EIU cuts its Cyprus GDP growth forecast

The Economist Intelligence Unit (EIU) have revised down Cyprus’ growth forecast for 2007 to 3.4% (from 3.6% previously) and to 3.6% in 2008 (from 3.8%), primarily owing to quarterly growth in the fourth quarter, which was slower than expected

GDP growth is expected to average around 3.6% in 2007-11, with a slight acceleration in 2008-09, after euro area accession. Inflation will remain moderate, although it will be higher than in the euro area. The current-account deficit will remain substantial, but financing problems are not expected.

Cyprus‘s score in the EIU’s business environment rankings improves in the forecast period (2007-11), but as improvements in other countries are more substantial, its relative position will deteriorate in the global rankings. Cyprus‘s main attraction for foreign investors is the low-tax environment and the proximity to Middle Eastern markets, combined with regulatory reliability, underwritten by the EU. The main drawbacks are the small size of the domestic market and the high labour costs relative to eastern Europe. The uncertainty resulting from the division of the island also cuts off the large potential market of Turkey, but the risk of conflict remains small.

“We expect Cyprus to meet the criteria for euro area membership and to adopt the euro at the beginning of 2008. The conversion rate is projected to be the same as the current central parity of CYP0.585:€1 when it is fixed in mid-2007. This will require a moderate depreciation from current exchange-rate levels,” notes the EIU.

Once the euro is adopted, the government will face calls for higher spending, including larger subsidies to low-income groups and an increase in public-sector wages. Although the government has so far managed to resist the potentially most expensive demands, the EIU assumes that it will respond to pressure in the run-up to the February 2008 presidential election.

“Our baseline assumption is that the budget deficit will widen only slightly and will remain just under 2% of GDP in 2007-08, well below the 3% ceiling established by the euro area Stability and Growth Pact. However, experience from the previous election suggests that public spending can go out of control very fast in Cyprus‘s small economy, therefore much will depend on the government’s vigilance. Under EU rules Cyprus is due to increase the rate of value-added tax (VAT) on specific items, including medicines and restaurants, from January 2008. Depending on the item, rates will go up from 0% to 5%, 8% to 15%, or 0% to 15%. However, the government is trying to negotiate a delay to avoid perceptions that adoption of the euro will lead to a spike in prices, as many Cypriots fear it might.”

The EIU expects Cyprus to meet the inflation target for adopting the euro, as the 12‑month harmonised inflation rates—the measure used for assessing whether a country has met the inflation criterion for adopting the euro—have consistently been below the indicative ceiling (1.5% above the three EU members with the lowest 12-month inflation rates). Cyprus‘s 12-month rate was 2.1% in February, compared with an estimated indicative ceiling of 2.9%, according to our calculations. For euro adoption purposes, Cyprus is likely to be judged on its 12‑month inflation performance to May or June.

Over the next two years, and on the basis of our global oil price forecast, price pressures are expected to be subdued, although there will be a higher than average increase in the inflation rate after the government imposes higher VAT rates on selected items, in accordance with EU rules. These increases are currently due in January 2008, but the government is reportedly trying to negotiate a delay to avoid the perception that adoption of the euro will lead to a spike in prices.

 

Politics

Pressure from the EU and the UN Security Council on the Greek Cypriots to re‑engage in efforts to solve the problem of the division of Cyprus appears to be increasing and is expected to lead to some progress in the coming months. However, substantive talks remain unlikely in 2007-08, owing to elections being held in Turkey in May (presidential) and November (parliamentary) 2007 and in the (Greek Cypriot) Republic of Cyprus in February 2008 (presidential). The incumbent president, Tassos Papadopoulos, is currently the favourite to win, as we assume that he will again be backed by the Progressive Party of the Working People (Akel). Since his main support comes from hardliners, a solution to the Cyprus problem remains unlikely if he is re-elected. The opposition Democratic Rally (Disy) is currently expected to put forward a popular former minister for foreign affairs and member of the European Parliament, Ioannis Cassoulides, possibly as an independent, in order widen his appeal.