The financial sector is mostly comprised of the banking sector, which largely provides insurance and asset management services. A large part of banking system assets relates to subsidiaries and branches of foreign banks. The banking sector poses risks by virtue of its size and concentration. The Cypriot banking system has weathered the crisis better than many other euro zone area countries. Significant headwinds for the overall banking system are expected, and the cooperative banks appear particularly vulnerable.


The financial sector is mostly comprised of the banking sector, which largely provides insurance and asset management services. A large part of banking system assets relates to subsidiaries and branches of foreign banks. The banking sector poses risks by virtue of its size and concentration. The Cypriot banking system has weathered the crisis better than many other euro zone area countries. Significant headwinds for the overall banking system are expected, and the cooperative banks appear particularly vulnerable.

III. Potential Growth and the Output Gap1

This note presents medium-term estimates of Cyprus’ potential growth and output gap and long-term projections of trend growth. Historical estimates and medium-term projections are based on a multivariate Bayesian approach which incorporates relevant information on unemployment, core inflation, capacity utilization, and construction cycles. The long-term exercise is based on a production function analysis and long run demographic projections. Results show that Cyprus economy was growing above potential during the boom years prior to the crisis. The growth rate of potential deteriorated significantly in 2009 as a consequence of the crisis, from an average 3.5 percent pre 2008Q4 to 2.1 percent thereafter. There is evidence, however, that potential growth started to weaken before the crisis, namely in 2008—when Cyprus entered the euro area—suggesting a possible initial loss of competitiveness associated with the euro adoption. Long term potential growth projections based on demographic and labor productivity assumptions show a slowdown to 1.9 percent by 2060 mainly due to the demographic transition to an older population and a deceleration in labor productivity growth. In light of the above, a reduction in labor costs through an adjustment of wages and structural measures to achieve fiscal consolidation are paramount for Cyprus to enhance the competitiveness of its economy and boost its growth potential in the medium and long term.

A. Introduction

1. Framing a view on potential output and output gap is important for policy makers in order to maintain the appropriate stance of monetary policy and assess fiscal sustainability. Inaccurate output gap estimates would provide a distorted assessment of the relative importance of business cycle fluctuations versus structural changes in potential output in determining output volatility, with the risk inflationary misalignments and rising external and fiscal imbalances. Having access to a reliable measure of potential growth is also helpful in the aftermath of the recent financial turmoil to guide policymakers with regard to the appropriate timing for exiting support measures.

2. While Cyprus growth has been relatively high and unemployment low by international standards, inflation and current account deficits have been higher than in peer country, and fiscal balances have been historically negative, suggesting that potential output and the output gap need to be carefully monitored. Real GDP has been growing at an average 3.7 percent per year since 1995, compared to an average 1.7 in other euro area countries. Unemployment has been historically low, at about 3 percent, and increased to 5.3 in 2009 as a result of the global financial crisis. However, CPI inflation has also been on a recurring positive differential with the euro area, suggesting periods of economic overheating. Current account deficits have widened over the sample period, reaching -17.5 percent of GDP in 2008, followed by a substantial improvement in 2009 in response to a sharp contraction in domestic demand. After having turned positive 3.4 and 0.9 percent respectively in 2007 and 2008, the fiscal balance deteriorated sharply in 2009 (-6.1 percent of GDP) and is projected to further deteriorate over the medium term, mostly on account of structural measures.

Figure III-1.
Figure III-1.

Cyprus: Economic Indicators

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Sources: Eurostat; and European Commission, Consumer Survey.

3. A preliminary decomposition of output growth2 shows that since 1995 Cyprus has been growing mostly as a result of labor and capital accumulation, while the contribution of total factor productivity (TFP) has been relatively small and variable over the period under review. This feature of Cyprus’ growth dynamics is particularly significant given that potential growth and the standards of living can only be raised on a lasting basis if efficiency increases. If it does not, and wages are indexed to inflation, domestic demand could easily exceed supply in times of positive business cycles, resulting in higher inflation and increasing external accounts imbalances.


