Cyprus Seeks to Develop its Energy Sector in the Wake of its Bailout

Cyprus Seeks to Develop its Energy Sector in the Wake of its Bailout 

Stratfor 17-Jan-14 

Summary 

Nearly a year has passed since Cyprus was confronted with the terms it had to meet to receive a 10 billion euro ($13.6 billion) bailout from the European Union and the International Monetary Fund. With the bailout, Cyprus avoided a sovereign default, but it has still fallen into a deep economic crisis that could last for years. Nicosia can profit from the attention of larger powers that want influence in the Eastern Mediterranean, but because of the geopolitical importance of the region, Cyprus will have little control over factors that influence the development of its energy sector. Overhauling the energy sector will remain a long-term goal for Nicosia even though such reform will not improve the country's economic situation in the short term. 

Analysis 

Cyprus received substantial international media attention in early 2013 as the latest eurozone country that needed a bailout. Because of its strong economic and financial ties to struggling Greece, Cyprus was one of the countries that would most likely need help from the European Union and the International Monetary Fund to avoid a default. Looming elections in Cyprus and Germany, skepticism toward bailouts in creditor countries, the prominence of the Cypriot financial sector and its ties to Russia were all factors that delayed the bailout negotiations, which were eventually concluded in March 2013. 

For the first time, creditors demanded in the agreement that bank depositors carry part of the burden in return for giving financial aid to the country. In Cyprus, this so-called "bail in" of depositors strongly affected foreigners, mainly Russians, since Cyprus was an important offshore financial center. 

Image: Cyprus' Unemployment Rate 

Because Cyprus has a small economy, the turbulence around the bailout didn't destabilize the eurozone overall, but it nonetheless had important consequences. Cyprus was a critical test case for the European Union because new EU guidelines say large depositors will generally have to carry part of the burden in future bank bailouts. Cyprus is still feeling the effects of the terms of the bailout and the economic downturn. The economy is expected to have contracted by around eight percent in 2013 and will likely see a further contraction of close to five percent in 2014. Some of the financial controls, implemented after the bailout for fear of a bank run, are still in place. Unemployment has increased from 14.7 percent in March 2013 to around 17.3 percent in November 2013, the fastest rise in the European Union over that time period. The current unemployment rate is close to three times higher than in late 2010 and shows that the Cypriot economy was already struggling before the bailout. Unemployment is expected to rise further and the country's domestic demand is likely to remain weak for a number of years under high unemployment. Cypriot politics are also likely to remain turbulent in the coming years as the political elite tries to maintain voter support. 

Few ways to Overcome the Economic Crisis 

Due to the size of the country and its distance from consumers, Cyprus has a small manufacturing base and is a strongly service-oriented economy. This is unlikely to change. Despite the restructuring of Cypriot banks and a weak current state, the financial sector is likely to remain an important part of Cyprus' economy. Over the past year, Cyprus' second-largest bank, Popular Bank, was closed and the largest institute, the Bank of Cyprus, was restructured. The international creditors' goal was to shrink the Cypriot financial industry so Cyprus could handle future problems in the sector and the country would become a less prominent offshore financial center. However, as a result of the restructuring and the bail in, large depositors -- particularly from former Soviet Union countries -- now have larger stakes in the Bank of Cyprus, since their deposits were converted into shares, giving them a greater say on the board. Because the European Union is closely watching the Cypriot financial sector, there are likely strong limits to what the board can independently decide. However, the numerous Russian members of the board can nonetheless influence the bank's strategic interests and attract more capital from Russia. 

Apart from the financial sector, shipping and tourism are important service sectors in Cyprus. But Cyprus will not be able to overcome the current crisis by relying on these sectors alone. 

The Energy Sector as the Possible Solution 

Nicosia hopes to diversify away from services by developing the country as an energy hub. The Eastern Mediterranean has large natural gas reserves, and Cyprus hopes to gain greater importance as a transit state for natural gas flows to Europe, as well as profit from domestic natural gas reserves off its coast. Beyond the uncertainty of the size of the natural gas reserves, political tensions in the region and the lack of capital are considerable obstacles to this strategy. 

