12. CYPRUS Deep recession to prevail over the forecast horizon

76

Rapid deterioration in economic activity

The weakness of economic activity seen in the second half of 2011 is expected to intensify in 2012, when the Cypriot economy is projected to contract by 2.3% against the background of unwinding imbalances and widespread loss of confidence among economic agents. The fiscal consolidation effort that has been pursued, the rapid deterioration in labour market conditions, and the high degree of economic uncertainty have together weighed heavily on private consumption. In addition, the tightening of credit conditions has aggravated the unfavourable economic environment while weak confidence has amplified the drag on investment activity. Adverse developments in the external environment, particularly in Greece, and the sustained volatility in European financial markets have affected Cyprus predominately via developments in the financial sector.

The economy is projected to contract by 1.7% in 2013, due to further declines in domestic consumption, as well as in government and private investments. Economic activity is expected to contract further by 0.7% in 2014 with domestic demand shrinking further and net exports still marginally supporting growth. Traditionally the main driver of growth, domestic demand is set to contract over the forecast horizon driven by markedly weaker consumer confidence and lower household disposable income, which stem in turn from the effects of fiscal consolidation and the worsening labour market outlook. Investment is projected to decline in view of the difficulties in accessing credit and the high level of corporate indebtedness. In spite of the reconstruction work at the electricity power plan and the private investment in a new oil storage facility, construction activity is expected to continue to shrink strongly in 2012 and 2013. Although construction indicators suggest that the correction should persist in 2014, this is expected to be at a milder pace reflecting the general level of economic activity in the economy as a whole.

On the other hand, the external sector is expected to provide a positive contribution to growth for the whole forecast period. In particular, imports of both goods and services are set to decline considerably against a backdrop of weak domestic

demand. Exports are expected to fall moderately in 2012, while the projected economic performance of Cyprus' major trade partners suggests a gradual increase in exports of both goods and services in 2013 and 2014. In services, both tourism and business services continued to perform well in 2012 and this trend is expected to continue in the coming years. In particular, revenues from tourism are expected to continue to rise. This reflects a projected increased flow of arrivals from Russia and new destinations helped by government policies promoting tourism, and from tourists' concern over stability in competing Mediterranean tourist destinations. Exports of transport services are expected to shrink, while financial and other business services will stagnate over the forecast horizon in view of worsen business confidence. Overall, the current-account deficit is expected to narrow gradually over the forecast horizon in spite of a deterioration of the income balance.

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01 02 03 04 05 06 07 08 09 10 11 12 13 14

Graph II.12.1:Cyprus - GDP growth and contributions

Output gap (rhs) Net exportsInventories Dom. demand, excl. inv.GDP (y-o-y%)

forecast

pps. % of pot. GDP

Worsening labour market conditions

Employment is expected to worsen in 2012 and subsequent years, reflecting the slowdown in economic activity. Job losses are particularly prominent in labour-intensive sectors such as construction and trade. The unemployment rate would remain on a strong upward trend, rising from 7.9% in 2011 to 12.1% in 2012, and is likely continue to increase further in 2013 and to be close to 14% in 2014. Given the unfavourable labour market conditions and the effects of fiscal consolidation, wage growth is expected to be negative. In particular, the freezing of public sector wages until 2014 should affect wages in the economy as a whole.

Member States, Cyprus

77

Inflation declining

HICP inflation is projected to decline to 3.2% in 2012 on the back of weaker domestic demand and the fading-out of the base effect of the electricity prices increases in 2011 despite increasing oil and commodity prices and of VAT standard rate by 2 pps. With domestic demand remaining subdued, the effect of the VAT increase and the projected decline of oil and commodity prices, headline inflation is projected to ease further to 1.5% in 2013 and to 1.3% in 2014.

Significant downside risks exist

Cyprus requested external financial assistance from the EFSF/ESM in view of the challenges facing the economy. Under the no-policy-change assumption (the draft 2013 Budget not yet available), significant downside risks are present for the current account, public finances, and the financial sector, testing the economy's sustainability. Failure to raise the required capital and to put policies back on a sustainable path could dramatically worsen the outlook and reinforce the negative loop of lower liquidity, higher indebtedness, worsening labour market

conditions, and lower productivity. Furthermore, any worsening of the economic situation in Greece remains a significant downside risk for Cyprus as well as any further needs of recapitalisation for the domestic banks.

