Undermining Central Bank independence, the Cyprus way (reads much like India’s story!)

It has been 5 months since RBI Governor resigned from the central bank. A lot was written exploring several reasons which led to his sudden exit from the central bank. But much of it is still speculation and truth is known to either Governor or someone close to the scenes in the Government. However, there is one book which reads much like what could have happened between the RBI and the Government.

The concerned book is written by Dr. Panicos Demetriades, former Governor of Cyprus (May-2012 to Apr-2014) and is titled as ‘A Diary of the Euro Crisis in Cyprus’. It is highly surprising that such an account by a central banker has not got due attention. The book was written in 2017 and should be on top of the charts. There are other central bankers who have written their accounts recently. But neither had they faced experiences as telling as those faced by Demetriades nor wrote as frankly as Demetriades.  One reason for ignorance is Cyprus being a tiny economy. Even then the book is a must read for those interested in political economy of central banking.

I came to know of this book by reading a recent speech by Lesetja Kganyago, Governor of the South African Reserve Bank. Kganyago speaks on how central bank independence is under attack including South Africa (which requires a separate article of its own) and picks insights from this book to reflect on Cyprus experiences. The events which happened in Cyprus during those 2 years read as the events in India during 2016-18. The resemblance is so striking, that it leaves you in splits.

What happened in Cyprus which is so telling?

First some basics. Before 2008, Cypriot banking sector grew enormously to touch 10 times the size of its GDP. The banks had invested heavily in Greek government bonds as they gave higher yields. Further, Cyprus banks not just offered higher deposit rates but also lend aggressively towards real estate sector. One of the real estate developers even became chairman of one of the Bank Boards. The financial transactions were not limited locally but funds flowed from and to Russia, Ukraine and Romania, becoming a deadly cocktail at the end. The banks were also the main advertisers in the media leading to no one really raising fingers.

Though, this was hardly unique to Cypriot banks as we saw banks in Iceland, Ireland, and US etc. following similar strategies only to end up in crises. In Cyprus too, the Greece crisis and European financial crisis engulfed banking system of Cyprus which was anyways built on shaky foundations. What is unique though is what transpired later.

Enter Panicos Demetriades who was appointed Governor of Cyprus Central Bank in May-2012. He had taken over from Athanasios Orphanides, who in in his send-off remarked that though banking system was quite stable under his tenure but wasn’t sure what would happen next.

Talk about prophecy as what followed was complete meltdown of the Cypriot banking system. The blame lies on Orphinades as well, as the fragile banking system took shape under his tenure. Demetriades knew he was sitting on a time bomb and tried to figure a solution but could not succeed. The troika of IMF, ECB and European Commission wanted to implement stricter norms for recapitalization which were not agreeable to politicians. The banks remained highly undercapitalized, politicians continued to underestimate the scale of problem also on account of high cronyism. Gradually losses mounted and the share of non-performing loans as a percentage of total loans in Cyprus was next only to Greece. Even today the share of NPLs are as high as 20% of total assets.

As banking problems worsened, a scape goat had to be identified and who better than a central banker! The media anyways disliked Demetriades right at his appointment as he was seen as an outsider. Soon, the political parties joined this chorus. The politicians wanted Demetriades to be ousted but as Cyprus was part of Eurosystem and under this system the central bank governor could not be fired. The only way was to pressurize the central banker and push him towards resignation.

The Government did two major things (apart from humiliation) in mid-2013 which pushed Demetriades towards his resignation – firing the Deputy Governor who backed the Governor and pushing the governance powers from Governor to the Central Bank Board!  Under the new legislation, the Government expanded the Central Bank Board membership from 5 to 7 with the two new members becoming Executive Directors. Further, the decisions related to licencing of new and old banks were to be made by the Board and not the Governor. The ECB protested against this legislation but to no avail.

The new Board stopped backing the Governor and even the loyal staff started complaining of harassment. Demetriades began to tire eventually and health started to suffer. The personal attacks mounted even bringing his family into picture. In March-2014, he submitted his resignation citing “personal reasons and difficulties working with the Board as the reason for resignation. This way the government won not just the battle but also the war against its own appointed Governor.

The events in Cyprus showed how governments can undermine central bank independence in interesting ways. The rules prevented the Governor from being fired but one could still build the pressure through the Board and firing the Deputy Governor.

Given this brief, there is a reason why I mention that Cyprus case reads much like India’s case. The RBI Governor was under pressure for rising NPAs, low credit growth and maintaining high reserves, leading to discontent with the Government. There was news on how the powers of governing RBI had shifted from the Governor to the Board members. There were also reports on how Governor Patel was tired fighting these battles and his health was suffering. In the end, these multiple events forced him to resign, also serving for two years just like his Cypriot counterpart. The resignation letter of the Governor also mentions personal reasons but not saying anything else.

The German classical archaeologist Gustav Hirschfeld once said ‘He who would become and remain a great power in the East must hold Cyprus in his hand.’  Paraphrasing the quote, those who believe in great power of central bank independence, should hold and read this account of Cyprus central bank Governor in their hands! Hope Dr Urjit Patel writes his own account as well.

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