Cyprus Economic Growth Expected To Remain Strong In 2017


The findings of the second post-programme surveillance (PPS) mission of Commission staff, in liaison with staff from the European Central Bank (ECB), which took place in Cyprus from 27 to 31 March concluded that risks for Cyprus’s capacity to service its debt to the European Stability Mechanism (ESM) remain low and the country is currently benefiting from robust growth and improving conditions in the financial sector, as growth picked up in 2016 and is expected to remain strong in 2017, moderating thereafter. But even so, the report prescribes vigilance and calls the government to resist fiscal relaxation pressure.

 The mission was coordinated with an International Monetary Fund (IMF) Post-Programme Monitoring (PPM) mission. Staff from the European Stability Mechanism (ESM) also participated in the mission on aspects related to the ESM's Early Warning System.

Cyprus is currently benefiting from robust growth and improving conditions in the financial sector.To sustain growth in the future, continued fiscal discipline and a renewed structural reform momentum are crucial. Fiscal consolidation has helped strengthen the credibility of the policy framework and facilitate market access of the sovereign. Important structural reforms adopted in recent years and during the economic adjustment programme have allowed Cyprus to turn the corner, with growth returning and the labour market situation improving. At this juncture, it is crucial to safeguard and build upon these hard earned achievements. On the fiscal side, the increased expenditure pressure should be resisted, allowing for the creation of fiscal space for growth-enhancing public spending. On the structural side, on the back of a noticeably weakening reform momentum, the mission encouraged the authorities and other key stakeholders to renew their efforts to improve Cyprus's growth potential and attract more productivity-enhancing investment.

Growth picked up in 2016 and is expected to remain strong in 2017, while moderating thereafter.Growth is becoming more broad-based, driven by private consumption, investment and strong tourism. Labour market conditions have improved overall in 2016, though the unemployment rate remains high, particularly among the young. Real GDP growth is expected to be 2½% in 2017. However, limited productivity-enhancing investment, insufficient structural reforms, and the persistently high level of private debt continue to weigh on growth prospects.

While fiscal performance has been stronger than expected, supported by robust economic growth, pressures for fiscal relaxation are rising. Despite strong economic growth, the budget for 2017 targets a decline in the primary surplus. This is partly due to the abolition of the Immovable Property Tax, which has narrowed the tax base. Moreover, the pressure for fiscal relaxation has increased; this should be resisted as medium-term fiscal risks remain significant and the downward path of public debt has not yet been firmly anchored. In this context, the authorities should ensure compliance with the provisions under the preventive arm of the Stability and Growth Pact. Strengthening fiscal sustainability also implies a need to contain the public sector wage bill, including by introducing a permanent mechanism to moderate wage growth. A thorough fiscal impact analysis should accompany draft legislation on reforms, including the healthcare reform, to ensure consistency with the existing fiscal space. Looking forward, it will be crucial to increase fiscal space to create the conditions allowing for additional growth-enhancing measures, including higher productivity-enhancing public investment and research and development spending. This could be achieved by broadening the tax base and better prioritising public expenditures.

 Important, albeit uneven progress has been made in resolving non-performing loans (NPLs), which remain very high. Strengthening confidence has allowed banks to broaden their deposit base and to improve liquidity and capital buffers. A noteworthy positive development is also the full repayment in January 2017 of the substantial Emergency Liquidity Assistance that had been granted to a Cypriot bank. New lending is picking up from a low base, but the outstanding stock of credit to the economy continues to contract due to necessary balance sheet deleveraging and the workout of NPLs. Banks' profitability is constrained by pressure on net interest margins amid ongoing deleveraging and the need for additional provisioning. The mission recommended more forceful loan restructuring efforts, notably by making full use of all available tools, in order to accelerate the pace of NPL reduction. Moreover, the prevalence of restructurings of already restructured loans suggests that the quality of restructuring solutions needs to be further enhanced. More vigorous efforts by the authorities and the banks are also necessary to increase the implementation and use of the insolvency and foreclosure frameworks. These frameworks have created incentives for borrowers to repay or to seek cooperative restructuring solutions. Nevertheless, a more forceful application would further strengthen these incentives and contribute to reducing strategic 6 defaults. The mission notably highlighted the need to make insolvency-related legal proceedings more efficient, in order to accelerate the deleveraging process.

Renewing the structural reform momentum should be a high priority to enhance long-term growth and fiscal sustainability. The House of Representatives has rejected key reforms, such as the comprehensive reform of the public administration and the privatisation of major state-owned entities. These should remain policy priorities to support fiscal sustainability and long-term growth. To further improve the business environment and attract more investment, progress needs to be made in several essential areas, most notably the modernisation of the justice system, including by establishing a commercial court. Other priorities include a more forceful implementation of the government's action plan for growth, the reform of the electricity market, and the creation of a sustainable and efficient title deeds issuance and transfer system.

Risks for Cyprus’s capacity to service its debt to the European Stability Mechanism (ESM) remain low. The State's cash position is expected to remain sufficient until 2018 thanks to a prudent public debt management policy. Borrowing conditions for Cyprus have improved, driven largely by European and global factors. Medium-term financing needs, particularly in 2019 and 2020, remain high. To ensure that they do not pose new challenges later on, continued fiscal discipline and the resumption of efforts towards adopting growth-enhancing structural reforms are required. The debt sustainability analysis shows that the public debt-to GDP ratio should decrease in the medium-term but will remain vulnerable to macroeconomic and financial-market shocks.

The next PPS mission will take place in fall 2017.