Today, we continue our thematic week on Cyprus, on the occasion of Cyprus’ EU Presidency, with a presentation of the Cypriot economy and its current troubles which have made the headlines.
The country became a member of the EU in 2004 and quickly joined the euro area, adopting the single currency in 2008.
Cyprus is the latest European Member State to have applied for financial aid, because of the tricky situation of its banks, very exposed to the troubles of the Greek economy. The negotiations between the Cypriot government and the Troika – EU, European Central Bank (ECB) and International Monetary Fund (IMF) – started in July and should last a few weeks.
This article mainly bases on the recommendations of the Council and the Commission issued in the framework of the European Semester, at the end of May 2012. The document can be found here (click then on any format in the EN column). The evaluation highlighted internal imbalances, mainly caused by the banking sector and the too high debt burden of the businesses, as well as by the risks for the corrective path of the public finances, due to a decreasing competitiveness and to the unfavourable economic environment marked by the exposition of the Cypriot banks to the Greek economy.
Reforming the Welfare State
Like many other European countries, Cyprus has to reform its pension system in order to ensure its viability. Reforms were already started and were saluted by the Commission who, nevertheless, considers that they are not sufficient.
Indeed, according to IMF projections, public expenditure related to pensions would rise from 9% of GDP in 2010 to 19% in 2050 if there was no reform. Furthermore, the system relies more and more on public transfers. This means that the government would have to increase its spending in this field by more than 350 million Euros (out of a budget of around 11.5 billion Euros) by 2020.
So, the Commission and the Council call upon Cyprus to pass measures “to preserve the employability of workers within businesses and to favour the raising of the effective retirement age” in order to take the lengthening of life expectancy into consideration.
Finally, there is also the problem of poor retired people that the government did not tackle strongly enough.
Furthermore, Cyprus should also reform its health care system, as its fairness and quality are challenged. In this respect, the government is called upon to settle a timetable determining the next steps for setting up national health-insurance system that must “ensure its financial viability while offering a general cover”.
Improving competitiveness and employment
In 2011, the Council and the Commission criticized the indexation of wages on inflation by means of an “high cost of living benefit”.
Indeed, salaries are deemed to have increased quicker than productivity during the past few years, undermining the competitiveness of Cyprus’ economy.
Both European institutions acknowledge the reforms already undertaken, such as a freeze in public sector’s pay during two years. What is more, the government, the management and the workforce have agreed to negotiate on a reform of the current system of “high cost of living benefit”.
Besides action on salaries and price-competitiveness, the recommendations also deal with the support offered to unemployed people to find a new job, as the unemployment rate (10.8% in May 2012), especially of young people, experiences a strong increase. In particular, measures should be more ambitious in the fields of education and vocational training.
The aim is to “improve the workers’ abilities so as to strengthen their professional mobility in order to direct them towards activities with high growth and high added value”.
To help young people, “traineeships in businesses and the promotion of working on a freelance basis” should be stressed.
More broadly, “groups that do not participate often in lifelong learning and training activities” should be favoured: elder workers, unemployed people and low-skilled workers.
Furthermore, Cyprus should support more innovation by businesses.
Finally, the Commission and the Council call upon Cyprus to reduce restrictions (access, price setting…) in the service industries, such as retail, tourism and building services, as well as several regulated professions (in particular lawyers and architects).
Keeping a close watch on public accounts
According to the government programme (2012-2015), a balanced budget (medium-term objective) would be reached in 2014 and maintained in 2015.
The Commission and the Council note that the growth rate of public expenditure should respect the rules of the Stability and Growth Pact (SGP) until 2014 – these rules impose a determined cap rate on the growth of public expenditure.
If these targets are met, the ratio debt/GDP will peak at 71.2% in 2012 and then decrease to 65.4% in 2015.
Nevertheless, external (notably the debt crisis, in particular in Greece) and internal (decreasing internal demand) difficulties could endanger the macroeconomic contemplated scenario, so that measures to tackle the deficit should be clearly defined, whatever the real evolution will be.
Furthermore, the necessity to help the islands’ financial institutions could also add to the burden weighing on the national budget.
Finally, the fiscal administration should be reformed in order to become much more efficient, because the costs of cashing taxes in are currently too high for too low results. So, balancing the budget also goes through fighting tax evasion and undeclared work.
Cyprus and its banks
Cyprus remains very exposed to the Greek debt and this is shown by the situation of the three main banks in the country – the Bank of Cyprus, the Cyprus Popular Bank and the Hellenik Bank – that could need financial help up to 10 billion Euros (more than half of the country’s GDP!) according to first estimates.
The restructuring of the Greek debt, which led to the abandonment of an important part of debt by Athens’s creditors, made of course the situation worse. Furthermore, the Cypriot banking sector also holds a lot of debt of the Greek private sector that is also fully hit by the economic crisis.
Cyprus’ Parliament passed two laws in December 2011, to “improve the resiliency of the financial sector to banking crisis. Nevertheless, the Commission considers that the results as regards the supervision of banking institutions, notably the cooperative credit societies (which hold around 40% of the Cypriot deposits) are insufficient. So, it recommends that the supervision of these societies should be similar to the one enforced on commercial banks, in order to facilitate the management and the anticipation of troubles.
Besides, it also suggests improving the planned measures to recapitalise a financial institution in case of an external (in particular, Greek) shock.
A new source of hope: the gas fields in the Mediterranean Sea
Gas fields were recently discovered at the South-East of Cyprus.
The Finance Minister, Vassos Shiarly, announces the exploitation will start in 2017 and gas export from 2019 on. This could change radically the island’s economy, mainly supported until now by the services (notably, the banking sector and the tourism).
This discovery will of course also have geopolitical implications that do not fit in the framework of this article; please look at other articles of our thematic week to know more about the geopolitical situation of the region.
One remaining question is how Cyprus will manage efficiently and durably this new source of revenues. The Economist, in an article published in the edition of July 7th, stated that the Cypriot government was studying the Norwegian system, where the resources are managed by a sovereign fund.