TRANSITION REPORT 2014 Innovation in Transition

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Highlights

  • Economic recession persists, but signs of bottoming out are starting to emerge. The economy continues to be damaged by the credit squeeze and lack of confidence, but quarterly growth rates in the first half of 2014 have improved relative to the previous year.
  • The banking sector is undergoing a major restructuring. The main banks in the country have undergone significant recapitalisation in the past year, but credit continues to decline and non-performing loans (NPLs) account for around half of total loans.
  • Critical reforms to public administration, social welfare and privatisation are advancing. Progress so far in these areas has been steady, but a lot more needs to be done to ensure a more efficient economy and a return to sustainable economic growth.

Key priorities for 2015

  • Significant progress is needed on privatisation. In order to remain on track with the internationally supported bailout programme, the authorities should ensure that the state-owned telecommunications company, Cyta, is brought to sale in 2015 and the energy, transport and ports sectors also advance towards the long-term goals of attracting major private sector involvement.
  • NPLs need to be tackled effectively. It is important to intensify efforts to deal with this major problem, for which a coordinated approach is needed between the authorities, the central bank, local banks and international financial institutions. The prompt implementation of new legislation on insolvency and foreclosure would help this process.
  • The corporate sector, in particular, needs help in the current climate. The authorities could help enterprises by promoting greater energy efficiency (and thus reducing energy costs) and amending the legal framework to facilitate debt restructuring for viable firms.

ECONOMIC RECESSION PERSISTS, BUT SIGNS OF BOTTOMING OUT ARE STARTING TO EMERGE

THE BANKING SECTOR IS UNDERGOING A MAJOR RESTRUCTURING

CRITICAL REFORMS TO PUBLIC ADMINISTRATION, SOCIAL WELFARE AND PRIVATISATION ARE ADVANCING

2014 sector transition indicators
Corporate Energy Infrastructure FI

Source: EBRD.
Note: FI – Financial institution; ICT – Information and communication technology; Water – Water and wastewater; IAOFS – Insurance and other financial services; PE – Private equity.


Main macroeconomic indicators %

  2010 2011 2012 2013 2014
          proj.
GDP growth 1.3 0.4 -2.4 -5.4 -3.5
Inflation (average) 2.6 3.5 3.1 0.4 0.4
Government balance/GDP -5.3 -6.3 -6.4 -4.9 -4.4
Current account balance/GDP -9.8 -3.4 -6.9 -1.9 -1.1
Net FDI/GDP 0.4 0.7 6.8 1.0 0.5
External debt/GDP 491.9 468.2 448.5 348.0 n.a.
Gross reserves/GDP n.a. n.a. n.a. n.a. n.a.
Credit to private sector/GDP 267.2 272.1 278.1 281.7 n.a.

Note:  Cyprus is a member of the euro area.

Macroeconomic performance

The Cypriot economy has contracted sharply in the past two years, but positive signs are emerging. The economy has been undergoing a severe recession, largely owing to a deep crisis in the banking sector and the introduction of necessary austerity measures. The international community is supporting Cyprus with a €10 billion programme: €9 billion from the European Stability Mechanism and €1 billion from the International Monetary Fund (IMF). The programme is managed by the European Commission, the European Central Bank and the IMF (collectively known as the “Troika”). Real GDP fell by 2.4 per cent in 2012 and 5.4 per cent in 2013. Unemployment climbed to 16 per cent in 2013, compared with 11.9 per cent a year before, and just 6.3 per cent in 2010. Youth unemployment is exceptionally high, estimated at more than 40 per cent. However, wages are also adjusting, cushioning some of the impact on jobs, with compensation per employee declining in 2013. In the first half of 2014 quarterly growth rates (seasonally adjusted), while still negative, moved in a positive direction, and the year-on-year change in GDP of -2.5 per cent in the second quarter of 2014 was the best outcome since the crisis began.

Fiscal performance under the Troika programme has been strong. The general government deficit was reduced from 6.4 per cent of GDP in 2012 to 4.9 per cent of GDP in 2013. Cuts to wages and pensions in the public sector have helped to contain spending while revenues have been boosted by increases in the rates of corporate income tax and value added tax as well as higher excise taxes. Public finance management has been strengthened and an independent fiscal council is being established. Nevertheless, general government debt exceeded 110 per cent of GDP in 2013 (up from less than 50 per cent in 2008) and is likely to peak at around 124 per cent in 2015. A steep decline in imports, combined with a resilient performance in the tourism sector, has contributed to a sharp reduction in the current account deficit, to the point where the current account is now more or less in balance.

