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Post-Programme Surveillance Report. Cyprus, Autumn 2023 - European Commission (europa.eu)

Post-Programme Surveillance Report. Cyprus, Autumn 2023 (europa.eu)

This report by the European Commission presents the findings of the fifteenth post-programme surveillance mission to Cyprus and identifies remaining challenges for the Cypriot economy.

Executive summary

The 15th post-programme surveillance mission to Cyprus took place from 25 to 29 September 2023. This mission involved European Commission staff in liaison with European Central Bank (ECB) staff. European Stability Mechanism (ESM) staff participated on aspects relating to the ESM’s Early Warning System. Economic growth in Cyprus is set to slow down over the coming years following a strong recovery post-COVID-19. Real GDP growth is expected to slow to 2.2% in 2023 from 5.1% in 2022.

Domestic demand and tourism continue their strong growth performance, but external demand for financial and business services is being negatively affected by global developments such as the ongoing Russia’s war of aggression against Ukraine. Growth is expected to continue on a moderate path in 2024 and 2025 at around 3%. This will mainly be driven by sizeable investments in the areas of energy, education, health and tourism, in part supported by the RRF.

The Cypriot labour market remains robust, with employment continuing to increase and unemployment expected to fall to its lowest level in over a decade, below 6% by 2025. Inflation is set to decelerate markedly to 4.1% in 2023 after reaching a peak in 2022 at 8.1% and is set to further decelerate over the coming years. However, core inflation is projected to remain elevated, partly due to the automatic wage-indexation system pushing up prices. The current account deficit widened in 2023 as external demand for non-tourism services is moderating. The deficit is expected to only gradually narrow in the following years. The fiscal position remains strong.

The general government balance posted a sizeable surplus of 2.4% of GDP in 2022. In 2023, revenues have remained buoyant, while expenditure has also increased, albeit to a lesser degree. According to the Commission’s autumn 2023 forecast, the general government surplus is expected to decrease somewhat before increasing again over the coming years. There are some potential risks to the fiscal outlook, such as possible new or extended measures, notably in case of a new surge of energy prices, and the contingent risks from the banking sector.

Cypriot banks recorded strong profits in the first half of 2023, benefitting from higher policy rates and the sector’s capital position remains solid. The bulk of the income gains derived from the banks’ excess liquidity placed with the ECB and to a lesser extent from a swift passthrough of the higher interest rates on variable-rate loans and a slower passthrough to deposit rates. As a result, Cypriot banks benefit from interest margins that are much wider compared to the rest of the euro area. The banking sector’s capital position remains solid, comfortably surpassing minimum requirements.

Asset quality has improved, mostly because of Non-Performing Loans’ (NPL) sales achieved over the last few years by the systemic banks. Further progress depends also on the ability of the smaller banks to deleverage. The past transfers of NPLs out of the banking system to the balance sheets of the credit acquiring companies (CACs) still burden the economy through private indebtedness.

Macroeconomic risks have increased moderately for Cypriot banks as higher interest rates and rising living costs weaken borrowers’ capacity to service their loans. Further progress in the management of NPLs requires an effective foreclosure framework. This is important for legal certainty and to maintain payment discipline as it provides lenders leverage over uncooperative borrowers.

Repeated suspensions of the foreclosure framework have hampered its efficacy. This can impact the efforts to reduce NPLs and as a result the robustness of the Cypriot banking sector. The effective implementation of the foreclosure tool is also important for the success of schemes like the mortgage-to-rent scheme, designed to protect the primary homes of vulnerable households. Cyprus retains the capacity to service its debt.

Despite a number of challenges, the economic, fiscal and financial situation in Cyprus is sound overall. According to the debt sustainability analysis, Cyprus faces low risks in the short and long terms, while medium-term risks appear to be medium. The government’s gross financing needs for 2023 and 2024 are low thanks to significant projected primary surpluses. Repayments of the principal on ESM loans will start in 2025 and will conclude in 2031. Cyprus has a very large cash buffer and continues to enjoy favourable market perception. Its sovereign debt rating was upgraded by three rating agencies in 2023, now being at least two notches within investment grade area by all four main rating agencies.