Cyprus: Staff Report for the 2006 Article IV Consultation

This 2006 Article IV Consultation highlights that economic activity in Cyprus has recovered from a relatively weak performance in 2002–03. Declines in interest rates and strong capital inflows associated with Cyprus’s accession to the European Union in May 2004 spurred growth in private consumption and investment while recovering tourist receipts reduced the external drag on the economy. The economy is experiencing rapid credit growth and brisk housing price increases. Total credit to the private sector accelerated recently, with mortgage lending leading the expansion.

Abstract

This 2006 Article IV Consultation highlights that economic activity in Cyprus has recovered from a relatively weak performance in 2002–03. Declines in interest rates and strong capital inflows associated with Cyprus’s accession to the European Union in May 2004 spurred growth in private consumption and investment while recovering tourist receipts reduced the external drag on the economy. The economy is experiencing rapid credit growth and brisk housing price increases. Total credit to the private sector accelerated recently, with mortgage lending leading the expansion.

I. Introduction1

1. As the easternmost country in the EU, Cyprus is well placed to emerge as a gateway to the East and a hub of business operations in the region. The thriving Cypriot economy is testimony to the government’s implementation of reforms and pursuit of prudent policies, in line with Fund advice (text table). The goal of adopting the euro has galvanized the collective will to place the fiscal accounts on a strong footing and reform the economy. However, success in the euro area will require safeguarding external competitiveness and confronting medium-term challenges.

Cyprus: Response to Previous Fund Advice

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II. Economic Background

2. Economic activity has recovered from a relatively weak performance in 2002–03 (Table 1). Declines in interest rates and strong capital inflows associated with Cyprus’s accession to the EU in May 2004 spurred growth in private consumption and investment, while recovering tourist receipts have reduced the external drag on the economy (text table). Cyprus has consequently made further progress on real convergence with its European partners. Employment growth has remained strong and unemployment ranks among the lowest in the EU. An open labor market and booming employment opportunities have attracted a growing number of low skilled foreign workers. This has contributed to lower real wage increases2 despite pervasive backward-looking cost of living allowances (COLAs) and upward pressure stemming from seniority-based wage increases in the public sector.3

Cyprus: Contribution to Real GDP Growth, 2001–06

(Annual percent change)

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Source: Statistical Service of Cyprus.
uA01fig01
Source: IMF, World Economic Outlook.
uA01fig02
Source: IMF, World Economic Outlook.
uA01fig03
Source: Ministry of Labor and Social Insurance.
uA01fig04
Sources: Eurostat; and IMF, International Financial Statistics.1/ Quarterly year-on-year rates.
uA01fig05

3. Inflation has slowed. The moderation (to around 2 percent) in 2004-05 was driven by (i) the waning impact of previous tax rate hikes related to the EU harmonization of minimum tax rates; (ii) a decline in the excise tax rate on cars in late 2003; (iii) increased competition in the telecommunications and air transportation sectors; and (iv) on the external side, euro appreciation. More recently, 12-month HICP inflation increased through the first seven months of 2006, but then declined rapidly to 1.5 percent in December, reflecting lower oil prices and euro appreciation. The November 2006 reduction in excise taxes on cars is expected to exercise further moderating influence.

4. Before inflation started falling, on September 1 the Central Bank of Cyprus (CBC) increased interest rates by 25 basis points to counteract inflationary pressures and strong credit expansion (Figure 1 and Table 2). This hike followed three consecutive rate cuts, for a total of 125 basis points in 2005 (text figure), responding to strong capital inflows related to Cyprus’s participation in ERM2. Although interest rate differentials against the euro area have fallen significantly, the exchange rate had traded close to the (unofficial) upper band of plus 2.25 percent above the central parity of 1 £C = €1.7086. Fueled by low interest rates and strong capital inflows, private sector credit growth increased to more than 15 percent in October from about 6 percent in 2004–05.

Figure 1.
Figure 1.

Cyprus: House Prices and Private Credit, 1990–2006

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Source: IMF, International Financial Statistics; IMF, World Economic Outlook; Staff Estimates.1/ Unweighted average.2/ Yearly growth as of July.3/ Growth rates of the respective aggregates.
Table 1.

Cyprus: Selected Economic and Social Indicators, 2002–08

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Sources: Ministry of Finance; Central Bank of Cyprus; World Bank, World Development Indicators; and Fund staff estimates.

General government.

Excludes intragovernmental debt and short-term liabilities of the Central Bank.

For 1-year fixed deposits over CYP 5,000.

For enterprises’ secured loans.

