Commission proposes that Cyprus adopts the euro in 2008

The European Commission concluded that Cyprus has achieved a high degree of sustainable economic convergence with the euro area Member States and that it fulfils the necessary conditions to adopt the euro. On the basis of this positive Convergence Report, the Commission proposes to the Council that Cyprus adopts the euro on the 1st of January 2008. The final decision will be taken by EU Finance Ministers in July, after consultation of the European Parliament, and following a discussion by EU leaders at their June summit.

“Cyprus has achieved a high degree of economic convergence with the euro area and is ready to adopt the euro in January 2008. However, in order to ensure that euro adoption will be a truly successful story, Cyprus must continue to implement stability-oriented policies in order to safeguard its external competitiveness. In addition, Cyprus must also speed up and finalise the crucial practical preparations to ensure that the changeover takes place smoothly, as was the case in Slovenia at the beginning of this year” said Joaquin Almunia, European Commissioner for Economic and Monetary Affairs.

On 13 February, Cyprus asked the Commission to assess that it met the criteria necessary to adopt the euro. To become part of the euro area, a European Union country must have achieved a high degree of sustainable economic convergence, measured against the criteria set out in Article 121(1) of the EU Treaty regarding the government budgetary position, price stability, exchange rate stability and convergence of long-term interest rates. Compatibility of the legal framework with the Treaty must also be examined.

Having carefully assessed the request, the Commission today adopted a Convergence Report concluding that Cyprus meets the criteria and proposes to the Council that it adopts the euro next January. The European Central Bank also adopted a Convergence Report reaching the same conclusion.

Inflation

The average inflation rate in Cyprus during the 12 months to March 2007 was 2.0 percent, below the reference value of 3.0 percent. Cyprus has respected the reference value since August 2005 and, based on the present outlook, is likely to continue to do so in the coming months. Moderate core inflation indicates that underlying inflationary pressures have remained limited. Progress towards price stability has been supported by wage discipline and increasing competition in some product markets, also related to integration in the EU single market and effects of globalisation. The improvement in price stability is based on sound foundations, suggesting that the moderate levels of inflation will be maintained after euro adoption. Nevertheless, Cyprus will need to remain vigilant to contain the potentially inflationary impact of further interest rate (too obscure) convergence, to mitigate credit growth and to avoid second-round effects from increases in indirect taxes. A prudent fiscal stance aimed at avoiding the build-up of excessive demand pressures, and wage developments in line with productivity gains would also be required.

Budgetary situation

Cyprus had a budget deficit of 1.5% in 2006, down from 2.3% in 2005, a figure which had enabled the Council, acting on a Commission proposal, to close the excessive deficit procedure started upon EU accession, in 2004. For 2007, the Commission’s Spring Forecast projects an almost unchanged deficit (1.4 percent of GDP). The government debt increased between 2000 and 2004 but has been on a declining path since 2005 to reach 65.3% of GDP in 2006. In 2007, it is seen declining further to 61.5% of GDP. The Ecofin Council has considered the budgetary strategy outlined in the latest Convergence Programme as sufficient to reach the Medium-Term Objective of a deficit of 0.5% by 2008 and the underlying risks broadly balanced. However, Cyprus was invited to control public pension expenditure, namely through further reforms in order to improve the long-term sustainability of the public finances and to implement the fiscal consolidation path as foreseen in the programme.

Exchange rate

The Cyprus pound has participated in the Exchange Rate Mechanism ERM II since 2 May 2005, i.e. for 24 months at the time of adoption of this report. During those two years, the pound has consistently traded in the upper half of the fluctuation band, close to the central rate, and has not experienced severe tensions.

Long-term interest rates

The average long-term interest rate in Cyprus in the year to March 2007 was 4.2%, below the reference value of 6.4%. Average long-term interest rates in Cyprus have been below the reference value since November 2005. They have decreased substantially in the past few years as have spreads to the euro area, which testifies to the low residual country risk priced in by markets.

Legal convergence

All outstanding incompatibilities have been addressed in a Law amending the Central Bank of Cyprus Laws of 2002 and 2003 adopted by Parliament on 15 March 2007. Legislation in Cyprus, in particular the Central Bank of Cyprus Law, is now compatible with the requirements of the EC Treaty and the ESCB Statute.

The Convergence Report can be found at:

http://ec.europa.eu/economy_finance/publications/convergence/2007/report2007_cyprus_en.htm

 

The ECB’s Convergence Report can be obtained on the ECB’s website: http://www.ecb.eu