Cypriots learning to live with recession
By Charlie Charalambous | Thursday 12 July 2012
Once prosperous Cyprus is reeling from its relatively large banking system’s exposure to toxic Greek debt and has become the fifth eurozone member to ask the European Union to bail it out. The recession-hit economy is struggling with record unemployment, austerity measures and trying to rein in a deficit twice the EU’s accepted limit. While seeking to prop up its banking system, the cash-poor government has promised the European Commission it will slash its deficit to 2.5% of GDP this year from twice the EU-ceiling of 3% it ballooned to in 2011.
The government has underwritten a €1.8 billion capital issue for the island’s second largest bank, Cyprus Popular Bank, which is the most heavily exposed to Greek debt. It is in a precarious position after shaving off €2.3 billion in a 75% haircut on Greek debt and needs to find a €1.8 billion capital buffer as required by the European Banking Authority. The total exposure of banks to Greek debt is estimated at over €20 billion.
Nicosia had been loathe to apply for a bailout as it took on the EU Presidency, but was forced to do so, on 25 June. In a statement, the government said: “The purpose of the required assistance is to contain the risks to the Cypriot economy, notably those arising from the negative spillover effects through its financial sector, due to its large exposure to the Greek economy”.
In addition, the country was in negotiation with both Russia and China on a bilateral loan to help reduce the cost to the EU. Last year Cyprus secured a €2.5 billion low-interest loan from Russia to cover its refinancing needs for 2012.
A major reason for the government’s reluctance to request EU aid is because it fears tough loan conditions might be imposed, such as demanding its 10% corporate tax rate – one of Europe’s lowest -- might have to be sacrificed.
Earlier, Central Bank Governor Panicos Demetriades had acknowledged that with an end-June deadline to find the money to recapitalise Popular Bank, the country was at “an important crunch time”.
Neither the government nor its commercial banks have been able to borrow from international money markets since 2011 due to the island’s debt being reduced to junk status by two of the three international credit agencies. On 25 June, Fitch Ratings became the last of the three to junk Nicosia’s credit score.
To make matters worse, the Communist-backed administration has been criticised for delaying a fresh austerity package to save an additional €200 million if Cyprus is to meet its 2.5% deficit target. Current Finance Ministry projections predict the deficit will reach 3.4% of GDP without further cost-cutting or tax raising.
An inefficient and unwieldy public sector – employing around 70,000 – that pays out high salaries and generous pensions is putting a drain on the economy. For the first time since the republic was established in 1960 the civil service is being downsized and public sector employees forced to contribute toward their pensions. Private and public sector workers are now obliged to pay emergency contributions – on monthly salaries above €2,500 – for two years to help the island exit economic turmoil.
In March, VAT was increased from Europe’s lowest flat rate of 15% to 17% and the government is wary of imposing more tax hikes on Cypriots while the country is in deep recession and unemployment is at a record 10%.
Cyprus’s eurozone economy will shrink by 1.1% in 2012, the Central Bank forecast in early June, a more pessimistic outlook than the zero growth seen in December. After suffering a year-long recession, Cyprus can only expect “anaemic growth” of 0.4% next year, the bank added.
The outlook is much bleaker than the government’s own estimate of a 0.5% contraction this year followed by 0.5% growth in 2013. The debt-to-GDP ratio is expected to increase to 72.2% in 2012 from 71.6% in 2011.
The Central Bank said consumer and business confidence was at a “very low” ebb, while the economic crisis in Greece signals “serious consequences” for the banking system, compounding an “already negative climate for 2012”. Moreover, official data show the economy fell deeper into recession in the first quarter, shrinking 1.6% annually. Although the government is committed to getting its bloated deficit to below 3% this year from 6.4% in 2011, it is reluctant to introduce deeper public cuts to drastically slash the deficit.
An in-depth review by the European Commission concluded that the Cyprus economy was experiencing “internal imbalances” due to the banking sector, corporate indebtedness and a lack of competitiveness. It also called Nicosia’s budgetary targets for 2012-204 “optimistic” for partly relying on “not fully specified measures”.
The Commission recommended that Cyprus must ensure the long-term sustainability of its pension fund and reform the twice-yearly automatically adjusted cost of living allowance index by linking it to productivity.
Two key drivers of the economy – construction and tourism – have had mixed fortunes with foreign investment in property drying up, while tourism improved last year as holiday makers opted for Cyprus as a safe destination during the Arab spring.
Tourism, which contributes around 12% of GDP to the island’s €17.5 billion economy, struggled at the beginning of the year, but officials believe revenues will exceed 2011 levels as big spending Russians continue to flock to the island.
Apart from a contraction in 2009, Cypriots enjoyed continuous economic growth and prosperity for decades. The country did not envisage the euro meltdown when it joined the single currency in 2008, four years after becoming a member state.
A major reason for the government’s reluctance to request EU aid is because it fears tough loan conditions might be imposed