EIU revises Cyprus growth target higher

The Economic Intelligence Unit (EIU) revised its Cyprus GDP growth forecast for 2007 and 2008 at 4.1% and 3.7% from 3.7% and 3.4% respectively while it forecasts a 3.5% growth in 2009. EIU expects real GDP growth to slow to 3.5% in 2009, as the rapid growth of bank lending (driven by demand for undeveloped land ahead of the imposition of VAT in 2008) will probably slow in 2008, reflecting the impact of VAT on borrowing, a weaker UK economy, which will dampen foreign demand for real estate, and as banks themselves find borrowing more expensive. According to EIU, growth in business activities outside real estate, such as exports, tourism and taxation services, will also be affected by a strong deceleration in UK demand. Finally the British agency says an outbreak of foot and mouth disease will have a negative impact on both agriculture and exports of halloumi cheese.

As per EIU, some of these factors will be offset in early 2008 by a fall in official interest rates as Cyprus joins the Euro area and looser reserve requirements for commercial banks. Moreover, for the time being banks are still highly profitable and for these reasons EIU expects the full impact of weaker markets to be reflected to a greater extent in the growth rate of 2009 than that of 2008.

EIU observes that inflation rate is picking up and expects that inflation rate will increase again in late 2007 as the impact of the cuts in car excise duties falls out of the index from November. EIU expects the national consumer price index (CPI) to reach 3.8% by the end of the year and the harmonized consumer price index (HICP) 3.4%. Upward pressure on inflation will continue in 2008, as a result of increases in fuel taxes and higher rates of VAT on certain items, which are due in January 2008, but EIU says that the government will probably delay these until mid-2008. In addition, high international oil prices will be only partly offset by an appreciation of the Euro against the dollar. EIU believes that a certain amount of rounding-up of prices (especially in the services sector) when the Euro is introduced in January 2008, will add to inflation, which will climb to 4% in 2008 (or 3.5% for the HICP rate), before it settles below 3% in 2009.

EIU believes that once the Euro is adopted, the government will face calls for higher spending and has already begun to respond to pressure for higher spending in the run-up to the February 2008 presidential election by loosening fiscal policy.

The government expects a fiscal surplus of 1.5% of GDP thanks to strong tax revenue in 2007 but given the number of recurring items in the recent measures, EIU assumes that the budget surplus will be eliminated quickly, leading to a small budget deficit of 0.5% of GDP in 2008 and a larger deficit of 1.5% of GDP in 2009. EIU says that experience from the previous election suggests that public spending can rapidly run out of control in Cyprus’s small economy.

According to EIU, the Central Bank of Cyprus appears likely to allow rates to converge downwards by default when the Euro is adopted on January 1st 2008, as current legislation allows, rather than cut its equivalent rate by 50 basis points at a time when credit growth remains high and inflation is rising. As a result of financial market instability, EIU expects the European Central Bank (ECB) to cut its benchmark rate currently at 4% (by 25 bps) in the first quarter of 2008. Minimum reserve requirements for commercial banks will also be looser after the adoption of the Euro. Thus, although inflation will rise, monetary policy conditions for Cyprus will be rather loose. EIU

says that this raises the risk of growing unit labor costs, a loss of competitiveness and a more painful adjustment via wages in future years.

EIU forecasts the Euro to strengthen against the US dollar substantially in 2008, but to weaken in 2009. The Euro is also expected to strengthen slightly against sterling in 2008 but to stabilize in 2009.

EIU revised its 2007 forecast for the current account deficit and now expects a current-account deficit close to 8% of GDP in 2007 (from 6%), falling to an average 6.3% of GDP in 2008-09 as import demand weakens. External debt (defined as non-resident debt), particularly borrowing by commercial banks, has risen rapidly in recent years and is expected to reach US$27.3bn, or 125.8% of GDP, by 2009. However, Cyprus’s adoption of the Euro in 2008 will reduce the exchange-rate risk of the debt, much of which is in euros.