Seasoned observers of the cypriot economy say they are not surprised by the speed with which it has rebounded from the devastating financial crisis of 2013, when the banking system imploded, unemployment rose from 11.9% to 15.9%, and real GDP shrank by 6%. “In 1974, the economy lost 70% of its production capacity following the Turkish invasion, but within 2-1/2 years we were back to the pre-invasion levels,” says George Syrichas, executive board member at the Central Bank of Cyprus. “It was a similar story during the first Gulf War. The economy ground to a halt in 1991 but expanded by more than 9% in 1992.”
While these historical vicissitudes may have led local economists to take the recent recovery in their stride, the strength of the rebound since the dark days of 2013 has clearly wrong-footed many overseas commentators. For example, when the European Commission (EC) reviewed the progress that had been made under the Economic Adjustment Programme, in March 2014, it applauded the government for meeting its fiscal targets “with considerable margin”. Nevertheless, the EC’s 2014 winter review predicted a 4.8% contraction in the economy in 2014 and a tepid 0.9% expansion of GDP in 2015.
In the event, real GDP shrank by only 1.5% in 2014, and when growth was restored the following year, it was at a much more impressive clip than the EC’s forecasts suggested, with real GDP expanding by 1.7% in 2015.
The international community was also surprised by the performance of the economy in 2016, when GDP grew by 2.8%. The solidity of this recovery, underpinned by a buoyant tourism sector, low interest rates and falling consumer prices, supported a continued fall in unemployment, from 14.9% to 13.3% at the end of 2016.
This year, the government believes this momentum can be maintained, and is forecasting growth of about 3%. Others have rather more modest expectations, with EBRD forecasting 2.2% and Bank of Cyprus and the IMF expecting growth of about 2.5% this year. “Over the medium term, growth is expected to remain brisk, although moderating gradually from the rapid pace of last year,” noted the IMF in early April, following its most recent post-programme monitoring (PPM) discussions in Nicosia. The IMF sees growth stabilizing at just above 2% from 2020.
In hindsight, some of the more unduly cautious views of Cyprus’s growth prospects may be explained by the fact that the island has perhaps had more than its fair share of economic good fortune over the last few years. Much of this has been a by-product of events well beyond the country’s borders. Its tourism sector, for example, has been a beneficiary of the geopolitical turbulence in a number of its regional competitors, most notably in Turkey.
Cyprus’s longer-term economic prospects, meanwhile, were given a boost in August 2015, with the discovery by Italy’s ENI of the Zohr gas field, which has potential reserves of 30 trillion cubic feet (TCF). Described by ENI at the time as “supergiant”, the Zohr reserves lie in Egyptian waters. But as the Shorouk offshore block where they were discovered is contiguous with blocks inside Cyprus’s Exclusive Economic Zone (EEZ), the Zohr discovery has encouraged a who’s-who of international oil companies to refocus their attention on the potential of the eastern Mediterranean.
Not just luck
It would be a misrepresentation, however, to attribute the turnaround in Cyprus’s economic performance solely to good fortune. Peter Sanfey, deputy director for country economics and policy within the department of economics, policy and governance at the EBRD in London, says that the commitment of the government to the adjustment programme has been impressive.
“The government did well to meet the objectives of the adjustment programme ahead of schedule, and since then it has consistently continued to achieve its fiscal targets,” says Sanfey. “Cyprus is a prosperous, well-run economy with a culture of impartial, independent civil servants which has served the country very well in recent years.”
The strength of Cyprus’s recovery story has not been lost on the ratings agencies, nor on international investors. Following a series of upgrades from the agencies in 2016, Standard & Poor’s (S&P) notched its rating on Cyprus up to BB+ in March 2017, attributing the upgrade to the country’s “stronger than expected economic growth and fiscal progress”.
These upgrades, which have taken Cyprus to within touching distance of investment grade, are an endorsement of the confidence that international investors have shown in the sovereign. Since June 2014, when it returned to the international capital market for the first time since the crisis, Cyprus has enjoyed what S&P describes in a recent update as “unfettered access” to funding in the financial market.
Compelling evidence of an all-round recovery underpins the government’s upbeat assessment of the outlook for growth in 2017, which it believes will exceed most economists’ expectations. “2016 was a good year in terms of growth being positive, unemployment continuing to fall and inflation stabilising,” says Andreas Charalambous, director of financial stability at the finance ministry in Nicosia. “We see further improvements in the labour market this year and we believe inflation will continue to move in the right direction.”
