Cyprus Growth Steady; Euro-Zone Entry On Track

In its annual review of Cyprus, the Economist Intelligence Unit (EIU) has revised down its forecast for Cyprus’s growth to 3.4% (from 3.6%) in 2007, and to 3.6% (from 3.8%) in 2008. Growth is expected to remain substantially flat over the next few years.

The EIU sees the island's low-tax environment and its location as its main attractions for investors, together with its regulatory reliability as an EU member state. However the local market is small, and labour costs are high relative to other countries in the region.

Cyprus is expected to join the eurozone in 2008: “We expect Cyprus to meet the criteria for euro area membership and to adopt the euro at the beginning of 2008.

The conversion rate is projected to be the same as the current central parity of CYP0.585:€1 when it is fixed in mid-2007. This will require a moderate depreciation from current exchange-rate levels,” says the EIU.

Although the current administration has resisted calls for higher spending by using the carrot of eurozone entry, the EIU sees it caving in during the run-up to a presidential election in early 2008: “Our baseline assumption is that the budget deficit will widen only slightly and will remain just under 2% of GDP in 2007-08, well below the 3% ceiling established by the euro area Stability and Growth Pact.

However, experience from the previous election suggests that public spending can go out of control very fast in Cyprus's small economy, therefore much will depend on the government's vigilance.

Under EU rules Cyprus is due to increase the rate of value-added tax (VAT) on specific items, including medicines and restaurants, from January 2008. Depending on the item, rates will go up from 0% to 5%, 8% to 15%, or 0% to 15%. However, the government is trying to negotiate a delay to avoid perceptions that adoption of the euro will lead to a spike in prices, as many Cypriots fear it might.”

The EIU is not hopeful of any imminent resolution of the island's partition. Despite pressure from the EU and the UN, it says that substantive talks remain unlikely in 2007-08, owing to elections being held in Turkey in May (presidential) and November (parliamentary) 2007 and in the (Greek Cypriot) Republic of Cyprus in February 2008 (presidential).

The Cyprus government sent its application to join the eurozone to European Central Bank President Jean-Claude Trichet and European Monetary Affairs Commissioner Joaquin Almunia in March. A decision on the application is expected to be made at an Ecofin meeting in Brussels in June, which would then be ratified by the EU Heads of Government; the Cyprus pound will then be locked permanently to the euro in July.

President Tassos Papadopoulos dismissed calls from the unions for a delay or for a devaluation of the Cyprus pound, which has easily remained inside its ERM variation band since accession in 2005.

'Definitely not, no way. If anything, the Cyprus pound could be revaluated upwards', said the President. 'All the indicators are against devaluation,' said Papadopoulos, adding that the fiscal deficit will have sunk to 1.5% of GDP in 2006.

In its recent budget, the government forecast GDP growth of around 3.9% in 2007, with inflation at 2.5% and the deficit continuing to fall. Public borrowing remains slightly above the Maastricht 60% criterion, but has been falling steadily, and is expected to dip below 60% in 2008.