Consumption and Investment fuel a vibrant recovery

Emergency support measures deployed in 2020 and extended in 2021 succeeded in insulating the economy from permanent damage during the pandemic. As a result, activity has recovered to its pre-pandemic levels and is set to pursue a rapid expansion in 2022. Employment has been largely protected thanks to the quick work suspension scheme, which covered up to 65% of the workforce during the worst pandemic. Given this protection of employment and accumulation of savings, household consumption (64% of GDP) will continue booming and remain the main driver of growth. The recovery of investment (20% of GDP), both public and private, will be strongly supported by NGEU funds, which will amount to 6% of GDP over the 2021-2027 period. The tourism industry, which directly and indirectly accounts for 20% of GDP, performed surprisingly well in 2021 and will keep improving in 2022. Still, it will not recover to pre-pandemic levels before the end of 2023. The progressive recoveries in tourism, shipping, and professional services will positively contribute to net exports. Though the corporate sector has shown impressive resilience under the support schemes, underlying vulnerabilities remain. Indeed, many hospitality and passenger transport SMEs have relied on loan repayment moratoria to stay solvent. After the first installment expired, loan restructurings jumped 400% YoY in H1 2021. In the long-run, successful diversification of the economy will depend to a large extent on the development of a natural gas industry, which, despite its potential, faces significant geopolitical and environmental challenges.

Fiscal and banking vulnerabilities still loom

With tax revenue rising on the back of the recovery and a slowdown in expenditure growth, the budget deficit is set to improve substantially. Still, expenditure growth will remain high (+7%), driven mainly by the structural strengthening of the healthcare system. The favorable economic performance, combined with still low-interest rates, will allow for a fast correction of the public debt ratio, which will remain high. In the longer term, two items weigh on the sustainability of public finances: contingent liabilities to the banking sector (6% of GDP) and the structural tax revenue gap left by the now-abolished Citizenship Investment Program (CIP) scheme. The banking sector still suffers from the scars of the Euro crisis, with an NPL ratio close to 18%, and is exposed to as-of-yet unmaterialized pandemic-related defaults. The CIP is estimated to have generated around EUR 10 million in revenue and investment between 2013 and 2020, an average of 1.4% of GDP per year. Furthermore, the end of the CIP program will imply a smaller flow of reliable FDI (14% of GDP). With a modest exporting goods sector (recreational boats, refined oil, food products), more than the services surplus is needed to avoid chronic current account deficits. Therefore, without investment-friendly reforms (gas exploitation has been slowed down by bureaucracy), less dependable capital flows will fund a larger share of the current account deficit. This is worrying given the country’s significant negative international investment position (-52% of GDP) and external debt (984% of GDP, primarily reflecting offshore financial exposures).  

Contested waters at the heart of a fragile geopolitical equilibrium

The island of Cyprus is divided between the Greece-aligned Republic of Cyprus (RC), a Eurozone member state controlling the southern half of the island, and the Turkish Republic of Northern Cyprus (TNRC), which heads the north and is recognized only by Turkey. While a peaceful stalemate has been maintained since the 1970s, rising geopolitical tensions between Greece, Cyprus, and the EU on one side and Turkey on the other have further strained this relationship. The 2021 parliamentary elections in the RC weakened the minority government of President Nicos Anastasiades, with his liberal, conservative party (Disy) still ahead of communist Akel and his centrist nationalist former coalition partner Diko, the first two losing seats to far-right Elam. The RC’s presidential system means he will stay in office until the 2023 presidential election. The escalating confrontation with Turkey and the TRNC over maritime claims with potential gas deposits remains a crucial challenge. Since 2018, Turkey has repeatedly sent exploration vessels escorted by military ships into contested waters. The EU and Greece support the RC, but diplomatic efforts to alleviate tensions have mostly failed. Cyprus remains a vital member of the EastMed Gas Forum, an alliance with Egypt, Greece, Israel, Italy, Jordan, and Palestine to foster a regional gas industry. However, in the wake of the EU’s green agenda, critical doubts have emerged concerning the economic and environmental viability of the EastMed pipeline project, reducing Cypriot influence in the group.