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Country Report Cyprus

Country Report

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Cyprus flag

Cyprus is in the midst of a severe economic depression. With aid from the EU and IMF, the country is slowly picking itself up, but there is a long road ahead. Negotiations on reunification of the island have recommenced and could (in the long term) lead to an improvement in the economic environment.

Strengths (+) and weaknesses (-)

(+) Educated workforce and well developed services sector

Cyprus has invested heavily in becoming an international provider of (financial) services. This included investing in human capital.

(+) EU membership

The EU and Eurozone membership has led to external support in the face of the serious financial and fiscal crises.

(-) Division of the island

The division between Northern Cyprus and Cyprus is hampering the economic prospects of the country in that it cannot develop its apparent wealth in natural resources.

(-) Public finances are very weak

Due to the banking sector crisis, and the resulting economic crisis, the debt and fiscal numbers have worsened severely and will continue to weigh on the economy for years to come.

Key developments

1. Cyprus is sticking to the Troika path

As the Greek crisis unfolded, the local (Cypriot) banks were hit hard as they held large positions in Greek sovereign and private debt. Cypriot banks were particularly affected by the write-downs in the form of the Greek Private Sector Involvement (PSI) in February 2012. As a result, the Cypriot government had to back up the banking system, but found out it lacked the capital to adequately do so as the banking sector amounted to 860% of GDP. EU assistance was requested in June 2012. After long negotiations, an aid package was finally agreed upon in March 2013. Under the program, the Cypriot government had to quickly implement comprehensive reforms in various segments of the economy. First and foremost on the agenda was the restructuring of the banking sector. The two largest banks were recapitalised, and the regulatory framework strengthened. The European Commission nonetheless has urged the Cypriot government to remain vigilant in maintaining momentum, as especially debt-restructuring frameworks are lacking, leading to an elongation of the process to make banks’ balance sheets healthier. In terms of fiscal targets, Cyprus is required to obtain a 4% of GDP primary surplus by 2018. The 2013 target for the headline balance was a deficit of 6.5% of GDP. With an estimated deficit of 5.9% of GDP, this target has been met last year. Part of this is due to the economy performing better than expected, contracting ‘only’ by 5.7% compared to an estimation in the program  of 8.7%.  Therefore, in spite of the good performance, it remains of the utmost importance that the government implements further structural measures in order to structurally improve the fiscal balance. Cyprus is urged by the European Commission to undertake severe reforms to prevent healthcare and pension payments to become a drag on fiscal expenditures. Also, government employees will be faced with repeated wage cuts, as well as a downsizing of the government itself. Next, the social benefits system will be tackled, and the large State-Owned Enterprises (SOE) sector will be targeted. For the latter, that means an increase in public-private partnerships, a restructuring of SOEs and privatisation of some of the SOEs. This may be the hardest task for the government to achieve, as there is significant political opposition to selling off state assets. Nonetheless, as the next elections will be held only in 2016, the government is likely to be able to make some progress in this area.

Figure 1: Growth performance
Figure 1: Growth performanceSource: EIU
Figure 2: Fiscal indicators
Figure 2: Fiscal indicatorsSource: EIU

2. Negotiations with Turkey resumed

In 2004, the UN and North Cyprus had backed a plan to move towards unifying the island. However, in the days prior to Cyprus’ EU accession, Cyprus rejected the plan, leaving North Cyprus out of the EU, and negotiations on the future of the island in limbo. In the past few months, the US has come forward in support of reunification negotiations. The process might have become more important for the EU as well, as there are indications of a vast amount of natural gas to be found in Cyprus’ waters. Turkey is vehemently opposing Greek-Cyprus undertaking any effort to exploit this wealth if it would not also benefit North Cyprus. Both governments have taken a positive stand on the process this time around, although no real steps forward have been made, and only slow progress can be expected. In the end, the citizens of both countries will have to show their support in a referendum on the issue. In a statement made in February 2014, the aim is to reunify Cyprus in a bi-communal, bi-zonal federation based on prior UN plans for the island. The idea is that a federative structure would be the best guardian against resurfacing hostilities between the two groups. This time around, the pressure seems to be on Greek-Cyprus to take some steps forward in the process. Currently, its economy is set back by the financial crisis, and the possibility of exploiting the assumed natural gas wealth will be a tantalizing prospect for the decision-makers. For the north, time may also become an issue, as part of the gas reserves border on Israeli waters and might therefore also be exploited by Israel.

Factsheet of Cyprus
Factsheet of CyprusSource: EIU, CIA World Factbook, UN, World Economic Forum, Transparency International, Reporters Without Borders, World Bank.

Background information

Cyprus gained independence from the UK in 1960. Only years later, the first spats of violence broke out between the Greek majority and the Turkish minority on the island. In 1974, after Greek-Cypriot nationalists attempted a coup-d’état, Turkey invaded the island. Under international pressure, a ceasefire was signed, but Turkish troops remained. The island has remained divided from that point in time, though the declaration of the Turkish Republic of Northern Cyprus came only in 1983. In the past decade, talks have been held to reunite the island, so far without success. Cyprus as a whole became a member of the EU in 2004, though only the Greek part can share the benefits of EU accession. The euro was adopted in 2008. Cyprus’ economy is built around the services sector, that accounts for some 80% of GDP. This has also proven to be a weakness for Cyprus, as the implosion of the banking sector dragged down the Cypriot government and economy in 2012/2013. The banking sector had an excessive size (8.6 times GDP), relied to a large extent on Russian deposits, and had a high dependence on Greece. A bailout package was requested in July 2012, and finally obtained from the European Commission, ECB and IMF in early 2013. The banking sector was forcefully restructured, capital controls were implemented, and also savings account holders were bailed-in in the process. As a result, the Cypriot economy entered into a depression. It is assumed that around the island, significant amounts of natural gas can be found. However, in order to exploit this resource, the unification of the island has to be resolved first as Turkey vehemently opposed any unilateral exploitation of this natural resource by Greek-Cyprus alone.

Economic indicators of Cyprus
Economic indicators of CyprusSource: EIU
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Author(s)
Jeroen van IJzerloo
Rabobank KEO

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