Which sectors will benefit from entry in ERM2
The entry of the Cyprus pound into the ERM2 at the existing parity rate of EUR 1.7086 per CYP or CYP 0.585274 per euro is widely seen as a very positive development that will lead to convergence of Cyprus rates with those of the euro-zone in the next two years, more transparency in prices and easier trading relations.
With the Cyprus Lombard (borrowing rate) currently at 5.25% while the ECB refinance rate is at 2%, the spread between the two is seen declining from the current 225bps to 50bps. This means that even if the ECB eventually hikes rates in two years time by 50bps to 2.5%, Cyprus rates will decline to at least 3%.
Lower rates are good for borrowers but bad for depositors.
We shall now look at who and which sectors will benefit most from the impact of ERM2 entry.
Real Estate/Property market
With property prices up about 100% during the last couple of years, we believe there will be no new rush to bid up prices from current levels. Even without ERM2, we were expecting property prices to take a tumble starting end of 2006, based on two important factors. The first issue is the shift from January 2006 in how problematic loans are classified by the banks. According to the Central Bank, from January 2006, all overdue loans more than 3 months will be classified as problematic and interest accrued by the banks suspended.
By itself, the regulation in insignificant. However, banks are working hard to amend the law on how they can forcefully seize mortgaged property of loans that are overdue.
Currently it takes something like 8 years for a bank to seize a property, but after the amendment, the period is seen declining to 8 months (as in Greece, but longer than the UK at 3 months).
Lower interest rates will certainly help cushion many borrowers from defaulting, but there will be at least many who will eventually default and their property will be seized and dumped into the market, resulting in bigger supply. As long as incomes are not rising, property prices cannot continue climbing.
Bonds
Bonds, mostly government issued are seen as most benefiting from the prospect of lower rates and a stable exchange environment, with money seen pouring in the market, leading to massive over-subscriptions during bond auctions.
Lower rates will drive bond prices higher and yields lower, which should be good news for the government finances. We also anticipate foreign investors targeting government bonds.
Local corporate bond issues are also seen benefiting from the move.
Stock market
First impact should be positive as the prospect of lower interest rates helps equity investments, but after the initial euphoria settles, the market will need to do a lot of test analysis to judge which company will benefit from the move.
For example, the likes of BOC, Laiki and HB, which are normally the driving force of the CSE, will get a hit from lower interest rates, first on their interest mismatch and also because euro adoption will squeeze their margins. In a stable exchange rate environment, more and more corporations will shift to euro borrowing to take advantage of lower rates, leaving local banks with too much excess liquidity in local currency.
On the other hand, the current dividend yield of the CSE listed companies will become increasingly attractive, leading to some shift of funds.
Tourism
The immediate impact is negligible, since the EU already supplies some 75% of incoming tourists, but there will be gains for the hoteliers and tour operators in terms of lower borrowing costs.
In the long term, the impact is seen as negative since euro adoption will immediately bring to the fore the relatively high prices prevailing here compared to other destinations as well as in some EU countries from where we are receiving tourists.
Trade
No impact is seen from euro adoption since the bulk of external trade is done with EU member states while the majority of Cyprus exporters already quote prices in euros, rather than dollar or other currencies.
Services
The impact on the remaining professional services such as auditors, accountants, lawyers and other professionals is also seen as negligible, since they have been quoting their prices in euros.
