EC: Cyprus' fiscal position remains strong

Cyprus retains its capacity to service its debts and its fiscal position remains strong, although challenges remain regarding the management of non-performing loans (NPLs) and the implementation of a relevant legal framework, according to the European Commission’s latest post-programme surveillance report for Autumn 2023.

On the fiscal side, the country's fiscal position remains strong, although potential risks remain in case of new or extended measures to address new increases in energy prices, as well as contingent risks in the banking sector.

Regarding the latter, the EC said there has been an increase in profits this year, and an improvement in asset quality due to the sale of NPLs in recent years. However, in relation to NPLs, the report highlights the need for an effective legal framework (the monitoring mission was completed before a relevant framework was approved by the House of Representatives on 8 December and therefore the legislation has not yet been analysed).

However, it is stressed that repeated suspensions of the enforcement framework have hampered its effectiveness.

According to the report, the economic, fiscal and financial situation in Cyprus is sound overall, while the repayment of the principal of the Stability Mechanism loans is expected to start in 2025 and to be completed in 2031.

As regards economic growth, a slowdown is expected in the coming years, as well as a decline in unemployment and a slowdown in inflation, with core inflation remaining elevated.

According to the executive summary of the report, economic growth in Cyprus is set to slow down over the coming years following a strong recovery post-COVID-19.

Real GDP growth is expected to slow to 2.2% in 2023 from 5.1% in 2022. Domestic demand and tourism continue their strong growth performance, but external demand for financial and business services is being negatively affected by global developments such as the ongoing Russia’s war of aggression against Ukraine.

Growth is expected to continue on a moderate path in 2024 and 2025 at around 3%. This will mainly be driven by sizeable investments in the areas of energy, education, health and tourism, in part supported by the RRF.

The labour market remains robust, with employment continuing to increase and unemployment expected to fall to its lowest level in over a decade, below 6% by 2025.

Inflation is set to decelerate markedly to 4.1% in 2023 after reaching a peak in 2022 at 8.1% and is set to further decelerate over the coming years. However, core inflation is projected to remain elevated, partly due to the automatic wage-indexation system pushing up prices.

The current account deficit widened in 2023 as external demand for non-tourism services is moderating. The deficit is expected to only gradually narrow in the following years.

The fiscal position remains strong. The general government balance posted a sizeable surplus of 2.4% of GDP in 2022. In 2023, revenues have remained buoyant, while expenditure has also increased, albeit to a lesser degree.

According to the Commission’s autumn 2023 forecast, the general government surplus is expected to decrease somewhat before increasing again over the coming years.

There are some potential risks to the fiscal outlook, such as possible new or extended measures, notably in case of a new surge of energy prices, and the contingent risks from the banking sector.

Cypriot banks recorded strong profits in the first half of 2023, benefitting from higher policy rates and the sector’s capital position remains solid. The bulk of the income gains derived from the banks’ excess liquidity placed with the ECB and to a lesser extent from a swift passthrough of the higher interest rates on variable-rate loans and a slower passthrough to deposit rates. As a result, Cypriot banks benefit from interest margins that are much wider compared to the rest of the euro area.

The banking sector’s capital position remains solid, comfortably surpassing minimum requirements. Asset quality has improved, mostly because of Non-Performing Loans’ (NPL) sales achieved over the last few years by the systemic banks. Further progress depends also on the ability of the smaller banks to deleverage.

The past transfers of NPLs out of the banking system to the balance sheets of the credit acquiring companies (CACs) still burden the economy through private indebtedness. Macroeconomic risks have increased moderately for Cypriot banks as higher interest rates and rising living costs weaken borrowers’ capacity to service their loans.

Further progress in the management of NPLs requires an effective foreclosure framework according to the report. In a footnote, however, it is pointed out that on 8 December 2023, the House of Representatives adopted legislation related to the foreclosure framework and the NPL resolution, which could not yet be analysed for the purpose of the report.

The existence of an effective foreclosure framework is important for legal certainty and to maintain payment discipline as it provides lenders leverage over uncooperative borrowers, but repeated suspensions of the foreclosure framework have hampered its efficacy according to the report.

This can impact the efforts to reduce NPLs and as a result the robustness of the Cypriot banking sector. The effective implementation of the foreclosure tool is also important for the success of schemes like the mortgage-to-rent scheme, designed to protect the primary homes of vulnerable households.

Cyprus retains the capacity to service its debt. Despite a number of challenges, the economic, fiscal and financial situation in Cyprus is sound overall. According to the debt sustainability analysis, Cyprus faces low risks in the short and long terms, while medium-term risks appear to be medium.

The government’s gross financing needs for 2023 and 2024 are low thanks to significant projected primary surpluses. Repayments of the principal on ESM loans will start in 2025 and will conclude in 2031.

Cyprus has a very large cash buffer and continues to enjoy favourable market perception. Its sovereign debt rating was upgraded by three rating agencies in 2023, now being at least two notches within investment grade area by all four main rating agencies.