Renewed growth, but fragile recovery, says EY Forecast
With the pace of decline in economic activity slowing in 2014, Ernst & Young (EY) believes that Cyprus remains on track for a return to growth next year. However, the main drivers of the turnaround - tourism and the services sector - will only be sufficient to generate modest GDP expansion of around 0.3% in 2015, after a 2.9% contraction in 2014, the advisory firm said in its EY Eurozone Forecast for December.
The report said that “although the biggest banks have passed stress tests after successfully raising capital, the sector’s non-performing loans have continued to rise (to over half the total). At the same time, new foreclosure procedures have been delayed in parliament. Bad debts will continue to restrain domestic credit growth and household and smallbusiness spending even after the recession ends.”
EY warned that Cyprus’ bailout conditions require continued tightening of fiscal policy in 2015–16, constraining recovery and leaving largely dependent on exports.
“Although cuts in the state wage bill have kept the budget on track for primary surplus in 2016, the tightened capital budget means only a muted return to fixed investment growth in 2015,” it said.
With hourly wage costs down by 4.5% on the year (and total hourly costs down by 3.9%) in Q2, the resulting competitiveness gains will help to support an acceleration of export growth in 2015–18, the report said. But a corresponding rebound in imports will prevent any move into current account surplus, meaning a need for continued direct and portfolio investment inflows.
“Price deflation at the end of Q3 reflects ongoing constraints on consumer spending, and fear of further falls will hold back investment recovery in 2015. The return of moderate inflation, forecast to average 0.7% in 2015 and climb to 2% by 2018, will promote recovery by reducing real interest rates and gradually lowering the real burden of debt.”
The EY ferocast added that “although the impact of Russia’s European Union export ban has been limited, minimal growth in the Russian economy in 2014–15 is likely to hold back the Cypriot economy by delaying the recovery of bank deposit inflows.”
Indicating a “cautious return to growth in 2015,” the EY report said that “after three years of recession, the economy is on course to return to growth in 2015, as a revival in export growth leads to a resumption of investment.”
It added that although further drops are expected in the next few quarters, growth is forecast to resume by mid-2015, underpinned by this year’s further reduction in the current
it account deficit to just 0.3% of GDP, a sharp improvement on the unsustainable double-digit deficit in 2012. It will also feature a return to positive price inflation, after the brush with falling prices during 2014. Public spending will continue to decline in 2015, as the bailout conditions imposed by the International Monetary Fund (IMF) and the EU force the government to continue targeting a return to primary budget surplus by 2016. However, the relaxation of budget pressures from 2016 will allow an acceleration of investment growth, lifting it to around 7% by 2018.
The growth outlook remains extremely subdued given the severity of the 2008–09 recession, and the brevity of the recovery that followed it before the latest downturn began in 2011. GDP remains well below the pre-crisis level, despite an upward revision under new Eurostat methodology.
Moreover, risks to the forecast remain firmly on downside, the EY report said.
On the banking sector, it said that the slow pace of the forecast recovery limits the proportion of bad debts that are likely to come good again in 2015–17, and their persistence will be an obstacle to the resumption of credit growth to nonfinancial businesses. The past two years’ sharp drop in real incomes, which will not be fully reversed by recovery of wage growth in the forecast period, will constrain the rate of recovery in domestic bank deposits even when trust in the system is fully restored. Non-resident deposit growth will be held back in 2014–15 by slow growth in the Russian economy, after its downturn in the first half of this year.
The report concluded that the government’s tight fiscal
the targets have prevented it from creating a “bad bank” for nonperforming assets or otherwise extending debt relief, leaving the banks to reschedule or write off much of the remaining bad debt without direct assistance. Capital controls imposed after the bailout may have helped stem further outflows of deposits, but only by further testing the patience of the banks’ larger creditors (already hit by the bail-in arrangement that forced them to absorb the rescue cost alongside shareholders).
This may make non-resident deposits hard to rebuild to the unusually high level achieved before 2008, EY said.