“At the same time, public finances will remain strong with a continued primary surplus,” adds Charalambous. While the budget surplus swung from a deficit to a small surplus of 0.1% of GDP in 2016, the primary surplus continued to rise last year, from €299m to €478m, or 2.6% of GDP.
The IMF welcomes the fiscal progress that the government has made, adding that Cyprus should be aiming to achieve a primary surplus of 3% of GDP “for the next several years”. It cautions, however, that “guarding against fiscal slippages, including from the envisaged national health service as well as from wage and social benefit spending, will be essential.”
Economists are confident that the government will maintain its commitment to the fiscal restraint that will be necessary to preserve a healthy primary surplus, and that it will resist any temptation to loosen the public purse-strings in the run-up to the presidential elections in February 2018. “Aside from some pay increases for nursing staff in 2019, the government is not making any extravagant promises about wage rises,” says Ioannis Tirkides, chief economist at Bank of Cyprus. “So far, wage demands from the unions have been reasonable, so although the government will need to be careful about public spending, I don’t see any immediate threat to the balanced budget.”
No room for complacency
Policymakers recognise that there is no room for complacency, and Charalambous is realistic about the challenges that still face the Cypriot economy. “We’re satisfied by what we’ve achieved but it is not yet a case of mission accomplished,” he says. “We still have a heavy burden of leverage in the public and private sector which is reflected in high non-performing exposures (NPEs) in the banking sector and a high debt to GDP ratio. Although these ratios are declining, we recognise that our indebtedness will remain a constraint on growth.”
External observers agree. As the IMF commented in early April, “restructuring has gained momentum over the past year, but NPLs remain very high and a portion of previously restructured loans tend to re-default.”
“We still have a long way to go, but the improved economy is helping the banking sector to address its key challenges, and we are continually seeing new tools and techniques introduced regarding NPE management,” says Nicholas Hadjiyiannis, CEO of the Cooperative Central Bank (CCB). “This is allowing the banks to focus more and more on growing their business.”
The ratings agencies have also been encouraged by the reduction in impaired loans in the banking system as well as by the trajectory of the government debt. S&P, for example, says that it expects net general government debt to fall to below 90% by the end of 2018, compared with just under 100% at the end of 2015. A further reduction, to 80%, would be one of the drivers that would exert upward pressure on S&P’s rating for Cyprus. The others would be accelerated economic growth and a further reduction in NPLs in the banking system.
In the meantime, economists remain relaxed about the debt, which at about €19bn (gross) was broadly unchanged at the end of 2016. As Bank of Cyprus noted in an update published in March, “debt affordability will be maintained as a result of the low interest rates prevailing in international markets, low average service costs of the Cypriot public debt and modest immediate funding needs.”
Unproductive privatisation programme
There are, however, several other challenges that Cyprus faces besides NPL management and further debt reduction. Foremost among these is the island’s poor productivity, which has been a drag on profitability and economic growth.
Economists say that one way in which the problem of weak productivity could be addressed would be through an acceleration in privatisation, which has perhaps been the most conspicuous blot on the government’s economic track record over the last three years. “The faltering privatisation programme has been disappointing,” says Sanfey at EBRD. “When Cyprus entered into the adjustment programme, it indicated that it would privatise the telecoms company, CYTA, and the electricity utility. Neither has been achieved. We have indicated that we are ready to play a role in the privatisation programme, but that the government needs to make the first move.”
The failure to offload a minority stake in CYTA to a strategic buyer has not been for want of trying. But proposals for its sale have met with such fierce opposition from unions that the government is now reported to have abandoned talk of “privatisation”. It has chosen instead to refer to “denationalisation” as the way forward for its telecoms company.
Economists say that the government is under no budgetary pressure to accelerate its on-off privatisation programme. They argue that the principal benefit associated with the withdrawal of the state from a number of key local utilities would be a much-needed improvement in efficiencies and the attraction of inward investment.
The IMF is urging Cyprus to put a renewed commitment to privatisation towards the top of its to-do list. “Progress with macro-critical reforms has largely stalled,” it cautions in its April update. “Focus should be on expediting judicial reforms to strengthen legal enforcement of commercial claims and speed up court procedures, restarting the privatization program to increase economic efficiency and competition, and streamlining business procedures to attract new service sectors.”