Cyprus has re-entered international capital markets. In June 2014 the country issued a five-year, €750 million bond. Investor interest was significant and the issuance was heavily oversubscribed, with a yield of just 4.85 per cent. In October 2014 the ratings agency, Standard & Poor’s, upgraded Cyprus’s credit rating from B to B+.

The short-term economic outlook remains very challenging. Despite the resilience of the economy, 2014 will be another year of recession, with GDP likely to drop by about 3.5 per cent for the year as a whole. The financial sector remains a significant drag on economic recovery, notwithstanding the major reforms to the system that are under way (see below). Further austerity measures will be needed to ensure long-term fiscal sustainability. Under a baseline scenario, some modest growth may return to the economy in 2015, with a more significant pick-up in 2016 and beyond, building on the positive results already achieved in the past year for exports and tourism. The outlook is subject to significant risks – exports and foreign direct investment could be adversely affected by regional instability and a eurozone downturn – while the necessary internal restructuring and reform agenda is subject to implementation risks.


Major structural reform developments

Large-scale privatisation is advancing. Under the Troika programme, the authorities have committed to an ambitious privatisation programme in the coming years, with the aim of raising €1.4 billion in revenues as well as improving the performance of privatised entities by attracting fresh capital. In February 2014 parliament adopted a new privatisation law, which enables the establishment of a new privatisation unit responsible for preparing and implementing detailed privatisation plans. The main short-term priorities are the telecommunications company, Cyta, the national airline, Cyprus Airways, and some of the Ports Authority’s commercial activities. During 2014 Cyta started a restructuring process and the authorities committed to convert Cyta into a joint-stock company by the end of 2014, with a view to finding a strategic investor in 2015.

Problems remain in the business environment. The country ranks 64th (out of 189 countries) on the World Bank Doing Business 2015 report for ease of doing business, one of the lowest scores in the European Union. Cyprus ranks poorly on getting electricity, dealing with construction permits, registering property and enforcing contracts. In addition, although its position on resolving insolvency is better than the country’s overall ranking (51st), laws on insolvency and foreclosure and their implementation proved inadequate in dealing with the legacy of bankruptcies and NPLs brought about by the crisis. As of the end of August 2014 the level of NPLs had reached approximately 48 per cent of total loans, an extraordinarily high total by international standards. In September 2014 parliament passed a law on foreclosure that aims to substantially reduce the time needed to foreclose on business loans and mortgages. However, the law was accompanied by other legislation that has raised concerns among Troika members. The President of Cyprus has referred some of these laws to the Constitutional Court for a ruling.

Energy sector reforms have begun. Major challenges exist in the energy sector, especially in the power component, which remains dominated by the vertically integrated Electricity Authority of Cyprus (EAC). The authorities have included EAC in the privatisation programme, but the timetable is likely to extend to several years. As a first step, the authorities have committed to unbundle EAC’s activities into separate legal entities by mid-2015. A search is under way to select advisers for this process. In the natural resources sector, Cyprus is believed to have substantial offshore reserves of natural gas and extensive exploratory work is under way, but the long-term commercial potential of these reserves remains unclear.

The banking sector is undergoing a major restructuring. Problems in the Cypriot banking sector were at the heart of the economic crisis in the past two years, but a fundamental restructuring of the sector is under way. In mid-2013, the largest bank – the Bank of Cyprus (BoC) – which had been declared insolvent, was recapitalised through the bail-in of uninsured depositors. The second largest bank, Laiki, was divided into a “good” and “bad” part, with the good part merged into BoC. Another major bank, Hellenic Bank, was recapitalised with private capital in October 2013, while the cooperative credit sector underwent a significant consolidation and recapitalisation in early 2014. In mid-2014 the BoC announced that it had attracted €1 billion in fresh capital from private markets. The authorities are enhancing supervisory standards in the banking sector prior to entering the European Single Supervisory Mechanism, led by the European Central Bank.

Capital controls are being gradually relaxed. As part of the authorities’ initial response to the crisis in spring 2013, a range of capital controls was introduced in order to stem the potential outflow of capital from the country’s financial institutions. These included tight restrictions on cash withdrawals (just €300 per day) along with similar limitations on cashless payments and transfers. By mid-2014 many of these restrictions had been either relaxed significantly or abolished. However, some capital controls remain in place as of October 2014.

Important social reforms have been introduced to protect vulnerable groups. In light of rising unemployment and poverty during the crisis, the government introduced in 2014 a guaranteed minimum income scheme that balances poverty reduction objectives with incentives to seek or remain in work. In parallel, the government has made a number of reforms to the pension system, including an increase of two years to the statutory retirement age for many groups of workers, with this retirement age to rise every five years, effective from 2018, in line with changes in life expectancy.