Data for 2006 as of October.

Table 2.

Cyprus: Monetary Survey, 2002–06

(in millions of £C)

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Source: Central Bank of Cyprus.

Includes reserve position in the IMF.

Nominal GDP/average money stock at beginning and end of year.

In millions of £C; data for 2004 as of June and change during January-June 2004.

Data for 2006 as of August.

uA01fig06
Source: IMF, International Financial Statistics.
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Reserves have risen.

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Sources: Central Bank of Cyprus; and Bloomberg.
uA01fig08

The pound has traded in a narrow range.

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Source: Bloomberg.

5. The fiscal deficit was cut in half to under 2½ percent of GDP in 2003–05 (Table 3 and Figure 2). As a result, in July 2006, Cyprus became the first new EU member to have its excessive deficit procedure abrogated. Data through September 2006 suggest that the deficit was on track to fall under 2 percent of GDP in 2006, notwithstanding a supplementary budget (about 1 percent of GDP) due to health care expenditure overruns.4 Almost three-quarters of the 2003–05 fiscal improvement reflected increased revenues, mostly from one-off measures, including a tax amnesty for undeclared income that yielded ¾ percent of GDP in 2004 and nearly 1 percent of GDP in 2005. This, however, is also thought to have contributed to future tax base widening. Fiscal adjustment also benefited from tight expenditure control, which has combined moderation in public sector wage increases with ceilings on the growth of public consumption and investment expenditures.

Table 3.

Cyprus: General Government Accounts, 2002–08 1/

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates.

Consolidates central government budget; public loans fund; social security funds; sinking funds; and defence fund.

Excludes intragovernmental debt and short-term liabilities of the Central Bank.

Figure 2.
Figure 2.

Cyprus: Central Government Finances, 1998–2006 1/

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Source: Ministry of Finance.1/ Consolidated central government budget, public loans fund, social security funds, sinking funds, and defence fund. Data for 2006 are projections.
uA01fig09

6. Rising energy costs (text table) and robust domestic demand have led to a widening of the current account deficit in 2004–06, to over 6 percent of GDP (Figure 3 and Table 4). Nonenergy imports surged in 2004—prompted by a sharp increase in investment and a reduction in excise duties on cars in 2003—and recorded robust growth in 2005-06. Pressure on export margins continued (text table), though less so than earlier in the decade. Recent declines in competitiveness—as the real exchange rate has appreciated—have contributed to the decline in the export market share of goods, but services exports have held their ground (Figure 4). The surplus in the services balance (as a share of GDP) was little changed in 2004–06, as a sluggish tourism sector was offset by some improvement in the nontourism services balance.

Figure 3.
Figure 3.

Cyprus: Balance of Payments, 1998-2006 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Source: Central Bank of Cyprus.1/ Data for 2006 are projections.
Table 4.

Cyprus: Balance of Payments, 2002–11

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Sources: Central Bank of Cyprus; and Fund staff estimates and projections.

Includes financial derivatives.

Includes valuation effects.

Figure 4.
Figure 4.

Cyprus: Competitiveness Indicators, 1998–2006 1/

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Sources: IMF, International Financial Statistics; IMF, World Economic Outlook; staff estimates; and OECD.1/ Data for 2006 are projections.2/ Four-quarter moving average.3/ Defined as the ratio of the GDP deflator to unit labor cost.4/ Defined as the ratio of the export price index to unit labor cost.5/ Index of the share of Cyprus’s exports over those of the EU-15 and the world respectively.

Cyprus: Impact of Oil Prices on the Current Account Balance, 2004–06

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Source: Cyprus authorities; and IMF staff estimates.

Cyprus: Export Margin, 2002–05

(Year-on-year rate of change)

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Source: IMF, World Economic Outlook.

Assumes a common unit labor cost for the economy.

uA01fig10

Tourism is slowly recovering.

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Source: Statistical Service of Cyprus.

7. Three decades of division have left Cyprus with an economic development gap. Publicly available data for the areas of the Republic of Cyprus not under the effective control of the government of the Republic of Cyprus (NGCAs) suggest that the GDP per capita was less than half that of the government-controlled areas (GCAs) in 2005 (text table).5 The growth performance of the areas of the Republic of Cyprus not under the effective control of the government has reflected a complex interaction of spillover effects from the Turkish economy, economic policy choices and political decisions.

Cyprus: Comparison of Selected Economic Indicators

(2005, unless otherwise indicated)

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Sources: Statistical Service of Cyprus; State Planning Organization (NGCA).