Fiscal and financing imbalances prevail

The general government deficit is set to narrow to 5.3% of GDP in 2012. Should no further measures be adopted, the deficit will rise further to 5.7% GDP in 2013 and to 6% in 2014. The downgrading of the government sovereign to non-investment grade raised yield spreads to prohibitive levels, with the government covering its financing needs through short-term borrowing from the domestic market. The government's participation in the recapitalisation of a commercial bank (which was unsuccessful in implementing its capital enhancement plan) is expected to increase the general government debt significantly from 71.1% in 2011 to about 90% of GDP in 2012. In view of shrinking economic activity, the government debt-to-GDP ratio is projected to reach 96.7% in 2013 and 102.7% in 2014. The fiscal imbalances are set to persist despite the significant consolidation effort pursued in 2012.

Table II.12.1:Main features of country forecast - CYPRUS

2011 Annual percentage changemio EUR Curr. prices % GDP 92-08 2009 2010 2011 2012 2013 2014

GDP 17979,3 100,0 4,3 -1,9 1,3 0,5 -2,3 -1,7 -0,7 Private consumption 11899,2 66,2 - -7,5 1,5 0,2 -3,4 -3,6 -0,9 Public consumption 3584,2 19,9 - 6,8 1,0 -0,2 -1,7 -2,4 -1,5 Gross fixed capital formation 2941,8 16,4 - -9,7 -4,9 -13,1 -22,0 -12,0 -5,3 of which : equipment 828,0 4,6 - -0,3 -5,9 -23,1 -26,0 -11,0 -3,7 Exports (goods and services) 7699,0 42,8 - -10,7 3,8 3,3 -0,9 0,8 1,3 Imports (goods and services) 8251,7 45,9 - -18,6 4,8 -4,1 -9,3 -5,5 -0,4 GNI (GDP deflator) 16481,6 91,7 4,4 -4,9 2,4 3,6 -2,4 -1,7 -0,7 Contribution to GDP growth : Domestic demand - -6,3 0,2 -2,4 -6,2 -4,4 -1,5

Inventories - -1,6 1,8 -0,5 0,0 0,0 0,0Net exports - 5,7 -0,7 3,4 3,9 2,8 0,7

Employment - -0,5 0,0 0,5 -4,0 -0,6 -0,3 Unemployment rate (a) - 5,5 6,4 7,9 12,1 13,1 13,9 Compensation of employees/head - 2,5 2,7 3,3 -0,9 -0,3 0,5 Unit labour costs whole economy - 3,9 1,4 3,3 -2,6 0,8 0,9 Real unit labour costs - 3,8 -0,5 0,5 -4,2 -0,7 -0,4 Saving rate of households (b) - 11,4 11,6 4,1 5,2 7,3 7,5 GDP deflator 3,4 0,1 1,9 2,7 1,6 1,5 1,2 Harmonised index of consumer prices - 0,2 2,6 3,5 3,2 1,5 1,3 Terms of trade of goods - 2,7 -0,9 -0,6 -1,7 -0,1 -0,9 Merchandise trade balance (c) - -25,5 -26,8 -24,2 -21,9 -20,6 -20,7 Current-account balance (c) - -10,7 -9,2 -4,2 -6,3 -3,5 -3,0 Net lending(+) or borrowing(-) vis-à-vis ROW (c) - -10,6 -9,0 -4,0 -5,5 -2,7 -2,4 General government balance (c) - -6,1 -5,3 -6,3 -5,3 -5,7 -6,0 Cyclically-adjusted budget balance (c) - -6,2 -5,3 -6,1 -4,4 -4,8 -5,3 Structural budget balance (c) - -6,2 -5,3 -5,9 -4,6 -4,8 -5,3 General government gross debt (c) - 58,5 61,3 71,1 89,7 96,7 102,7

(a) Eurostat definition. (b) gross saving divided by gross disposable income. (c) as a percentage of GDP.