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High fiscal risk for Cyprus

January 23, 2019 at 8:21am
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Cyprus faces risks of fiscal stress due to competitiveness, current account deficits and investment reluctance, according to the Fiscal Sustainability Report 2018 of the European Union.

In fact, Cyprus is the only EU country being at risk of fiscal stress in the short-term, according to the report which provides an overview of the short, medium, and long-term fiscal sustainability challenges facing EU Member States.

Over the short term – within 2019 – Cyprus faces risks mainly due to the economy’s macroeconomic, financial and competitiveness aspects, exacerbated by increased public debt, the report warns.

And over the medium term, overall fiscal sustainability risks appear to be medium for Cyprus with medium risks and low risks according to the sustainability gap indicator.

Over the long term, Cyprus is deemed at medium fiscal sustainability risk with a slightly negative sustainability gap indicator to stabilize debt over the long term combined with debt burden vulnerabilities implying that Cyprus is deemed at medium risk.

More specifically, the report finds that the erosion of the country’s competitiveness is above the minimum acceptable levels while the current account deficit and high negative investment position also contributed towards that direction. In addition, some financial factors such as household and business short-term debt and private debt levels, in general, were also taken into account.

On the other hand, it is noted that the country has primary surpluses, which could allow the reduction of debt in the new year. The forecast is that the country’s public debt will drop to 83.3% in 2023. As announced on Monday, due to the recent developments with the now defunct Cyprus Co-operative bank, the budget surplus recorded by the country in recent months has been reduced to a deficit of €723 million.

The report makes particular reference to the risks that may arise for public finances from  non-performing loans and a possible derailment in the banking sector. In the case of a major banking crisis in the short term, that is in 2019, the financial impact would be subtle for all EU countries except for Cyprus, with an impact of more than 1%, namely 3.2% of GDP . In the long run, however, in 2029 in particular, if such a banking crisis takes place, the impact would be relatively limited for Cyprus and would amount to 0.4% of GDP, albeit as a percentage higher than that of other countries.

As far as medium-term budgetary risks are concerned, Cyprus is ranked at a medium level with other countries such as Croatia, Romania and Slovenia. A similar picture is presented in the long run, with Cyprus staying with another 14 countries at a medium-level fiscal risk.

Aging population

The report records a trend for a general increase in the EU population that will work after the age of 65. It is forecast that by 2070, the proportion of workers over 65 compared to workers aged 15-64 will rise to 51% while in 2016 this was only 30%. The dependency ratio for older people is expected to increase in all member states, but at different levels. Cyprus has one of the highest forecasts of 61% for 2070. Higher rates are recorded only in Greece (63%) and Poland (62%).

 

Read more:  EU institutions, ECB and IMF call upon Cyprus to maintain fiscal discipline and accelerate reforms

The European institutions (EC, ESM) the ECB and the IMF have called upon Cyprus to maintain fiscal discipline and accelerate reforms, especially those linked to Non Performing Loans reduction, mindful of the Cyprus Cooperative Bank implications with public debt levels.

A joint mission of the four institutions concluded today, warned in a written statement that “Buoyant tax revenues, combined with prudent expenditure management, resulted yet again in an impressive fiscal performance, but the CCB sale comes with very high costs for the government”.

The auditors state that “headline and primary surpluses further increased in the first seven months of 2018 compared to the same period in 2017”, however, “the fiscal implications related to the sale and orderly winding down of CCB have resulted in a large increase in public debt and may also weigh on the budget balance in 2018, depending on the still to be determined statistical treatment”.

“This sale has also resulted in contingent liabilities in relation to the Asset Protection Schemes (APSs)”, they note, stating tha”the final costs to the government will depend on the actual proceeds from the NPL workout by the residual entity and the potential losses under the APSs”.

EC, ECB, the ESM and the IMF staff praise Cyprus on the public debt-to-GDP ratio that is expected to resume its declining path as of next year, but warn that “it remains one of the highest in the euro area”.

