Sharp slowdown, but tourism and European funds provide resilience
Driven by resurging tourism and buoyant household consumption (boosted by pandemic-inherited excess savings), the Cypriot economy has surpassed pre-pandemic output levels. Tourism and EU-backed investment will remain reliable pillars of growth into 2024. However, global inflationary headwinds, above-average exposure to the Russian economy and diminishing European demand have induced a slowdown. Although Cyprus has low direct exposures to Russian energy supply, the island country depends overwhelmingly on imported oil, and therefore remains vulnerable to global energy shocks. Domestic demand growth will be eroded by diminishing purchasing power and tightening financial conditions. The professional services and financial sectors are strongly dependent on subsidiaries of Russian and Ukrainian companies exposed to sanctions. The tourism sector has managed to weather the losses of the Russian and Ukrainian markets with increased visitors from Western Europe (mainly the UK). In total, services exposure to Russia is estimated at 10% of GDP, thereby constituting a source of substantial downside risk. That said, inflation is expected to moderate in 2024, barring a stronger-than-expected impact of China’s reopening onto global energy and commodity markets. The investment outlook will continue to be dampened by the abolition of the citizenship-by-investment scheme, which constitutes a durable negative shock to FDI inflows. Though the country is set to benefit from substantial European support in the form of NGEU funds (6% of 2019 GDP), in practice the disbursement schedule for these funds has been slowed by a failure to implement reforms in time. Due to slowing service exports and increasingly costly imports (energy, capital goods and construction materials), the growth contribution of net exports will be close to zero.
Decreasing sovereign and banking risk
The strong post-pandemic rebound and associated rising tourism revenues have allowed the country to post surprisingly good fiscal results, with a strong surplus in 2022. The progressive withdrawal of pandemic-era and energy crisis support measures, combined with rising revenue from taxes on private-sector wages and corporate earnings, will allow for sustained surpluses over the forecast horizon. This is expected despite the increases in public sector wages and pension hikes of around 7.5%. The compounded effect of strong nominal GDP growth and budget surpluses will result in a rapid decrease of the debt ratio. With manageable financing needs (estimated at 5-6% of GDP per year), robust cash buffers standing at 10% of GDP and over two-thirds of the debt stock in fixed interest rates, sovereign risk is reasonably contained. The main risk to the fiscal outlook stems from uncertainty over the cost-of-living allowance, an inflation-indexed wage subsidy scheme the costs of which could spill over should the government yield to trade union pressure. The health of the banking system, albeit still bearing some of the scars of the eurozone crisis, is also on a positive trajectory. This is true of the asset side, where the NPL ratio has decreased to 9.3% (as at Q1 2023), as well as liabilities, with an average CET-1 capital ratio of 17.7% (end-2022). The country’s structurally large current-account deficit is only partially worrying, as it is overwhelmingly funded by FDI related to holdings of foreign multinationals. Part of it is due to the country’s dependence on imports for manufactured goods and basic commodities, which is manifested by the 18% of GDP goods balance deficit. However, a large amount is also due to the activity of Special Purpose Entities domiciled in Cyprus, through which global corporations active in maritime trade register their vessels, thus inflating imports. The undiversified industrial structure of the country leaves it vulnerable to global supply shocks.
Despite signs of easing, ongoing tensions with Turkey are prevalent and pertinent
The island of Cyprus is divided between the Greece-aligned Republic of Cyprus (RC), a eurozone member state controlling the southern half of the island, and the Turkish Republic of Northern Cyprus (TNRC), which controls the north and is recognised only by Turkey. While a peaceful stalemate has existed since the 1970s, rising geopolitical tensions between Greece, Cyprus and the EU on the one hand and Turkey on the other have further strained this relationship. President Nicos Christodoulides, an independent, is forced to govern with a fragmented parliament, with legislation passing on a case-by-case basis in the absence of a majority. Embattled by these governance challenges, Cyprus has lagged in its capacity to capitalise on EU funds due to delays in the implementation of reform objectives (tax collection, energy, health, education and transport infrastructure) necessary to access its allocated share. The escalating stand-off with Turkey and the TRNC over maritime claims including potential gas deposits is a crucial sticking point. Since 2018, Turkey has repeatedly sent exploration vessels escorted by military ships into contested waters. While there have recently been some signs of détente, the path to a durable solution is not obvious or likely at the moment. Cyprus remains a key member of the EastMed Gas Forum, an alliance with Egypt, Greece, Israel, Italy, Jordan, and Palestine, aimed at fostering a regional gas industry.