Image: Eastern Mediterranean Oil and Gas Fields 

The Aphrodite natural gas field was discovered in 2011 off Cyprus' southeastern coast and raised hopes of further discoveries in Cypriot waters. A pipeline bringing natural gas from Israel to Europe through Cyprus is also an option being discussed. Further, Nicosia hopes to build a liquefied natural gas liquefaction terminal but needs further natural gas discoveries to make such a terminal commercially viable. 

A complication to the strategy is Cyprus' conflict with Turkey. Since a Turkish intervention in 1974, the island has been split between what Turkey regards as the Turkish Republic of Northern Cyprus and the larger Republic of Cyprus in the south. Ankara does not recognize Cyprus or several border agreements that Nicosia has struck with Israel, Lebanon and Egypt. Ankara has not taken significant action to block exploration and has focused on domestic and regional instability rather than escalating a conflict with Cyprus. Nonetheless, some kind of accommodation with Turkey would be necessary for commercial natural gas operations. The European Union supports Cyprus but has little capacity to focus on the Eastern Mediterranean in light of Europe's structural crisis. Beyond joint plans with Israel, further U.S. or Russian involvement will be required to either facilitate an agreement with Turkey or to give companies the security that, despite Turkish threats, their developments will not be blocked. 

The degree to which these larger powers support Cyprus strongly depends on the evolution of other developments in the region (such as tensions between Turkey and Israel, Turkey and Russia and Russia and NATO). Independent of the developments in the energy sector, Nicosia will heavily depend on foreign interest in the island to deal with its current economic crisis. 

Nicosia Seeks to Strengthen Alternative Alliances 

Cyprus is strongly integrated with Europe politically and economically. The country has no interest in leaving the European Union or the eurozone because such a move would likely have devastating effects on the economy. However, Nicosia is nonetheless seeking to strengthen alternative alliances, particularly with Moscow, because the bailout demands and Europe's structural weakness have reduced the appeal of the European Union in Cyprus. 

Nicosia and Moscow have long had strong ties, and the country looked to Moscow for financial assistance several times in the past. Russian capital will likely also be an important factor in future Cypriot privatizations demanded under the bailout agreement. 

Beyond attracting Russian capital, Nicosia benefits from this relationship by keeping Western powers interested in the island out of fear of an expansion of Russian influence in the Mediterranean. Moscow has been willing to support Cyprus because of the importance of its financial sector, and Cyprus has gained further importance to Russia militarily as the crisis in Syria lingers. Syria's port of Tartus is Russia's only naval base in the Mediterranean and Cyprus is a good alternative location since it is not in NATO. Particularly since mid-2013, Moscow has been making greater efforts to gain more permanent access to Cypriot airfields and ports. On Jan. 10 the Cypriot government reportedly approved a draft proposal put forward by the Cypriot Defense Ministry to allow Russia to use the Andreas Papandreou Air Base in emergency situations and for humanitarian reasons. The deal is not yet finalized, according to Cypriot media, but Moscow has already been allowed to use Cypriot ports and airfields. Although the agreement under discussion is unlikely to give Moscow a permanent base, it is an important deal given that Western countries with strong military interests in Cyprus closely follow the evolution of the Cypriot-Russian relationship. The United Kingdom in particular -- from which Cyprus gained independence in 1960 -- still owns two sovereign base areas on the island as part of its overseas territories. 

Closer ties with Russia in the form of a more permanent military base could come at a big cost for Cyprus. European and U.S. partners play an important role in its energy sector plans. U.S. company Noble Energy has been exploring for natural gas in Cypriot waters, and Italy's ENI and France's Total have shown interest in the sector as well. Moscow could also get more involved in developing the Cypriot energy sector and could help counter a potential threat by the West to drop its support for these initiatives. However, a withdrawal of Western interests as a result of stronger Cypriot ties to Russia would make Nicosia dependent on aid from Russia. It could also undermine Cyprus' plans to develop its natural gas sector, since Moscow would have little interest in providing Europe with alternative natural gas sources. 

These issues plaguing Cyprus were likely addressed when Cypriot President Nicos Anastasiades visited the United Kingdom from Jan. 14 to Jan. 17. The Cypriot delegation not only celebrated its close ties to the West but also reminded its Western partner of the island's continued geopolitical importance in light of Europe's structural crisis and Russia's expanding influence.