ESM on Cyprus: Risks to debt constrained

Risks to debt sustainability were contained in 2022 despite a weakened macroeconomic outlook, according to the chapter on Cyprus in the annual report of the European Stability Mechanism.

The report also highlights the strong growth of the Cypriot economy, partially due to a smaller than expected impact from the war in Ukraine, while it says that the government’s reform efforts could contribute to the country’s further growth.

The government budget balance was found to have moved into a surplus as pandemic-related fiscal support ended and energy-related spending remained limited. Sovereign financing conditions deteriorated throughout the year, it said.

In the banking sector, “profitability improved but NPL reduction slowed” and “risks to debt sustainability and repayment capacity were contained, despite a weakened macroeconomic outlook”.

As noted in the report, Cyprus’ GDP grew swiftly in 2022, confirming the resilience of the economy despite the challenging economic and geopolitical environment. Real economic activity grew by 5.6% in 2022, above the euro area average and largely driven by robust domestic demand, in particular private consumption, and to a lesser extent external demand.

The economic fallout from Russia’s invasion of Ukraine and subsequent sanctions imposed on Russia had less impact than expected. Exposure to Russian energy imports was limited, while the tourism sector coped well with the loss of Russian tourists and saw demand approaching pre-pandemic levels, it is added.

The labour market remained strong overall, with an unemployment rate of 7.4% in December 2022. Cyprus received its first disbursement of €85 million under the EU’s Recovery and Resilience Facility in December.

Strong economic activity, prudent fiscal policy, and the end of pandemic-related support contributed to turning the 2021 fiscal deficit into a surplus of 2.1% of GDP in 2022.

Higher revenues and contained energy-related expenditure pushed the primary surplus to 3.6% in 2022. In the high-inflation environment, this contributed to a sharp fall in the public debt-to-GDP ratio to 86.5% in 2022, the report says.

Cyprus’ credit ratings improved in 2022 due to better-than-expected economic and fiscal results, proven resilience to external shocks, support from the Recovery and Resilience Facility, and the positive medium-term economic outlook. All major rating agencies assigned an investment grade to Cyprus, except for Moody’s, which nonetheless changed its outlook to positive.

Still, Cyprus faced a more challenging market environment in 2022. Yields increased throughout the year as inflation rose and monetary policy started to tighten financing conditions.

It is also noted that Cyprus’ banking sector remained resilient. The direct negative effects of Russia’s invasion of Ukraine were primarily concentrated on one Cypriot bank, which decided to voluntarily phase out its banking business following the impact of geopolitical risks on its operations.

The volume of outstanding NPLs stabilised in 2022, following considerable reductions over the past few years. In the medium term, the excess liquidity in the system and a further slowdown in NPL workouts could limit banks’ overall profitability gains. The government launched several policy initiatives to address high private sector indebtedness and avoid the build-up of new NPLs. This has become even more urgent in the current high interest rate environment.

Cyprus’ economic activity is forecast to lose momentum and grow by 1.6% in 2023, while headline inflation is expected to decline to 4%.

The ESM’s assessment of market distress indicates that Cyprus would retain the capacity to repay all obligations due to the ESM over the coming 12 months. An adequate cash buffer helps limit the risk of short term market stress.

Over the medium to long term, Cyprus faces moderate risks to the sustainability of public debt and its repayment capacity. To mitigate these risks, Cyprus has committed to fiscal prudence and implementing the investments and reforms foreseen under its recovery and resilience plan.

Macro-critical reform priorities include facilitating the transition to a diversified, green, and digital economy, as well as further improving the operational and legal environment for non-bank financial institutions (credit acquirers and servicers). The recurring challenges to and the partial suspensions of the foreclosure framework continue to pose risks to further NPL reduction.