Decomposition of Output Growth

(Percent change)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Sources: Eurostat; and IMF, World Economic Outlook.

4. Typically, beside the steep fall in actual output, potential growth is likely to be persistently lower following a crisis as a result of the effect of the crisis on production inputs, including:3

  • Subdued capital investment and obsolescence of the existing capital stock through business failures. Decreasing demand for product and high uncertainty on returns and risk premia might have lowered the incentive to invest, while tighter lending standards might have limited firms’ access to finance.

  • Discouraged worker effects and erosion of skills as a consequence of high and prolonged unemployment. Weaker labor market can lead to an increase in the structural unemployment rate through hysteresis effects, particularly in economies with rigid labor market institutions.

  • Lower spending in research and innovation (R&I) with negative effect on TFP. R&I spending tends to be pro-cyclical by nature and might therefore have been discouraged by the economic downturn also due to higher risk premia.

  • Policy responses from public authorities to mitigate the economic downturn might have also an effect on growth. For example, temporary fiscal measures can lead to permanent increases in government size and in debt, with negative effects on growth, while investment in infrastructure is likely to boost potential output.

5. While some of the above listed channels are not directly applicable to Cyprus, the economy remains significantly exposed to an enduring downward correction in the real estate market. According to data by the Central Bank of Cyprus, the lending conditions in Cyprus have not been significantly tightened and credit/loans continue to record positive growth rates in 2010. Moreover, prolonged unemployment is not a feature characterizing the Cyprus labor market and the average long-term unemployment in 2009 was only 0.5 percent, while R&I spending is very low and not concentrated in sectors hit most by the crisis (construction and tourism). On the other hand, investment in construction consists mainly of investment in housing, which is likely to be persistently lower post-crisis as a consequence of the real estate bubble burst.

6. In the long run, in a full recovery scenario potential output should return to its pre-crisis level. However, this is subject to several conditions, and less optimistic scenarios may unfold. In particular, potential output might recover but at a lower than pre-crisis level or, at the worst, potential output may linger below both its pre crisis level and growth rate. The prevailing outcome will depend on the structural adjustment that Cyprus, as well as its peer countries, will manage to undertake as the recovery takes place.

7. The remainder of this note is organized as follows. Section B presents results from medium term estimates. Section C explains the assumptions underlying the long term exercise and summarizes the results. Section D discusses risks to the proposed outlook and concludes. Details on the model and parameter estimates are provided in the Annex.

B. Medium Term Analysis

8. Several techniques have been presented in the literature to estimate potential output. Univariate approaches such as the Hodrick and Prescott (HP) (1997) filter provide estimates of the potential growth of output by decomposing real output in a trend and a cyclical component.4 Due to their univariate fashion, however, such techniques disregard relevant economic information besides the actual GDP data series itself, thus providing a purely historical analysis. In addition, some of these methods are subject to ‘end-point bias’ and undergo large revisions as new information becomes available. A production function approach, which applies univariate filters to the function’s inputs, partly solves this problem, but it ignores relevant linkages between the output gap and other variables such as inflation and unemployment.

9. This note is based on a multivariate Kalman Filter analysis which incorporates relevant empirical relationships between actual and potential output, core inflation, unemployment, and capacity utilization. Such methodology is an augmented version of the one proposed by Benes et al. (2010) for measuring and updating potential output and the output gap within the framework of a small macroeconomic model.

10. The baseline model is extended to take into account peculiarities of the Cyprus’ economy, such as the importance of the construction and tourism sectors. Tourism is the single most important sector in Cyprus, when the restaurant and hotel sector is combined with the impact of tourism on retail, construction and transport. Moreover, Cyprus experienced a buoyant housing market in recent years, which has been fuelled by the purchase of holiday homes by non-residents, especially Britons, and has contributed to drive the economy to overheating in 2007–08. The weakness of the tourism and construction sectors has also been one of the main drivers of the recession in 2009. In order to take into account the impact of these sectors on the business cycle we modify and extend the baseline model to introduce linkages between the output gap, capacity utilization in the tourism sector, and a construction output index.