8. Despite all parties’ stated interest, a solution to the Cyprus problem remains elusive. A divided Cyprus entered the EU in 2004 after the failure of the “Annan Plan” for reunification. Following a two-year hiatus in face-to-face talks, the leaders of the Greek Cypriot (G/C) and Turkish Cypriot (T/C) communities agreed in July 2006 to hold “technical discussions.” These talks were intended to improve the day-to-day lives of all Cypriots, build mutual confidence, and prepare for a comprehensive political settlement of the Cyprus problem, but they have yet to bear fruit. In this difficult setting, staff has not been in a position to deliver nonfinancial Fund assistance, such as TA, to the T/C community, as suggested by Directors in concluding the 2004 Article IV consultation.

III. Policy Discussions

Cyprus continues to converge to euro area income levels and, by vigorously tackling fiscal imbalances, stands on the doorstep of EMU. The key objective now is to ensure that euro adoption proceeds smoothly, which requires maintaining low inflation and safeguarding fiscal consolidation. Besides addressing the fiscal costs of aging and other medium-term risks to the budget, sustaining economic growth and competitiveness requires continued efforts to strengthen the financial sector and implement structural reforms.

A. Economic Outlook

9. There was agreement on the favorable economic outlook. Activity is set to strengthen in 2007–08, sustaining employment growth, with a gradual slowing of domestic demand being more than offset by a broad-based recovery in services exports. The external current account deficit is envisaged to narrow gradually and continue to be financed by foreign direct investment, portfolio inflows, and bank borrowing (historically resilient to economic shocks). While staff saw inflation as hovering close to the Maastricht limit, the authorities expressed confidence that it would remain below this limit, and recent developments are encouraging in this respect. The authorities singled out the reduction in energy-related cost pressures, while the reduction in excise duties for cars would also hold down inflation in 2007, although it would have a smaller effect than the 2003 tax cuts and would be partially offset by the need to align VAT rates with EU directives.

10. Risks to this outlook appear balanced. Declining oil prices were seen as boosting economic activity. The opening of Turkish ports to Cypriot vessels (text table), the prospects of which remain uncertain, could provide a further stimulus as transportation services account for almost 15 percent of total exports.6 The authorities, however, were concerned that a further appreciation of the euro against the dollar could hamper the incipient recovery in Europe and hurt Cyprus’s external competitiveness. Also, although the conflict in Lebanon earlier in the year had subsided with no appreciable adverse effects on Cyprus, the island remained exposed to regional geopolitical tensions.

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Source: IMF, World Economic Outlook.

Cyprus: Merchant Shipping Fleets, 2000–02

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Source: UN and Lloyd’s Register of Shipping, World Fleet Statistics.

B. Adopting the Euro

11. Cyprus is well placed to benefit from euro adoption. The economy already benefited from lower interest rates and the removal of barriers to the free flow of goods and services, capital, and labor; the introduction of the euro would provide additional benefits by further reducing transaction costs and, possibly, long-run interest rates.

uA01fig12
Source: IMF, Direction of Trade Statistics.

12. The authorities aim to enter the euro area on January 1, 2008 and plan to submit their euro-adoption petition in early 2007. The recent track record of delivering on the fiscal front, as well as broad compliance with Maastricht criteria in 2005 (text table) helped reduce uncertainty about the timing of euro adoption (Figure 5). The authorities expect Cyprus to be assessed against the Maastricht criteria in the first half of 2007, and, subject to a positive assessment, the Cypriot pound exchange rate would be locked in as of mid-2007, with the lock-in rate being determined in line with the relevant Treaty provisions.

Figure 5.
Figure 5.

Cyprus and Other ERM2 Countries: Real and Nominal Convergence with the Euro Area, 1995–2006

Citation: IMF Staff Country Reports 2007, 076; 10.5089/9781451809909.002.A001

Sources: IMF, World Economic Outlook; and Eurostat.1/ Projections for 2006.

New EU Members and Maastricht Criteria, 2005

(In percent of GDP unless otherwise indicated)

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Source: IMF, World Economic Outlook.

13. The authorities pointed to various studies suggesting that the exchange rate was broadly in line with its equilibrium level.7 Mindful of uncertainties in estimating the equilibrium real exchange rate, the mission agreed that the exchange rate appeared to be broadly in line with fundamentals (Box 1). However, it underscored the need to enhance productivity since there was little scope for any further loss of external competitiveness, and given that any such losses would be particularly difficult to recoup once in the euro zone. Also, staff’s external debt sustainability analysis suggests that the current account deficit in the baseline scenario (based essentially on the authorities’ Convergence Program) needs to be narrowed substantially to stabilize the external debt position (Table 5).

