The European Commission expects the Cyprus economy to grow by about 4% in 2005-06, according to its latest Spring Forecast.
This, it says, is mainly domestic-demand led, linked to continued strong private sector investment and consumption growth in an environment of improving investor and consumer confidence.
Consumption growth is supported by rises in disposable income as real wages increase in line with productivity development in near-full employment conditions.
An increased competitive environment following EU accession and positive investment conditions provided by liberalisation in financial and utilities markets and the positive outlook on further fiscal consolidation are expected to continue to stimulate further investment expansion.
At the same time, the growth contribution from external demand is expected to turn positive for both years. Mainly based on the moderately positive EU growth outlook, the forecast projects a continuing modest recovery in export growth in 2005-2006, in tourism and even more in non-tourist services.
Import growth will slow
As one-off demand factors fade out, import growth is expected to slow in 2005 and then pick up with domestic demand growth in 2006. All in all, the forecast projects a concomitant modest decline in the current account deficit to below 5% of GDP for this year and 4.5% of GDP in 2006. However, projected trade developments, especially in tourism and oil prices, remain fraught with uncertainty.
Labour market, costs and prices
Unemployment rose somewhat to 5% in 2004 but is expected to inch downward as growth picks up further. The (limited) border opening with the Turkish Cypriot (T/C) community has led to an increase of the share of daily commuting T/C workers in total employed labour to about 1%.
The contribution of foreign workers on the one hand and wage moderation in the public sector on the other seem to exercise a moderating pressure on wages, which are expected to increase between 1.5 and 2% in real terms in 2005 and 2006, below expected productivity growth.
Inflation fell back to 1.9% in 2004 after peaking at 4% in 2003 when it was pushed up by increases in VAT rates and excise duties.
Notwithstanding the projected growth rebound from 2004 onward and possible oil price rises, inflationary pressures are expected to remain relatively subdued with inflation projected to slightly increase to 2.3% in 2005 and then move back toward 2% by 2006.
Monetary conditions appear stable with a slight restrictive bias, which helps to keep the exchange rate steady vis-à-vis the euro. In the context of moderate inflation pressures and ongoing fiscal consolidation, interest rates were lowered by 25 basis points in February 2005.
Public finances
The 2004 deficit is estimated to have declined to 4.2% of GDP, down from 6.3% of GDP in 2003.
This distinctly better-than-expected positive outcome is attributed to the successful impact of fiscal consolidation measures both on the expenditure and revenue side, despite negative revenue effects linked to delays in the introduction of some measures initially planned for 2004 and which are now to be implemented in 2005.
Revenues were also supported by a more domestic-demand based growth composition, leading to extra tax revenues. This outturn for 2004, together with the recent successful negotiations with social partners on a number of key planned consolidation measures and the ongoing implementation of other measures planned for 2005, provide the basis for a further projected deficit decline to just below 3% of GDP in 2005.
The projected deficit of 1.9% of GDP for 2006 is marginally above the Cyprus updated convergence programme target, which is mainly linked to the slightly lower forecast GDP growth projection for 2006.
The economy in 2004
Following a pick-up of economic activity in the second half of 2003, GDP growth strengthened further in 2004, reaching 3.7% for the year. The recovery was driven by domestic demand growth, especially in private consumption and investment in construction and machinery.
Government consumption dropped in real terms. Private consumption growth rebounded to 6.1%, in line with the increase in disposable income and was further stimulated, inter alia, by restrained demand for consumer durable goods in previous years and certain elements of the tax reform including the lowering of excise duties on cars.
After a decline in 2003, investment also picked up strongly with an estimated increase of more than 9%, reflecting improved profitability and more positive investor expectations. Therefore, the interest rate hike on April 30, related to political uncertainties regarding the reunification process as well as the final stage of liberalisation of capital movement restrictions at the date of EU accession, did not seem to have negatively affected private domestic demand.
Fiscal consolidation led to a strong decline in government consumption which contributed to a marked reduction in the general government deficit.
Net external demand contributed negatively to growth. After declining in the previous two years, exports of goods and services in 2004 staged a modest recovery. Tourism arrivals increased by 2%, the first positive growth since 2001 but still below historical growth rates.
However, imports surged, especially of cars, as a result of the expansion in domestic demand and lower excise duties on cars. Together with rising oil prises, these factors led to a significant widening of the current account deficit to an estimated 5.7% of GDP.
Source: European Commission Spring Forecast.