Contribution of Sectors to GDP Growth

(Percentage points)

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Source: Cystat

Empirical Results

11. Results show that Cyprus was growing above potential during the boom years prior to the global financial crisis. The country went through two full economic cycles over the last fifteen years before falling into the recession in the second quarter of 2009. The model shows negative output gaps during the period 1996–99 as a string of adverse shocks dampened growth, including a fall in tourism receipts due to disorders along Cyprus’ “Green line”, a particularly severe three-year drought, and a strong earthquake in October 1996. The output gap turned positive in 1999 as a consequence of the high-technology bubble, before reverting into negative territory in 2002 when the bubble burst and Cyprus got affected by the global slowdown, mainly through the fall in tourism arrivals and the decline in air traffic following the events of September 11. The resulting contraction was however moderate compared to the previous one. Starting in 2006 Cyprus has experienced a period of strong expansion, with growth above its potential and an output gap up to 3 percent sustained by a thriving real estate and construction sector. The output gap turned negative in the second quarter of 2009 as the global crisis started to affect Cyprus and the real estate bubble burst. The output gap for 2010 is projected to reach its bottom at -3 percent, and to turn positive only in 2013.


Output Gap and Inflation


Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Source: IMF staff estimates.

12. The growth rate of potential GDP deteriorated substantially in 2009 as a result of the global crisis. Potential output growth varied substantially over time in line with the business cycle. However, while being systematically above its assumed long-run steady state level, at an average of 3.5 percent during the pre-crisis period, the growth rate of potential GDP is estimated to be only around 1.4 percent at the end of 2009. Thereafter, forecasts suggest potential growth to bottom out at 0.4 percent in the last quarter of 2010 followed by a gradual convergence to the assumed steady state, but at a lower than the pre-crisis level. It is worth noting that the large decline in potential growth makes the current recession comparable to the contraction that occurred in 1995–99 in terms of output gap, although the fall in real GDP growth has been much steeper in 2009.


Year-on-Year Growth Rates


Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Source: IMF staff estimates.

13. While output gap only turned negative in the second quarter of 2009, potential growth already started to decline at the beginning of 2008 at the time of Cyprus’s accession to the euro area. This development suggests that Cyprus might have experienced a loss of competitiveness which outstripped productivity when joining the euro area, possibly due to overvalued relative prices and real effective exchange rate appreciation. This hypothesis is confirmed by external sector dynamics, as evidenced by the significant widening of the current account deficit in 2008.


Economic Activity Gaps


Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Source: IMF staff estimates.

14. Notwithstanding substantial variation in potential output growth predicted by the model, the output gap depicts significant fluctuations consistent with movements in inflation and in the other economic gaps. As expected, the estimated unemployment gap is strongly correlated with the output gap while slightly lagging behind and exhibits a more persistent dynamic with longer cycles and smaller variability. This is consistent with the relative rigidity of the labor market and its lagged response to changes in the business cycle. On the other hand, the capacity utilization gap in the tourism sector is subject to more pronounced volatility and wider cyclical fluctuations. Movements in inflation are consistent with the business cycle and they evolve in tandem with the economic activity gaps.

15. Medium term estimates predict a gradual recovery in the output and unemployment gaps, with the latter characterized by a more prolonged revival, while capacity utilization displays a steeper upswing given the marked decline occurred during the 2009 recession. The output gap is projected to close by 2013 after dropping to its lowest level, at -2.7 in 2010:Q2. While staff estimates forecast the gap to close by 2015, the implied shorter horizon reflects an acknowledged feature of the MV filter rather than an idiosyncrasy of Cyprus economy. The unemployment and capacity utilization gaps are also projected to close by 2013 although at different relative speeds. Estimates also show evidence of hysteresis in the labor market, with the non-accelerating inflation rate of unemployment (NAIRU) climbing above 5 percent in 2010 and persisting there, likely due to discouraged worker effect and skill erosion. For the rest of the forecasting horizon the model predicts a mild recovery with positive but narrow output gaps and a smooth rebound in inflation.

