Abstract
This 2002 Article IV Consultation highlights that after four years of strong growth, economic activity in Cyprus has tailed off since late 2001, affected by the global economic slowdown. The authorities estimate growth for 2002 to have declined to 2.3 percent, with falling tourist arrivals and weakening consumer and business confidence. Inflation has risen to 2.9 percent year-over-year in December on account of indirect tax increases, but core inflation remains low. The current account deficit is expected to have deteriorated in 2002 to 5.5 percent, on account of lower tourism receipts and temporary factors.
On behalf of the Cypriot authorities, I would like to thank staff for the constructive policy dialogue. In the authorities’ opinion, the staff report is a comprehensive and sound assessment of developments and prospects of the economy as well as the policy challenges facing Cyprus in the period ahead. The additional analysis in the Selected Issues paper is equally welcome.
Introduction
Since the last Article IV Consultation in 2000, the Cypriot authorities have proven their steady commitment to achieve the strategy and objectives presented in the Pre-Accession Economic Program. Under these circumstances, Cyprus has successfully withstood adverse shocks while maintaining macroeconomic stability and achieved substantial progress on the market-oriented reform agenda. These efforts have borne fruit and at the Copenhagen summit in December 2002 Cyprus was invited to join the European Union.
The authorities are in broad agreement with the staff analysis as regards the direction of policies and recommendations. At the same time, the authorities are well aware of the challenges posed ahead, and wish to restate their determination to continue with the prudent policy aimed at ensuring long-term sustainable economic growth. Consequently, I would limit my comments to some areas of special importance for future developments in Cyprus.
Economic Performance
In the last years the Cypriot economy performed well, rapidly approaching the average level of GDP per capita in EU countries. In this respect, it is worth to mention that real income per capita has reached around 80 percent of the average EU level and is well above the level of other countries invited to join the EU; growth has been driven by steady diversification of the economy, with tourism and financial services developing rapidly.
Since mid 2001 Cyprus, as a small and open economy, has been affected by changes in the external environment. The global economic slowdown and effects of the September 11 attacks have clouded the economic performance, mainly through a reduction in tourism activity. The authorities have tried to find an appropriate policy mix to balance the need for reducing the impact of external shocks and continuing the EU integration process. Despite the adverse external conditions the authorities have made efforts to consolidate macroeconomic performance and substantial policy changes have been implemented to align the economy and its legal framework to EU requirements:
- the historical ceiling on interest rates was abolished,
- the exchange rate band was widened in response to substantial capital flows,
- new legislation was approved by Parliament, giving full independence to the Central Bank of Cyprus and prohibiting public sector borrowing from the central bank,
- a comprehensive tax reform was introduced recently in line with EU standards and,
- restrictions on medium- and long-term capital movements have been gradually lifted, the full liberalization being completed by EU membership.
A better economic performance in the last quarter of 2002 has brought encouraging signs for the year as a whole. Based on earlier information, staff has correctly pointed out that the real GDP decelerated during 2002, estimating a growth rate decline to 1.7 percent in 2002 compared with 4.0 percent in 2001. According to the most recent information, which included the provisional data for the fourth quarter, real GDP growth is estimated to be 2.3 percent in 2002, indicating a strengthening of real economic activity in the final months of the year. The authorities are confident that a steady recovery of the global economy and a peaceful and stable environment, would boost the growth rate in the near future to its normal potential.
Fiscal Policy
Fiscal policy has a key role to play and the authorities will stand ready to continue fiscal consolidation in line with macroeconomic requirements and their declared objective of balancing the budget over the medium term (by 2005). Nevertheless, the authorities largely agree with the staff analysis on fiscal developments. But, while the government budget deficit projected by the staff for 2002 is 3.6 percent of GDP, the Ministry of Finance is estimating a lower fiscal deficit of 2.8 percent of GDP, taking into consideration the most recent information covering budgetary developments in the first 11 months of 2002 and decisions affecting the budgetary accounts for the full year. This revised figure is attributable mainly to the higher tax collections in the last part of 2002 that reflected faster economic growth, the implementation of the tax reform, and the transfer of the excess surpluses of two semi-governmental organizations to the central government. These transfers resulted from the better-than-anticipated profits of the two organizations and were made in accordance with the law on semi-governmental organizations requiring that surpluses above provisioning for development projects and programs be transferred to the Central Government. Thus, in the authorities’ view the revised estimation of the fiscal deficit would suggest that the extent of the stalling in the fiscal consolidation process in 2002 was not as great as implied by the fiscal estimates and analysis of the staff.
