Cyprus interest rates are forecast to rise by 75 basis points by March 2007 according to the Economist Intelligence Unit Country Report update for October, while the GDP growth rate has also been revised higher.
After a long pause, interest rates are expected to continue rising. The Central Bank of Cyprus raised rates on September 1 for the first time in two years. The marginal lending facility and the overnight deposit facility were raised by 25 basis points (bps), to 4.5% and 2.5% respectively, while the minimum bid rate on the main refinancing operations was increased by 125 bps to 4.5%. This latter rate is now the main reference rate.
The increases indicated that the Bank is concerned about rising inflation, but also that it does not want to narrow the spread with the European Central Bank (ECB) too quickly: 15 months still remain before Cyprus’ planned adoption of the euro in January 2008.
Assuming that the Central Bank follows ECB rate moves, local rates will rise in three stages by a cumulative 75 bps by the end of the first quarter of 2007, but will converge rapidly towards ECB rates from mid-2007 if, as assumed, Cyprus gets the go-ahead then to adopt the euro, the EIU says.
GDP growth revised higher
Upward revisions to growth in the first quarter, as well as a surge in investment that appears to be related to an aircraft purchase, have led the EIU to revise up the forecast for real GDP growth in 2006 to 3.5% (from 3.2%).
A smaller drag on growth from imports will be largely responsible for a slight acceleration in 2007, to forecast growth of 3.6%. In 2008 the expected adoption of the euro in January and the related fall in interest rates is expected to lead to investment and consumer-led growth of 3.8%. These factors will offset a weakening of demand in the UK and in the euro area in 2007-08.
Growth in 2006 has been held back by a poor year for tourism resulting from weak demand in the UK and Germany. Arrivals fell by 2.4% year on year in the first eight months of 2006.
Beyond tourism, however, demand in the sectors of retail sales, construction, financial services and even the public sector appears fairly buoyant, while car sales have also begun to pick up again. Lower oil prices in 2007-08 should lead to a small recovery in tourism via lower airfares, while the widely publicised bomb attacks in some of Turkey’s tourist resorts may also indirectly benefit Cyprus. This should lead to stronger private consumption growth of 3.9% in 2007 and 4% 2008. The overall environment for investment should be stronger, thanks to the adoption of the euro in 2008, but a one-off large purchase of aircraft in 2006 will depress actual investment growth rates in 2007-08. Government consumption growth, which was strong in the first half of 2006, will remain fairly buoyant in 2007-08 as the presidential election in early 2008 approaches. Export growth should pick up, thanks to the expected recovery in tourism, while import growth, which will be influenced in 2006 by investment, will be largely dictated by consumer demand in 2007-08. The main risk to this forecast is that more airline security alerts will put off travellers, particularly from the UK, which supplies more than half of Cyprus’ tourists.
Inflation
There is a risk that Cyprus will miss its inflation target for adopting the euro, although given the economy’s small size, the government will probably be able to push inflation downwards by adjusting indirect taxes, the EIU report said.
The inflation rate has been on a rising trend: the EU harmonised index of consumer prices (HICP) rate reached 2.7% year-on-year in August, compared with only 2% in January. For euro adoption purposes, Cyprus will be assessed in mid- to late-2007 on the basis of its 12-month harmonised inflation rate at that time. This must be no more than 1.5% above average inflation in the three member states with the lowest inflation rates (countries with deflation are excluded).
Cyprus’ 12-month inflation rate in August was 2.3% and average inflation in the three lowest inflation countries was 1.3%, implying that the target in August 2006 would have been 2.8% — only 0.5% above Cyprus’ 12-month rate.
EIU analysts now expect the slight easing of international oil prices to lead to a fall of inflation rates in 2007-08. However, the impact of falling communications prices, which have kept inflation lower than it would have been otherwise, is also likely to start to fall out of the index. They expect the consumer price inflation rate (national measure) to ease only slightly, therefore, from an estimated 2.9% in 2006 to 2.7% in 2007 and 2.5% in 2008. Inflation could fall faster depending on the timing of the planned cut in car import duties.
EIU expects train crash to be avoided
The European Commission will review Turkey’s progress towards EU membership in its annual report, to be published on November 8, while the European Council (heads of government) will make their decision on the future of Turkey’s accession negotiations on December 14-15.
Unless a last-minute deal can be pulled off, it seems unlikely that Turkey will have implemented the Ankara Protocol by then, the EIU says in its report. This is a Turkey-EU protocol signed in July 2005, but not yet ratified by Turkey, that requires it to extend the customs agreement to all new member states.
This implies opening its ports and airports to Greek Cypriot ships and planes, which Turkey is reluctant to do for fear that it implies recognition of the Republic of Cyprus.
EU member states are raising the pressure on Turkey to ratify the protocol and the Cypriot government has suggested that it could veto any further progress in Turkey’s accession negotiations if the protocol is not implemented.
Turkey’s stated position is that it will open its ports in exchange for the lifting of restrictions on direct trade between the Turkish Cypriot north and the EU, which, it argues, the EU pledged to do in April 2004 in the form of the statement it made days before Cyprus joined the EU. The European Council said on April 26, 2004 that it was “determined to put an end to the isolation of the Turkish Cypriot community”,
and this led the Commission to propose the so-called direct trade regulation on direct trade between the EU and northern Cyprus in July 2004, together with the so-called financial aid regulation. The Greek Cypriots have agreed in principle to the financial aid regulation, but have blocked adoption of the direct trade regulation, as they consider that it entails the de facto recognition of the internationally unrecognised Turkish Republic of Northern Cyprus.
Moves by individual EU members as well as the European Commission to try, in effect, to swap Turkey’s implementation of the Ankara Protocol for Greek Cypriot support of the direct trade regulation have so far failed. Although Turkey appears to have been convinced by the UK and others that opening its ports would not constitute full political recognition, the Greek Cypriots want the return of the uninhabited town of Varosha as part of the deal. Turkey in return, has suggested that it could only consent to the return of Varosha if Cyprus allowed international recognition of Ercan/Tymbou airport in the north. However, it is not certain that either party is prepared to go that far, especially when both sides face elections within the next 18 months.
Turkish parliamentary elections are due in November 2007 and the Republic of Cyprus presidential election is due in February 2008.
Since all sides appear keen to avoid the much heralded “train crash”, some form of face-saving compromise, in which Turkey’s accession negotiations maker slower progress, but Cyprus does not stop negotiations altogether, seems to be the most likely outcome at present.
This is likely to involve the suspension of any chapters relating to the single market. While a compromise would avoid the “train crash”, it does raise the risk that enthusiasm among EU leaders and among the Turkish public for Turkey’s EU membership fades away. This would be a bad scenario from the Greek Cypriot point of view, since if Turkey does not join the EU, it is unlikely ever to withdraw the 35,000 or so troops that are stationed in the northern part of the island, and thus the Cyprus problem would never be solved.