External Competitiveness

The Cypriot economy has coped well with declines in price and cost competitiveness since the early 1990s. Aside from the 2002-03 slump, economic growth has been robust, labor markets operate close to full employment, and strong FDI inflows indicate profitable business opportunities.

In part, this reflects the fact that the recent appreciation in the REER reversed earlier gains. Moreover, the rate of appreciation appears to be moderating. The ULC-based REER suggests more appreciation, owing to strong real wage increases (Figure 4).

Estimates of the equilibrium exchange rate for the Cyprus pound suggest that the REER is broadly in line with its equilibrium level. Pattichis and others (2005) estimated that the Cyprus pound’s exchange rate was slightly undervalued relative to its equilibrium rate in 2000. Since then, the REER of the pound has appreciated by about 15 percent. However, some of this appreciation reflects income convergence with the euro area, including Balassa-Samuelson effects, and exchange rate movements of the euro against other currencies. Kyriacou and Papageorgiou (2005) also concluded that the pound was in line with economic fundamentals in 2004.

uA01fig13
Source: IMF, Information Notice System.

In terms of business competitiveness, Cyprus compares favorably to most new member countries, but not with the rest of Europe (Figure 6).

Table 5.

Cyprus: External Debt Sustainability Framework, 2001–11

(In percent of GDP, unless otherwise indicated)

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Derived as [r- g - r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, with r = nominal effective interest rate on external debt; r = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-r(1+g) + ea(1+r)]/(1+g+r+gr) times previous period debt stock, r increases with an appreciating domestic currency (e 0) and rising inflation (based on GDP deflator).

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current account and non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes the debt ratio assuming that key variables (real GDP growth, nominal interest rate, dollar deflator growth, and non-debt inflows in percent of GDP) remain at their levels of the last projection year.

14. The key short-term policy priority is therefore to ensure a smooth changeover to the euro. A number of committees devoted to the task have been established, and draft laws to reform the institutional framework for monetary policy are expected to be adopted in early 2007. The mission supported the authorities’ euro adoption plan, but noted the need to contain inflationary pressures and assuage the public’s concern that prices might be rounded up when converted into euros. In welcoming the planned dual display of prices, it noted that vigorous domestic competition would be the most effective way to discipline retailers. Furthermore, to ensure that inflation remained in check, the mission called for continued wage moderation and faster fiscal consolidation than envisaged by the authorities.

C. Safeguarding Fiscal Consolidation

15. The 2007 budget targets a further reduction in the fiscal deficit (to 1.6 percent of GDP), though at a slower pace than recently. The authorities noted that, in a break with the past, the budget was free of one-off measures and focused on current expenditure adjustment. On the meager increase in the primary surplus, they noted that cost containment efforts would be partially offset by an increase in (other) transfers, primarily of a social nature. They also noted the need to offset the net effect on the budget of the termination of EU budgetary transfers amounting to 0.4 percent of GDP from 2007 onward. The mission stressed that more consolidation than foreseen in the budget was essential to safeguard the moderation of inflation, and that this could be achieved by avoiding supplementary budgets (rigorously applying the provision on this in the 2007 budget) and strengthening expenditure control mechanisms to observe budget limits.

Cyprus: The Convergence Program, 2006–10

(General government; in percent of GDP at market prices)

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Sources: Convergence Program 2006–2010, December 2006; EU Commission; and staff calculations.

2006 data from the Convergence Program 2005–09

16. The Convergence Program (CP) targets fiscal balance by 2010. The bulk of this adjustment is planned to result from reductions in current spending associated with expenditure containment measures already in place (text table). The CP envisages lowering the public debt to 46 percent of GDP by 2010; the staff’s debt sustainability analysis suggests that debt projections are sensitive to certain shocks (Table 7 and Figure 7). The mission supported the authorities’ medium-term fiscal consolidation plan, and stressed the importance of reining in current expenditures as a means to high-quality adjustment.

Table 6.

Cyprus: Proposed Gateway Process for PPPs

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Assumes that SC and PM continue operating after the PPP contract is signed. If not, functions should be exercised by relevant entities/committees replacing them.

Source: Draft PPP framework.
Table 7.

Cyprus: Public Sector Debt Sustainability Framework, 2001–11

(In percent of GDP, unless otherwise indicated)

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General government gross debt.

Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency. denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/as r-π (1+g) and the real growth contribution as-g.

The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

For projections, this line includes exchange rate changes.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominal interest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.