Cyprus: Risk Assessment
Country Rating1
Rating: B
Business Climate Rating1
Rating: A3
Risk Assessment2
Recovery is sluggish in the wake of both households and Cyprus banks difficulties triggered by the lasting bursting of the property bubble. Cyprus financial institutions are not only exposed to the Greek sovereign, but having granted a large part of their loans to Greek households and companies, they also face the growing risk of default of these clients.
Economic recovery impeded by high private debt and weakened public sector finances
In 2011 GDP growth will stay sluggish, around 1%. It will fail to match the 4% average rate maintained from 2004 through 2008. Those years of economic overheating, financed by the build-up of private debt, which reached 280% of GDP in 2009, culminated in the bursting of the property bubble to which banks and households were highly exposed. The rise in unemployment, the tightening of credit and the burden of household debt will undermine private consumption. Investment will remain weak due to the difficult recovery of the property and construction market. Industrial production will be constrained in the second part of the year by the explosion in July of the Vassilikos power station, that has taken out half of the country's electricity supply. Competitiveness in the pharmaceuticals and chemicals sectors will continue to erode. Tourism, which has suffered from the deterioration of infrastructure, could benefit, however, from the current tendency of tourists to shun North African destinations. Yet, public spending will be squeezed by the low level of fiscal revenues and the impact of measures taken since 2010 to reduce the public sector deficit. Pension contributions were raised in 2009 and the 15% VAT could be increased by 1% in 2011. But the government will be highly unlikely to take action on increasing the corporate tax rates (10%) since such a move could jeopardize the country's position as a regional business services hub. And unless an adjustment is made in the current growth regime founded on a low tax rate, the fiscal deficit will continue to grow and the public-sector debt could exceed the 60%-of-GDP threshold this year.
The growing vulnerability of the financial sector
The banking system proved more resilient to the crisis in Cyprus than it was in the other euro zone countries. Cypriot banks remained profitable and well capitalized in 2010 with good liquidity ratios. But in view of its size and relatively high concentration, it exposes the Cypriot economy to relatively high risks: With the sector's total assets amounting to over 10 times the country's GDP, its high exposure to the Greek economy notably constitutes a substantial source of vulnerability. Cypriot commercial banks hold bonds issued by the Greek government and banks. They also lend to Greek households and companies via their subsidiaries and branch offices. Late 2010, the exposure to Greece of the three largest Cypriot commercial banks amounted to as much as 53% of their assets, including €23 billion in loans granted to Greek households and companies. 40% of the loans detained by Cypriot banks have been delivered to Greek households and corporate businesses. Therefore, the Cypriot banking sector appears very fragile in the wink of the Greek recession. Actually, it could be jeopardized by a Greek public debt restructuring and by a sharp contraction of the activity in Greece. Cypriot commercial banks and cooperative/mutual institutions are also exposed to the slowdowns in the domestic property and construction sectors. In that perspective, the situation in the sector will likely deteriorate considerably in 2011 despite the measures taken - belatedly - by the oversight authorities especially as regards the level of reserve requirements. The banking sector's exposure to Greek debt (a risk that represents 1.7 times Cypriot GDP) could, if Greece defaults, give rise to an additional annual cost to the Island-nation's government, representing 10% of GDP in each of the three coming years, for the recapitalization of the banking system.
A very slow negotiation process on reunification
Little progress has been made in the negotiations on the Island's reunification, which resumed in September 2008. Despite the efforts made thus far by the Greek and Turkish presidents, much work remains to be done to smooth the divergences (power-sharing, settlement of the despoiled property question). Moreover, since the victory in the Turkish Cypriot presidential election in April 2010 of Dervish Eroglu, leader of the Nationalist Party, there is little likelihood of the reunification process coming to a successful conclusion in the near. And this will come to pass notwithstanding the efforts of the current Greek Cypriot president, Demetris Christofias, who has been preparing his country to assume the presidency of the European Union in the second half next year.
Strengths
- Per capita GDP statistics show the island to be the richest country in the region
- Membership of euro zone eliminates foreign exchange risks
- Developed infrastructure, substantial tourist potential
- Regional business services hub, favorable business environment
Weaknesses
- Real estate market down-turn dampening growth prospects
- Large trade deficit, deteriorated public-sector finances
- Very high private debt
- Financial sector highly exposed to the Greek crisis
- Uncertain outlook for reunification of the island