Nevertheless, the authorities would subscribe to the staffs view that renewed efforts must be made to ensure that the momentum of fiscal consolidation is strengthened so as to attain the short- and medium-term budgetary targets. In this connection, general price subsidies to the consumer to cover increases in prices of imported energy products have been terminated, and efforts are being made to contain the overruns of expenditure on current transfers.
For the medium-term, the Ministry of Finance is giving serious consideration to establishing a multiyear fiscal framework, so as to link more closely the budgetary process with the macroeconomic objectives specified in the Pre-accession Economic Program and future convergence programs with the European Union. The authorities are determined to continue the fiscal consolidation, which will remain at the center of their economic strategy in the next years, reaffirming the commitment to eliminate the fiscal deficit by 2005.
The Cyprus authorities welcome and agree with the findings of the study on “Aging and Long-Term Fiscal Sustainability in Cyprus” in the Selected Issues paper that focuses on the significant impact of the aging Cyprus population on the public finances. The findings are in line with the latest actuarial report examining the longer-term financial viability of the social security funds. Indeed, this study will reinforce the efforts of the Cyprus authorities to take prompt action on pension reform so as to alleviate future pressures on public finances arising from demographic trends.
Monetary Policy
Monetary policy conduct has been prudent and the nominal exchange rate anchor has served the economy well. At the same time, the central bank remains committed to maintaining the firm stance, acknowledging, in broad agreement with staffs opinion, that the demanding challenges associated with the removal of remaining capital account restrictions are indeed significant and allow no room for complacency. Moreover, the authorities will stand ready to use their available policy tools (including exchange rate movements within the fluctuation band) to respond to capital flow volatility and other external shocks. The authorities expressed their intention, supported by staff, to join the euro area as soon as it is possible and appropriate.
Financial Sector
The banking sector has been strengthened considerably and banking legislation is now at a high degree of alignment with EU and international standards and progress has been achieved in all financial sector areas. The authorities have focused their efforts on strengthening the legal framework for effective supervision and further development of banking supervision practices, thereby creating preconditions for the stability of the financial system over the medium term. Also, new legislation is under preparation to strengthen supervision of Cooperative and Credit Societies, which will bring these institutions in full alignment with EU directives. Following the recommendations of the Offshore Financial Center (OFC) Assessment published in 2001, steps have been taken to address the mentioned vulnerabilities, as presented in the Box 4 of the staff paper. Furthermore, in order to enhance the efficiency of financial supervision over the medium term and ensure the central bank’s access to the necessary information for fulfilling its macro-prudential surveillance, a memorandum of understanding was recently signed by the Central Bank, the Securities Commission and the Insurance Companies’ Control Service of Cyprus. As such, the memorandum constitutes a significant step towards improving and strengthening the institutional arrangements in Cyprus and its main goal is the improvement of institutional cooperation with the view to discharge functions and responsibilities of these institutions in a more effective and efficient manner. Moreover, all banks are required by law to strengthen the institutional and monitoring capacity with regard to money laundering.
Other Issues
At the conclusion of the last Article IV Consultation, Directors recommended changes in the collection of balance of payments statistics as necessary step for a better monitoring and in line with steps of capital account liberalization. Since that time, the authorities have made significant efforts to bring balance of payments statistics in line with the most recent IMF standards and in line with Eurostat and ECB rules. As a result, a new BOP collection and compilation system is now in operation which has greatly enhanced both the coverage and comprehensiveness of statistics. Under the new settlements based system, domestic banks are reporting to the Central Bank of Cyprus all transactions taking place between residents and non-residents, based on the Fifth Edition of Balance of Payments Manual’s definition of residency. The compilation takes place in full accordance with the IMF methodology. Quarterly data for 2002 onwards are being produced on a “geographical level 1 plus each of the EU 15” and have been communicated to the IMF as well as to Eurostat and the ECB. Cyprus has also participated with success in the 2nd Coordinated Portfolio Investment Survey conducted under the aegis of the IMF. Moreover, the authorities are aware that significant demanding work is still lying ahead and the picture in the area of external debt statistics, the reserve template and the International Investment Position has yet to be completed and, therefore, are determined to continue efforts to reach this goal as soon as possible.
Concluding, I would like to reiterate that the Cypriot authorities are determined to take the necessary actions to ensure macroeconomic stability both in the short and medium term. They are also committed to undertaking further steps required for full membership of the European Union.