“This calls for safeguarding fiscal sustainability in line with the requirements of the preventive arm of the Stability and Growth Pact”, they stress and in this context they conclude that,”increasing pressure for fiscal relaxation should be resisted, particularly in view of contingent financial sector liabilities, potential cost overruns from the implementation of the healthcare reform, and the cyclical nature of tax revenues”.

On the macroeconomic front, the four institutions conclude that “the Cypriot economy continues its strong cyclical upswing, creating favourable conditions for tackling the key vulnerabilities of the country, thus ensuring sustainable growth”.

“After recording an impressive GDP growth rate of 4.2% in 2017, the economic expansion has continued at a robust pace in the first half of 2018, while inflation has remained subdued”, they state, noting that “further increased tourism and construction activity have had positive spill-overs to the other sectors of the economy”.

According to the institutions report “the labour market situation has also continued to improve, with employment increasing across most sectors and unemployment falling rapidly, while youth unemployment remains high”. The auditors forecast that “growth should remain solid but decelerate somewhat over the medium term”, subject to outlook risks related to “the reduced, but still very high, non-performing loans (NPLs), high private and public debt, and higher levels of uncertainty in the external environment”.

On the sale of Cyprus Cooperative Bank (CCB) to Hellenic Bank (HB), the European Institutions conclude that “it has reduced uncertainty in the financial sector, improved depositor confidence and helped consolidate the banking system”, but warn on remaining significant challenges “including the reduced but still very high NPL ratio”.

Nevertheless they note positivelly that “the CCB sale has put the banking sector on a sounder footing and was an important driver for the return of the Cypriot sovereign to investment grade for the first time since 2012.”

According to the mission report, “around one third of total NPLs (or EUR 5.7 b) were shifted from the CCB to the publicly-owned wind-down entity. The envisaged large NPL sale by Bank of Cyprus (BoC) is expected to further significantly reduce the NPL ratio in the banking sector, which nevertheless remains the second highest in the euro area”.

Moreover the mission welcomed the adoption of the legislative package to accelerate NPL resolution, which included amendments to the insolvency and foreclosure frameworks, legislation on the sale of loans and the adoption of the securitisation law.

“Improving the payment culture needs to remain the government`s overarching priority” the auditors warn, and in this context, the mission stressed that “the final design of the ESTIA scheme should mitigate moral hazard risks and fairness issues”, tightening the eligibility criteria and that, “should there be re-default, foreclosure will be promptly initiated.”

Moreover, the auditors stress that “it will be essential to ensure that the CCB residual entity is independent from the government and its sole objective is to divest its assets with a view to maximise the returns to the state in a swift manner”. “This and other commitments undertaken in the context of the state aid decision will be closely monitored by the Commission”, they state, noting that “other challenges also include the full integration of CCB into HB, which should be carefully managed”, concluding that “overall, the banking sector continues to be under pressure, given low interest income, the potential need for additional provisions in the context of high NPLs, and high operating costs”.

Finally the four institutions call upon the government on “renewing the structural reform momentum”, something that is necessary “to sustain strong economic growth”.

“The strengthened legal framework for NPL resolution needs to be complemented with the comprehensive reform of the judicial system, including more efficient court procedures, stronger legal enforcement of commercial claims, and resolution of the high backlog of court cases”, they  state.

Moreover, “efforts need to be stepped up considerably in order to accelerate the issuance and transfer of title deeds, especially with regards to the resolution of the legacy cases”. Efforts should be made “to enhance the business environment and attract productivity-enhancing investment by, inter alia, swiftly adopting the strategic investment law, opening up the electricity market, and proceeding with foreseen privatisations”. “Other pending reforms that should be given priority include the local government reform and the integration of pension and insurance supervision”, they conclude

The next Post Program Surveillance mission will take place in spring 2019.

(Cyprus News Agency)