sector has recovered and the number of NPLs has reduced substantially.
However, a major problem still exists – namely the persistent level of private indebtedness (both for individuals as well as companies).
This is still very high (more than 200% of our GDP) which creates multiple problems for our economy.
It’s important to understand that although the number of NPLs has dropped, problematic loans are not out of the economy; what has happened, to a large extent, is the transfer of those loans from the banking sector to asset management companies and funds that bought them at a discount price.
The condition of the high level of debt is named debt overhang, i.e. when the level of debt is so high that the companies cannot borrow more money, even for projects that would have a positive Net Present Value (NPV). So, what needs to be done in such cases?
Well, the debt levels need to be further reduced (by continuing the process of restructuring, exchange of debt with assets, write-offs in some cases) but there also needs to be equity capital injections into companies.
Equity capital has advantages and most importantly reduces the dependence on debt/bank borrowing.
Too much debt creates distress risk and the likelihood of bankruptcy.
Equity financing is an alternative source of capital injection to debt capital with fewer costs. So how can the equity capital injection take place?
- If we had a well-functioning capital market/stock exchange, then that could help. Unfortunately, our stock exchange is in a very bad state and needs an urgent boost. Talks about privatisation are in the right direction, but until we see results it will take some time.
- Another avenue is the private-public equity fund announced in the summer by the government. This will be a joint fund between the government and private investors and its purpose is to invest in SMEs and start-ups within the Cyprus market. This is a promising initiative but it remains to be seen if it will be successful or not. For this to be effective there needs to be interest from private investors which can only come if they expect to earn a good return on their investment.
- Capital injection can also come from venture capital and private equity funds. Venture capital funds are willing to take high risks and invest in start-ups hoping that some of them would turn out to be successful. Their average holding period is around eight years. Unfortunately very few of those exist in Cyprus and we need to improve our entrepreneurial ecosystem to attract more. Private equity funds would invest in companies or properties. Those companies might be distressed or face problems and the intent is to operationally manage those, grow them, and eventually sell them with an average holding period between five to seven years. We have a few recent cases of investments in Cyprus by private equity funds in the banking sector and real estate market. We need more of those though.
In order for the above approaches to be effective a few things need to happen – there needs to be the right legal framework, companies in Cyprus need to start providing reliable and timely financial statements for investors to assess, and the new economic model needs to include other industries (apart from the traditional ones, such as energy and technology) to give choices to foreign investors.
Recent initiatives by the government such as the National Board for Research and Innovation, the role of the Chief Scientist or the proposed establishment of a Ministry for Research and Innovation are steps in the right direction and can help start-ups to grow or established companies to improve and modernise their operations.
Lastly, the culture in Cyprus of family-owned businesses that want to hold onto their business and pass it on to their children needs to gradually change.
It’s good to allow other investors to enter even if it means that you have to give up some of the ownership. This is a way to bring capital, expertise, and grow.
Source: Financial Mirror