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OUTLOOK 2020: Cyprus economy at an inflexion point

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By Yiannis Tirkides

The Cyprus economy has achieved considerable progress in the post-bailout years, and the recovery that started in 2015 continued uninterruptedly into 2019 as well.

The outlook for 2020 remains positive even if less upbeat.

However, new challenges will be surfacing or will become more apparent in 2020. Growth will be slowing because the underlying drivers of the recovery are weakening.

The underlying savings-consumption balance, now tilted toward consumption at the expense of investment, will be revealed as a vulnerability.

Fixed investment now geared toward building activities, is not boosting productivity enough. In the banking sector, progress has been extraordinary, but the job is not finished yet whilst the cost-to-income relationship will become more pressing.

In the public sector, the underlying fundamentals remain positive, but some trends are starting to change at a time when the debt load is still excessively high.

All these will be happening at a time when the global economy will be slowing further.

Growth in the recovery period so far has been strong but driven more importantly by the traditional sectors namely, construction, manufacturing, tourism and trade. Contributions from higher value-added services sectors have been relatively low.

On the demand side, growth originated from the domestic economy with net exports making negative contributions despite healthy increases in services exports.

This reflected the low ratio of national savings as well as the relatively low investment ratio. In terms of productivity growth, the results were somewhat disappointing, and growth overall relied more heavily on employment gains instead.

These trends are unsustainable in the longer term and changes will be needed.

Investment in productivity-enhancing areas will need to rise; national savings will likewise need to increase and the current account imbalance to narrow; consumption expenditures by both the public and private sectors will need to slow and investment ratios to rise.

Policies will have to be conducive for these changes to come about.

In the banking sector, there have been some bright spots. Private indebtedness of non-financial companies and households has declined significantly depending on how one measures it, and likewise for non-performing loans.

Further declines are anticipated in 2020 which will be positive.

Specifically, total loans at the end of October 2019 were €34 bln of which €25.3 bln or 115% of GDP accrued to non-financial companies and households. Total provisions at the end of June were €5.2 bln or 24% of GDP.

By contrast, at end-December 2012 total loans amounted to €72.5 bln excluding loans abroad in Greece and central and eastern European countries.

Of this, €48.5 bln or 250% of GDP then, accrued to non-financial companies and households. In this sense deleveraging has been considerable and private indebtedness is stabilising at reasonable levels save for further adjustments that will be linked to further reductions in non-performing loans expected in 2020.

Toxic Loans

Coming to non-performing loans, their levels have dropped markedly, almost by two thirds from their peak in early 2015, even as the corresponding ratio to gross loans at around 30%, remains the highest in the EU after Greece’s.

At the end of June 2019, there was €9.5 bln in non-performing loans between non-financial companies and households. About half were terminated accounts and impairment provisions of €5.2 bln.

The financial framework has greatly improved after the government passed legislation that closes the loopholes in the insolvency and foreclosure regime also facilitating sales of loans. The reduction of remaining non-performing loans can be expected to accelerate.

In public finances, there is an upbeat sentiment after significant consolidation in the programme years that resulted in the high net budget surpluses of the last couple of years.

It is expected that the general government budget will generate a substantial surplus in 2020 also. Total public debt increased in 2018 due to a €3.2 bln capital injection into Cyprus Cooperative Bank.

The debt ratio, as a result, increased to 102.5% in 2018 up from 95.8% of GDP in 2017 but declined significantly in 2019 and expected to drop further in 2020 and subsequent years. Debt also remains affordable which reflects the very large share of official creditors in the total, and the relatively low-interest charges.

But underlying fundamentals can change quickly if policy becomes lax.

Pressures to increase expenditures are escalating particularly in the areas of public wages and health care.

Public sector wages will be the main downside risk to fiscal sustainability in the coming years. Public wages have recovered since 2017 rising by 5% in 2018 and accelerating further in 2019.

Even after the cuts of the programme years, public sector wages are still amongst the highest in Europe in relation to GDP.

In 2018 public sector wages were 11.7% of GDP compared with an average of 9.9% of GDP in the EU.

In contrast, at the peak of the bubble in 2011, public sector wages at 14.6% of GDP were the highest in the EU after Denmark’s, when the average in the EU was 10.6% of GDP.

The March 2019 ruling by the Administrative Court that considered the reduction in public sector pay from such bubble levels, and the freeze on wages implemented during the crisis, to be unconstitutional, poses an added threat.

Health Spending

Besides, the introduction of the General Health System last June poses further risks to fiscal sustainability.

Although the government has a framework to manage the rise in health care costs, trends can easily get out of control.

The budgeted amounts are about one billion euro or 6% of GDP, which is close to the average health spending in the EU.

However, total health spending in the public and private sectors are currently much higher than that.

Financial sustainability of the General Health System thus will depend to a large extent on cutting waste, which in turn will depend on the ability of the system to contain abuse and rationalise the provision of services.

There is nothing so far, after half a year of implementation to guarantee that the system can do that.

A new law on public hospitals compels the government to finance any potential deficits of health care providers associated with the GHS in the first five years of the implementation of the scheme.

Also, the government is currently negotiating with private clinics to guarantee their budgets before joining the system.

The rationalisation of health care spending and the elimination of waste and abuse will be necessary to safeguard the sustainability of the system.

Overall the economy is expected to perform well in 2020, but it will be an inflexion year in some respects.

The growth drivers of the economy will be weakening, and overall growth will slow further.

Expenditure pressures in the public sector will reveal embedded vulnerabilities which if left unchecked, will jeopardise underlying debt trends.

In the banking sector balance sheet correction will continue, but increasingly the strategic focus will be shifting to the profit-and-loss account and the cost-to-income relationship. Long-term planning and strict adherence to the principles of prudent fiscal management will be needed to steer the economy in what might prove to be a difficult new decade worldwide.

 

Economic Research Manager, Bank of Cyprus. The opinions expressed are his own personal views