16. HP filter and production function based estimates provides a similar picture of the output gap path, with some noteworthy minor discrepancies. In particular, with the exception of the 1999–04 period where the three estimates move closely together, the multivariate (MV) model estimates more negative output gaps during the 1996–99 recession, and less positive ones during the 2006-08 economic booms. This suggests that the information conveyed by core inflation, unemployment, capacity utilization and the real estate cycle translates into higher estimates of potential output. Therefore the model would suggest comparatively tighter policies during downturns and more accommodating ones during booms. Consistent with this finding, the current economic downturn is estimated to be significantly worse under the MV model while the production function method suggests an economic recovery taking place as soon as in the 2009:Q3. Finally, the MV model also estimates a faster recovery from the tech bubble crisis and a positive output gap as soon as 2006:Q2, compared to 2007:Q1 in the alternative models implying a longer (although comparatively less buoyant) boom episode prior to the global financial crisis.


Output Gaps


Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Source: IMF staff estimates.

C. Long Term Analysis

17. This section presents a longer term exercise which translates long-run demographic and productivity projections into potential GDP growth projections. The time frame is 1995–60. Calculations for 2010-2015 are based on the 2009 summer WEO round, those beyond reflect population projections produced by Eurostat and the macroeconomic assumptions and methodologies on labor force and labor productivity agreed by the European Commission.5 Potential GDP growth is calculated combining the resulting profiles in employment and labor productivity growth net of normal cyclical variations.

18. Population in Cyprus is projected to increase through the end of the projection period, supported by high life expectancy and inward migration. Its structure is also expected to become increasingly dominated by elderly people as a result of ageing. Population is expected to rise by some 65 percent by 2060 compared to its level in 2009, with positive although slower rates of growth over the whole projection sample.

19. The projections show a significant increase in the dependency ratio (young and old over total population) mostly driven by a marked increase in people aged more than 65 years. The share of people aged over 65 years is projected to more than double through the end of the sample as compared to its value in 2009 vis-à-vis a decreasing share of younger people. As a result, the dependency ratio, which is projected to be at its lower in 2012, will be on an increasing path over the projection horizon to reach 41 percent in 2060.

20. Working age population is also projected to increase in the long run but the growth rate is limited by the rising dependency ratio which acts as a drag on growth. Working age population is expected to peak around 2040 and then to stabilize in until 2060, with sharply lower and occasionally negative rates of growth consistently with the dynamic in dependent population.

21. The labor supply and employment are on a raising path, therefore providing a positive contribution of labor input to potential GDP growth. The participation rate is expected to peak in 2025 and slightly decrease to stabilize at 78 percent thereafter. The unemployment rate is assumed to converge to its long term NAIRU by 2015. As a result, labor supply is projected to increase and employment will also be on a growing path although with significantly decreasing growth rates after 2015.

22. The labor input in terms of hours worked is projected to grow in line with employment growth. Hours worked per employee, which have been decreasing over the last decade as a result of increasingly flexible labor markets and part time labor, are projected to stabilize by 2030, and to grow in tandem with employment thereafter. The total hour worked are projected to grow as high as 1.7 percent in 2015 and decelerate thereafter, to 0.1 in 2050 and 1.2 in 2060.

23. Labor productivity growth (per hour worked) is assumed to be the main contributor to growth over the long run, with TFP explaining most of productivity growth. The capital deepening contribution to productivity is comparatively higher in the first part of the projection period reflecting some catching up progress, but gradually declining to the steady state growth value of 0.6 percent in 2040. TFP growth is assumed to climb at 1.7 in 2020 and converge toward the rate of 1.1 by 2050. As a result, labor productivity growth is projected to peak in 2010 and converge to its steady state growth rate of 1.7 by 2050.

