European Commission: Cyprus’ economy is still imbalanced

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Cypruseconomy is still characterized by large economic imbalances, which, unless addressed, may impede its medium-term economic prospects”, the European Commission warns in its in-depth analysis of the state of the economy, published today in Brussels, under the European semester rules.

According to the European Commission, “Cyprus’ large imbalances are a legacy of the 2013 crisis and include high stocks of private, public and external debt and nonperforming loans”.

Overall the European Commission informed the Council that “Cyprus has made limited progress in addressing the 2019 country-specific recommendations”. Cyprus has made no progress on privatisations.

“Cyprus has made limited progress in addressing the 2019 country-specific recommendations.”

In this context, the European Commission calls Cyprus “to step up reforms in key areas to attract productivity-enhancing investments, diversify the economy and help foster inclusive and environmentally sustainable growth in the long term” and warns that “the long-term sustainability of the growth model of Cyprus is put at risk by rising external uncertainties and pending structural reforms”, while stating that “economic evidence suggests that Cyprus’ tax rules are used for aggressive tax planning purposes” and “the design of the Cypriot corporate tax residence rules, and the residence and citizenship by investment schemes, are a cause for concern”.

In detail, the European Commission states in the report that “Economic growth has remained resilient so far, but is expected to slow down in the coming years. GDP growth, projected to be 3.2%% in 2019, has remained strong, supported by resilient domestic demand”. Meanwhile, net exports had a negative impact, reflecting a less supportive external environment.

“The long-term sustainability of the growth model of Cyprus is put at risk by rising external uncertainties and pending structural reforms.”

The economy is expected to continue growing — albeit at a slower pace — by around 2.8%% in 2020 and 2.5% in 2021, in view of the anticipated weakness of the global economy.

The current account deficit is significantly negative, and is set to worsen to around 10%% of GDP in 2019-2021 due to lower exports and increased imports in the context of strong domestic demand. Unemployment fell to 7.5%% in 2019, the lowest level since 2011, and is expected to fall further. Inflation remained low, and this trend is projected to continue over the next couple of years. Cyprus is expected to record a significant budget surplus in 2019.

The headline budget balance is set to return to surplus in 2019 (above 3.5%% of GDP) and to remain in surplus in 2020 and 2021, which would enable considerable debt reduction. To safeguard fiscal sustainability going forward expenditure developments should be carefully monitored, especially in the light of possible future risks to the robustness of revenues.

Growth relies heavily on specific sectors, such as tourism, foreign-funded residential construction and services linked to foreign companies, which are vulnerable to potential negative external developments.

“To safeguard fiscal sustainability going forward expenditure developments should be carefully monitored.”

NPFs drop a further €175 million in July-September 2019, Central Bank says

The main findings of the in-depth review contained in this report and the related policy challenges are as follows:

“Despite the considerable progress made over the last two years, the stock of nonperforming loans remains high. In mid-2019, the share of non-performing loans accounted for 33.5% of the total loans in the banking sector, which is still one of the highest proportions in the EU.

The effective use of the legal framework, including for foreclosures and insolvency, is essential to reducing nonperforming loans further, enhancing the payment discipline and addressing strategic defaulters. Non-performing loans, including the growing proportion held outside of the banking sector, need to be resolved.

This is, in particular, the case for the loans held by the state-owned asset management company (KEDIPES) where delays and organizational set-up challenges need to be addressed to ensure a successful performance. Strengthening the supervision of credit-acquiring companies is also important.

The banking sector’s profitability remains under significant pressure. While sales of non-performing loans are expected to reduce the proportion of bad loans held by the banks in 2020, low-interest margins, excess liquidity and high operating costs still dampen banks’ profitability.

Private sector debt remains high, although it is decreasing. Both households’ and nonfinancial corporations’ debt ratios are decreasing. (ESTIA scheme should help reduce the private sector debt and the housing market recovery could help reduce private debt).

