Is economic growth sustainable in Cyprus?


In an article published in January, I asked whether the Cyprus economy was decoupling from tourism. I cited the unusual combination of falling tourism numbers but rising real GDP.

According to the full breakdown of figures published by the Statistical Service, Cystat, on Friday, the economy does seem to be decoupling from tourism. In the first quarter of 2007, gross domestic product (GDP) grew in real terms by 3.8% compared with the first quarter of 2006 on a seasonally adjusted basis. In the same period, however, tourism arrivals fell by 3.9%.

In 2002-03, when tourism arrivals fell by an average 7.5%, real GDP growth dipped to average just 1.9%, compared with 3.8% in the previous two years.

The same pattern does not appear to be repeating itself this year.

-- What is driving growth?

If economic growth is decoupling from tourism, now is the time to ask if such growth is sustainable.
Clues to this answer lie in what actually drove growth in the first quarter of 2007. Looking at GDP by sector, one sector that rose faster than average was “wholesale and retail trade; hotels and restaurants; and transport, storage and communication”, which rose by 4.1%. This is rather a large sector which was probably driven by car sales, as we shall see.

The main sector that rose faster than overall GDP in the first quarter was “financial intermediation, real estate, rental and business activities”, which rose by 6.0%.

This is also a large sector that encompasses bank lending, property sales and general businesses. For reasons explained below, the main driver of growth here was probably bank lending.

-- The car-loan economy

Looking at GDP by expenditure, it is clear that the main driver of growth was “gross capital formation”, which comprises fixed investment (normally in things like machinery) and stocks.
This category rose in real terms by a fast 14.8% year on year in the first quarter of 2007 compared with overall GDP growth of 3.8%. This, in turn, was partly driven by a very large increase in transport equipment investment, up by 28%.

Normally, and in an industry-led economy, this would be good news. It would mean that businesses are investing in new technologies. However, in Cyprus, there are two reasons to be cautious.
First, this is simply “bounce-back growth” from a low baseline in the first quarter of 2006, when investment in transport equipment fell by 6.6%.

Second, it looks like this “investment” is simply businesses taking advantage of the tax-cuts to buy new cars. In the first two months of 2007, imports of passenger motor vehicles rose by 47% (in Cyprus pounds terms) to CYP 60.4 mln from CYP 41.1 mln in the same period of 2006.

Cars bought by businesses count as investment, whereas cars bought by individuals count as consumer spending.

Cars sales by individuals are also booming (up 32% in January-April), which explains why household consumption was up 5.6% in the first quarter.

And how are these car purchases being funded? With bank loans.

Bank lending has not only been increasing, it has been increasing at a faster pace.

The Central Bank of Cyprus publishes bank lending figures only two months at a time. But by painstakingly keeping records, you can see the remarkable trend.

For a year-on-year growth rate of 6.4% in January 2006, bank lending had accelerated to growth of 19.5% by March 2007.

Foreign borrowing, mainly in euros, has risen very dramatically, by 54.1% in March 2007 and by 53.3% on average since January 2006.

-- Can it last?

This leads us to the question of whether this kind of growth rate will last. And the answer is that it may well do, but for all the wrong reasons.

As we have seen, growth in the first quarter appears to have been driven primarily by car sales, which in turn were driven by strong bank lending.

Bank lending growth will dip significantly only if bank profits suffer or if interest rates rise sharply. The first seems unlikely in the current climate, with healthy bank profits forecast for this year. The second is also unlikely to happen, though here the outlook is less certain.

Adoption of the euro in January 2008 is now a near certainty and if the European Central Bank does not raise rates again this year, the base rate in Cyprus will fall another 50 basis points (0.5%) by the end of 2007.

The Cyprus minimum bid rate on the main refinancing operations is 4.50%, while the ECB main refinancing operations minimum bid rate is 4.00%

Bank lending rates could fall even further as banks realise that customers can quickly compare the rates on car and housing loans in Cyprus with those in other eurozone states.

Even if continued growth in lending leads to a bubble in Cyprus, the European Central Bank is hardly likely to make its judgements on the basis of such a small economy.

Just as in other small eurozone states, therefore, interest rates are likely to be lower in Cyprus than they really should be and national instruments for offsetting this growth in lending will be fairly weak. Thus the credit boom will continue for longer than classical theory suggests.

This is also why the housing market in Cyprus will probably continue to be buoyant for years to come. Construction output rose by a fairly healthy 3.6% in the first quarter and according to the BuySell home Price index, the average year-on-year growth rate of house prices has been 9.3% up to May year.

The average house price in Cyprus is now CYP 97,064 (EUR 166,610).

According to dinner-table theory, this cannot last because property prices are already beyond the reach of the average consumer.

But remember that the Cyprus housing market is probably where the UK one was about 20 years ago.

And remember too, that every time house prices seem to reach a peak, something happens to keep the market going. Banks offer longer-term loans (in the UK you can now get 40-year loans; in Japan there are two-generation loans), or they allow bigger multiples of income.

Or, as is happening in Cyprus, developers build smaller properties more closely packed together.
One way or another, the market adjusts, people panic that they will never be able to get on the housing ladder, so beg and borrow to do so.

That doesn’t mean that the housing and credit-led growth we shall see will be healthy. Sooner or later Cyprus will experience a Spanish-style bust, and those who have borrowed too much will suffer.

But it could be many many years before we actually get to that stage.