VZCZCXYZ0421
RR RUEHWEB

DE RUEHNC #0790/01 3561411
ZNR UUUUU ZZH
R 221411Z DEC 09
FM AMEMBASSY NICOSIA
TO RUEHC/SECSTATE WASHDC 0378
INFO RUEHBS/USEU BRUSSELS

UNCLAS NICOSIA 000790 
 
SENSITIVE 
 
SIPDIS 
 
DEPT FOR EUR/SE 
 
E.O. 12958: N/A 
TAGS: ECON EFIN CY
SUBJECT: CYPRUS: Relatively Gloomy Economic Outlook 
 
REF: NICOSIA 594 
 
(U) This cable is sensitive but unclassified.  Please protect 
accordingly. 
 
¶1. (SBU) Summary.  Cyprus was late entering its current recession 
and it will be late exiting it.  Underlying structural problems 
(such as rigidities in the labor market - including exceptionally 
strong unions and a blanket wage indexation system - along with a 
large and extremely well-compensated civil service) have much more 
to do with Cyprus' current state of affairs than the global crisis 
which served as the trigger. Whether the government will be able to 
use this crisis to introduce some much-needed changes or just wait 
for the global economic climate to improve and hope for the best 
will be a major factor for the country's medium term outlook.  End 
Summary. 
 
Economic Outlook by the Numbers 
------------------------------- 
 
¶2. (U) While many countries are beginning to witness encouraging 
signs that the worst of the global financial crisis has passed, 
Cyprus seems far from a recovery.  The economy has been recording 
negative growth rates since the last quarter of 2008 - later than 
most economies - and is expected to close 2009 with a year-on-year 
contraction of up to 1.3 percent.  In Q3, the economy shrank 2 
percent, as most other EU economies began to emerge from recession. 
Growth in 2010 is expected to be only marginally positive for both 
Cyprus and the rest of the EU (between 0.1 and 0.5 percent for 
Cyprus, and around 0.7 percent for the EU 27 as a whole). 
 
¶3. (U) The numbers for the first three quarters of 2009 indicate the 
slowdown here accelerated throughout the year but conditions should 
not continue to deteriorate much more.  Credit expansion in 3Q 2009 
dropped to 6.9 percent - the lowest since November 2006 and 
appreciably less than the 24.6 percent recorded a year earlier.  The 
current account deficit reached 9 percent in the first half of 2009, 
still high but considerably better than last year's record-setting 
17.7 percent, which was abetted by exceptionally strong consumer 
demand for luxury imports. 
 
¶4. (U) During January-October 2009, tourism arrivals recorded a 
reduction of 11.1 percent, while tourism revenue (responsible for 11 
percent of GDP) was down 16.7 percent.   Property sales in 2009 were 
50 percent of those in the previous year, reflecting a complete 
absence of foreign buyers.  Property prices in Nicosia and Limassol 
have held up surprisingly well, propped up by domestic demand. 
However, property prices in areas relying heavily on foreign demand, 
like Paphos and Ayia Napa/Protaras, fell by as much 30 percent. 
 
¶5. (U) Unemployment reached 6.0 percent of the labor force in 
October 2009, from 3.6 percent a year earlier.  Although still lower 
than the average for the Eurozone countries (9.7 percent), Cyprus 
has not seen unemployment this high since 1976, when the Cypriot 
economy was still picking up the pieces from the 1974 events. 
 
¶6. (U) Inflation has slowed considerably during 2009 and is expected 
to reach 0.2 percent for the year, from 4.7 in 2008, largely on 
account of reduced international oil prices.  In 2010, inflation is 
expected to rebound to 2.6 percent. 
 
Public Finances Deteriorate 
--------------------------- 
 
¶7. (SBU) Public finances deteriorated significantly over the past 
year.  When the Christofias administration came to power less than 
two years ago, it inherited a fiscal surplus of 3.4 percent.  This 
surplus shrank to 0.9 percent in 2008, and swung into deficit in 
¶2009.  Until recently, the GOC claimed it would keep the deficit 
below 3.0 percent.  The Central Bank projects the deficit will reach 
3.5 percent in 2009 (possibly worse), and 5.7 percent in 2010.  If 
this scenario is realized, Cyprus will be placed under Brussels' 
supervision, in accordance with the EU's Excessive Deficit Procedure 
(EDP).  Five other EU countries (Greece, Malta, Ireland, Spain, and 
France) have already been placed under EDP supervision this year. 
Another eight EU countries (Cyprus' fellow Eurozone members Germany, 
Austria, Belgium, the Netherlands, Portugal, Slovenia, and Slovakia 
-- along with the Czech Republic, which is outside the Eurozone) may 
also be placed under EDP supervision.  Cypriots are concerned that, 
apart from losing face, being subject to EDP will mean increasingly 
strict public oversight regarding its budget, and more expensive 
foreign borrowing as the country risks a downgrade of its sovereign 
credit ratings if the deficits continue to mount. 
 