Government debt is projected to steadily decline steadily from 2019 onwards. After increasing in 2018 because of the measures to support the sale and orderly winding down of the Cyprus Cooperative Bank, the debt-to-GDP ratio is set to decrease to 82%% of GDP by 2021, mainly due to expected sizeable headlines surpluses and solid economic growth.

However, the Commission’s fiscal sustainability analysis shows that risks remain. In particular, the still high level of public debt and the combination of a large current account deficit and high private debt make Cyprus vulnerable to potential financial and economic shocks. However, relatively modest medium-term financing needs mitigate the risks somewhat.

Potential growth is expected to increase over the medium term. The projected increase of the labour force and increased investment are set to be the main drivers of higher growth potential. However, the continued focus on residential investment, small and medium-sized enterprises’ ongoing difficulties in accessing finance, the high level of private sector’s debt, and the shortcomings in the business environment could hamper growth and productivity in the longer term.

A number of other key economic issues analysed in this report point to particular challenges to the Cypriot economy, namely:

Key challenges remain in relation to environmental sustainability. The country’s weak environmental performance is a major concern. Despite some action, Cyprus remains vulnerable to climate change due to droughts and water scarcity. At the same time, Cyprus is among the Member States with the highest greenhouse gas emissions per person and the economy heavily relies heavily on fossil fuels.

The justice system continues to face serious inefficiencies that undermine the enforcement of contracts. Lengthy court proceedings and weak enforcement of judgements harm the business environment and hinder banks from using the available legal tools to reduce non-performing loans. Addressing these inefficiencies would also help to strengthen the payment discipline in the country. Preparations for the justice system reform are advancing but there are still no tangible results.

The housing market as a whole has seen a recovery, but the sector is segmented. The housing market has been recovering, supported by buoyant foreign demand for new luxury residences stemming mainly from the residence and citizenship by investment schemes. In contrast, domestic demand for housing and demand for existing properties remain low. This is also reflected in differences in housing price trends developments between new and existing residences and between regions.

The labour market is still facing challenges. Despite measures undertaken in this area, there is still scope for bringing the public employment services into line with best EU practices. Furthermore, the public employment services’ effectiveness is at risk as additional recruitments are only on short-term contracts. Further progress to reduce undeclared work is hindered by a lack of resources and the fact that legislation is still pending.

Reforms of the education and training systems face considerable challenges. The relatively high public spending on education is not reflected in observed outcomes, as highlighted by the recent results from the Programme for International Student Assessment. The weak support for early childhood education and care undermines potentially high long-term benefits of quality childcare, and hinders people from working or looking for a job. Improving educational achievements and skills, as well as increasing participation in adult learning and vocational education and training are essential for fostering sustainable growth in the future.

The health sector is undergoing fundamental reform. The new National Health Insurance System is expected to make the health sector more efficient and affordable, but some operational challenges remain. It provides a pivotal opportunity for targeted investments to improve public healthcare and develop e-health, among other things. The reform needs to be carefully implemented to reduce fiscal risks.

Economic evidence suggests that Cyprus’ tax rules are used for aggressive tax planning purposes. The absence of withholding taxes, the design of the Cypriot corporate tax residence rules, and the residence and citizenship by investment schemes, are a cause for concern. In addition to the implementation of European and internationally agreed initiatives, Cyprus has announced some unilateral measures.

These include the introduction of withholding taxes on dividend, interest and royalty payments to countries on the EU list of non-cooperative jurisdictions on tax matters, the introduction of a tax residency test based on incorporation, and the reviewing of the transfer pricing framework to take into account the transfer pricing recommendations from the OECD base erosion and profit shifting project.

Inefficiencies in the public sector are harming the business environment. Key reforms to improve the efficiency of the public administration and the local government are still pending. The impact of the efforts made to improve the governance and financial monitoring of state-owned enterprises remains to be seen. Private investment, including in key utilities, could be facilitated through privatisations and simplifying procedures. Corruption is perceived as a problem by businesses, and adopting pending key anti-corruption legislation, as well as stepping up the implementation of the adopted action plan is essential for improving the business environment.”

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