24. The long run demographic and productivity assumptions ultimately translate in a positive but decreasing potential output growth over the projection horizon, down to 1.9 percent in 2060. While the contribution of both labor input and productivity growth remain positive, growth rates are assumed to decelerate considerably implying a marked slowdown in potential growth compared to the historical average of 3.6 percent.

Table III-1.

Cyprus: Long -Term Projections

article image
Sources: European Commission Services (DG ECFIN); Eurostat; EPC (AWG); and IMF staff calculations.

D. Conclusions

25. After growing above potential during the boom years prior to the global financial crisis, Cyprus entered the recession in 2009 and is only projected to return to its potential in 2013. Cyprus approached the crisis with positive output gaps, meaning that the economy was overheating in the years leading to the crisis. The output gap is estimated to have turned negative in 2009 and bottom out in 2010 at -2.7, slowly recovering thereafter in concert with other activity gaps.

Figure III-2.
Figure III-2.

Cyprus: Long Term Projections

Citation: IMF Staff Country Reports 2010, 289; 10.5089/9781455206407.002.A003

Sources: Eurostat; European Commission Services, EPC; and IMF staff calculations.

26. Cyprus’ estimated potential growth rate deteriorated substantially in 2009 as a result of the global crisis from an average 3.5 percent pre-crisis to an estimated 1.4 percent at the end of 2009. While the output gap only turned negative in the second quarter of 2009, however, potential growth already started to decline at the beginning of 2008 at the time of Cyprus’s accession to the euro area, suggesting an initial loss of productivity.

27. In the long run, a demographic transition to an older population and a projected deceleration in labor productivity growth is also expected to translate into a further deterioration of potential growth to reach 1.9 percent by 2060.

28. There are however risks to this outlook. The analysis assumes that the sharp and rapid deterioration of economic activity due to the global financial crisis will have no structural implications over the medium and longer term. In particular, the medium run exercise assumes no change in the steady state level of the relevant variables and in the structural relationships among them. However, these relationships may have been altered as a consequence of sectoral shifts or a persistent increase in the NAIRU during the crisis period. On the other hand, the labor productivity assumptions—which are determinant for the long term projections—do not incorporate possible effect of the global financial crisis on capital deepening and TFP.6

29. All in all, the results discussed above provide a baseline scenario. They consider the current crisis as ‘normal’, with no structural adjustments to the economy. This might not however be the case and the global financial crisis will likely continue to weight on economic performance on a structural basis for some time to come.

30. In light of the above considerations structural efforts towards fiscal consolidation, better designed wage policies and measures to attract foreign workers will be key to enhancing potential growth both in the medium and longer run. Fiscal relaxation and salary indexation in recent years have resulted in excessive price and wage increases, which have corroded Cyprus’ competitiveness on international markets. Without an adjustment of wages and a reduction in labor cost the economy will face an inexorable corrosion of potential growth. In view of population ageing and the resulting tightening in domestic labor supply, maintaining the supply of labor through immigration flows would also be chief to ensuring wage moderation and sustain potential growth in the long run. While it is difficult to implement structural measures in years of slow economic activity such reform are urgent for Cyprus to enhance its growth potential.


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  • Benes, J., K. Clinton, R. Garcia-Saltos, M. Johnson, D. Laxton, P. Manchev and T. Matheson (2010), “The Global Financial Crisis and Its Implications for Potential Output,” IMF Working Paper.

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  • Beveridge, S. and C. R. Nelson (1981), “A New Approach to the Decomposition of Economic Time Series into permanent and Transitory Components with particular Attention to measurement of the Business Cycle,” Journal of monetary Economics, Vol. 7, No. 2, pp. 151174.

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  • Christiano, L. J. and T. J. Fitzgerald (2003), “The Band-Pass Filter,” International Economic review, Vol. 44, No. 2.

  • European Commission, ECFIN/EPC (AWG), “Ageing Report 2009.”

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  • Hodrick, R. and E. C. Prescott (1997), “Postwar U.S. Business Cycles: An Empirical Investigation,” Journal of Money, Credit, and Banking, Vol. 29, February.