¶8. (SBU) Almost all of our business and economic sector 
interlocutors (including government economists) are incredulous that 
the government failed to plan for the rapid economic downturn.  They 
argue that instead of predicting the deterioration in public 
finances and working towards its amelioration, the government 
contributed to the problem by creating 1,100 new positions within an 
already bloated civil service.  During the recent Annual General 
Meeting of the politically powerful Cyprus Chamber of Commerce and 
Industry its chief, Manthos Mavrommatis, sternly called on the 
government (with President Christofias sitting in the front row) to 
reign in its payroll, citing the following figures: from 1990 to 
2009, the number of civil servants mushroomed from 33,978 to 51,787, 
while the civil service payroll exploded from Euros 372 million to 
Euros 2 billion.)  Quarter after quarter over the past year, Finance 
Minister Stavrakis kept revising his estimate for the deficit, 
costing him much credibility.  Instead of heeding the advice of 
Central Bank Governor Orphanides, who had warned about deteriorating 
public finances last year, Stavrakis chose to publicly differ with 
the conservative outlook of Central Bank, as well as the IMF, which 
he publicly disparaged. 
 
Stavrakis Kicks Off Discussion on Major Changes 
--------------------------------------------- ------ 
 
¶9. (SBU) More than the immediate problem of returning to growth, 
what disturbs analysts here (as well as the IMF in a June 2009 
report) are long-term problems: 
 
-- Return to growth in two of Cyprus' main economic pillars, 
construction/real estate and tourism, seems unlikely anytime soon. 
 
-- Structural inefficiencies in the economy (especially a bloated 
civil service, automatic cost-of-living adjustments, and high level 
of transfer payments) make Cyprus less competitive than many 
competing economies. 
 
-- Following often ill-advised government policies, e.g. locking 
increases in future government spending (by hiring civil servants 
and increasing pension payments), while cutting back on spending 
that would generate current economic activity or improve the 
economic infrastructure. 
 
¶10. (SBU) Minister Stavrakis now seems to be embracing the need to 
address these difficult issues.  Seeking to minimize the political 
fallout, he called a meeting with political leaders on November 30 
to seek their views and make proposals on how to improve public 
finances.  Stavrakis submitted five ideas aimed at cutting the civil 
service payroll.  His suggestions (radical by Cypriot standards) 
provided: 
 
-- Zero pay increases for civil servants (without specifying the 
duration); 
 
-- Reducing wages for new incoming civil servants; 
 
-- Trimming the size of the civil service by as much as 3 percent 
annually, entirely through attrition; 
 
-- Having new civil service employees contribute to their pension 
funds (unlike existing employees who make no payments into their 
pension fund); 
 
-- Limiting overtime (by introducing a "ceiling" on the number of 
overtime hours). 
 
¶11. (SBU) After the meeting, Stavrakis said everyone recognized the 
existence of "an ongoing structural problem with the public finances 
of Cyprus, with state expenditure increasing at a faster rate than 
revenue, causing a long-term, structural budgetary problem." 
Outside of the meeting, Stavrakis focused on discussing ways to 
increase the rate of tax collection (without increasing tax rates). 
He accused wealthy doctors and lawyers of evading taxes which, if 
collected, Stavrakis claims would go a long way towards solving the 
budget problems. 
 
¶12. (SBU) Stavrakis also used the meeting to sound out political 
party leaders about amending the Cost of Living Allowance (COLA). 
COLA has been a long-standing institution in Cyprus, providing 
employees across the board with wage increases twice a year to 
compensate for inflation.   Many economists, including from the IMF, 
have called for its amendment or abolition over the years, only to 
encounter vehement opposition from local unions.  If nothing else, 
the current economic climate has convinced three major parties 
(including communist AKEL) that the time has come for a dialog on 
amending COLA.  One idea currently being considered is to introduce 
a tiered COLA, thereby maintaining full wage indexation only for 
lower-wage employees, and reducing it further up the income scale. 
In previous years, AKEL refused to discuss any change to the COLA. 
 
 
Greek Downgrade Sends Ripples Through Cypriot Banks 
--------------------------------------------- ------ 
 
¶13. (SBU) Despite a slight rise in domestic non-performing loans and 
slow loan growth, the Cypriot banking system appears sound with 
adequate reserves and capital.  However, Cypriot banks, with their 
large exposure to the Greek market through their Greek branch 
systems, are watching recent developments in that country anxiously 
in the wake of the downgrading of Greek risk.  In addition to 
growing bad loans from their Greek customers, Cypriot banks will 
have to write down the value of Greek bonds held in their 
portfolios, with a corresponding hit to bank profitability. 
 
¶14. (SBU) The Greek downgrade also dashes hopes for interest rate 
reductions in Cyprus.  Domestic rates remain stubbornly above those 
in most of the rest of the Eurozone by as much as 200 basis points. 
This is due, in large part, to Greek bank branches in Cyprus 
aggressively trying to attract local deposits to help fund their 
parent companies.  The recent GOC decision to issue three-year bonds 
valued at Euro 3 billion to increase liquidity and drive rates down 
was a welcome, albeit belated, response to tightening liquidity in 
Cyprus. 
 
¶15. (SBU) Comment: While Cyprus entered its current recession on the 
heels of the global crisis, getting out will have much more to do 
with addressing Cyprus' long-standing, underlying structural 
problems than with global conditions.  In many ways, Cyprus is at an 
economic crossroads.  There is a growing realization among 
politicians and the public that past models will not work in the 
future - there is no longer a currency that can be used to gain 
competitiveness and EU rules limit other tools that in the past 
could have been utilized.  Tourism has limited potential as an 
economic driver and the island has priced itself out of the EU real 
estate game.  The financial services sector continues to be a bright 
spot but it, too, is under some strain as labor costs rise.  In 
short, the Cypriot economy may need to re-invent itself.   End 
Comment. 
 
COHEN