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  • International Monetary Fund (2008), “Spain: Notes on Potential Real GDP Growth and its Determinants,” Mimeo.


The model

The model has six observable inputs, namely real GDP, the headline and core CPI inflation, unemployment, a measure of capacity utilization in the tourism sector and a real estate variable.7

The output gap is defined as the log difference between actual and potential output:


Similarly, the unemployment gap is defined as the difference between the actual unemployment rate and the equilibrium unemployment rate, or NAIRU:


The tourism capacity utilization gap is the difference between the actual tourism utilization index—in terms of percentage bed occupancy—and its equilibrium level:


The level and the change in the output gap influence current year-on-year core inflation according to an augmented Phillips curve:


where the level of the gap incorporate short run effect and the change reflects rigidities in the adjustment of the economy.

The unemployment gap is also linked to the output gap through an Okun’s Law equation modified to take into account the lagged reaction of employment to changes in output:


A similar relation describes the capacity utilization gap:


The equilibrium unemployment rate (NAIRU) is modeled as a stochastic process that assumes a fixed steady-state level of unemployment in the long run U¯ss while including persistent and more transitory shocks8:


where the persistent shocks follow a damped autoregressive process:


Potential output depends on changes in the NAIRU as well as the underlying trend growth rate GtY¯:


And the underlying growth rate of potential follows serially correlated deviations from the steady-state growth rate GSSY¯:


The stochastic process for the equilibrium capacity utilization also includes persistent as well as pure level shock:




The long term inflation objective follows an autoregressive mean reverting progress which converges to the steady-state inflation target πSS:


To include real estate macro linkages we add to the baseline model a block of equations with respect to a real estate variable R, which is assumed to be a function of its equilibrium level R¯ which is itself a random walk and the future expected output gap 4 quarters ahead:


Finally, the output gap is explained by its lag and the inflation deviation from the target, as well as by η, a distributed lag of εR:


The output gap equation, along with equation (4) formalizes the transmission of monetary policy to the core rate of inflation through the output gap, while also taking into explicit account the effect exerted by real estate on the output gap itself. Thus, if activity in the real estate sector is higher than expected based on future economic conditions the output gap will be wider. The coefficients imposed in equation (17) are intended to reflect a pattern in which both present and lagged unanticipated shocks to the real estate sector affect the output gap with equal weights.

Parameter Estimates

The table below presents prior distributions and estimated posterior distributions from regularized maximum likelihood estimation.

article image
Source: Staff estimates.

Standard deviations of the Gaussian prior distributions before truncation


Prepared by Valentina Flamini (EUR).


The decomposition is based on a standard Cobb-Douglas production function with labor share in value added equal to 0.7 as in most industrialized economies. Data are from Eurostat (real GDP, employment and gross fixed investment) and staff calculations (TFP). Past data availability restricts the analysis to the time frame 1995 to 2009. The capital stock series is constructed from total investment according to the formula: Kt = (1 – δ)Kt-1 and assuming perpetual inventories. The depreciation rate δ is assigned the value 0.055 while an initial benchmark is computed as: K1995 = I1995/(δ + i) with i being the average logarithmic growth rate of investment in the sample period.


See Furceri and Mourougane, 2009 for estimates of the effects in OECD countries.


Additional univariate methods include the Baxter and King (1999) filter, the Christiano and Fitzgerald (2003) filter, the Beveridge and Nelson (1981) decomposition.


Relevant assumptions for Cyprus and other European countries are in the European Commission 2009 Ageing Report and 2009 Sustainability Report.


The AWG/EPC macroeconomic scenario was finalized in 2008 while crisis only started to take hold in Cyprus in 2009.


See Benes et al. (2010) for a more detailed description of the baseline model.


The steady-state level of unemployment in the long run U¯ss

article image
and the steady-state growth rate GSSY¯
article image
are assigned priors equal to 3.63 and 3.5 respectively, the steady-state inflation target πss is assumed equal to the ECB inflation target of 2 percent.

Cyprus: Selected Issues
Author: International Monetary Fund