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RR RUEHWEB

DE RUEHNC #0447/01 1650846
ZNR UUUUU ZZH
R 130846Z JUN 08
FM AMEMBASSY NICOSIA
TO RUEHC/SECSTATE WASHDC 8867
INFO RUEHBS/USEU BRUSSELS
RUEHTH/AMEMBASSY ATHENS 4018
RUEHAK/AMEMBASSY ANKARA 5207
RUCPDOC/USDOC WASHDC

UNCLAS NICOSIA 000447 
 
SENSITIVE 
 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN CY
SUBJECT: CYPRUS: Global Economic Turmoil Takes its Toll 
 
REF: 07 NICOSIA 949 
 
(U) This cable is sensitive but unclassified.  Please treat 
accordingly. 
 
¶1.  (SBU) Summary.  Rising oil and food prices and the global 
economic turmoil is finally taking its toll on Cyprus.  Cyprus is 
going to have to live with slower growth rates (albeit, still double 
that of the EU average), and to forget about fiscal surpluses. 
However, the main threat is inflation, which recorded a five-year 
high in May.  Faced with a sharp deterioration in the economy and in 
its own finances, the government seems to be anxiously pressing all 
sorts of economic buttons in a search for additional revenue to fund 
the social programs it promised during the election campaign. The 
good news is that, thus far, the economy continues to grow, consumer 
and business confidence remain robust, and the government's lack of 
finesse has been limited to revenue enhancement in ways that do not 
affect Cypriot companies or consumers.  End Summary. 
 
Inflation on a Five-Year High 
----------------------------- 
 
¶2.  (SBU) Less than four months after coming to power (February 24), 
the Christofias administration is facing a considerably bleaker 
outlook for the Cypriot economy, primarily due to the deteriorating 
external environment.  As in the rest of the EU, inflation is the 
main concern.  Year-on-year inflation reached a five-year high for 
Cyprus of 4.9 percent in May 2008, against 2.2 percent in May 2007. 
Domestic price increases have been particularly strong in housing 
and utilities, including electricity (7.3 percent); transportation 
(6.5 percent); and foodstuffs 6.4 percent).  Depending on how oil 
and cereal prices behave over the next few months, year-end (2008) 
inflation in Cyprus is expected to be above 4.0 percent. 
 
¶3.  (SBU) According to Eurostat, inflation in the EU 27 for April 
(latest month available) averaged 3.6 percent, against 4.3 percent 
in Cyprus.  One of the main reasons inflation is higher in Cyprus 
than in the rest of the EU is Cyprus' complete dependence on 
imported oil.  Eurostat placed Cyprus at the very top of the list of 
EU 27 countries in terms of oil dependency, with an overall 
dependency score of 100.7 percent, against an EU average of 52.7 
percent.  Public transport in Cyprus, whether inter-city or 
intra-city is virtually non-existent, so Cypriots rely almost 
exclusively on privately-owned vehicles for their transportation 
(with a resident population in the south of 780,000 people, Cyprus 
has around 600,000 registered motor vehicles).  Additionally, Cyprus 
has done little to adopt renewable or more environment-friendly 
energy sources (like natural gas), falling far short of its Kyoto 
commitments to the European Commission. 
 
¶4.  (SBU) Further exacerbating inflation is the legally-mandated 
Cost of Living Allowance (COLA).  The COLA adjusts wages fully for 
inflation twice a year.  It covers employees across the board and is 
considered a sacred cow by unions, which wield considerable power in 
Cyprus, with support from most political parties.  Anyone suggesting 
 
that the COLA should be amended gets pilloried immediately, as 
Central Bank Governor Orphanides found out recently (reftel).  The 
result is a wage indexation system that most economists here believe 
may be good for the employees' sense of social justice but is bad 
for the economy's competitiveness and feeds inflation and the 
bloated government payroll. 
 
Construction, Tourism, and Retail Trade Down 
------------------------------------------- 
 
¶5.  (SBU) Building permits issued during the period January-March 
2008 recorded a 16.2 percent decrease compared to the corresponding 
period of 2007.  The total value of these permits decreased by 8.9 
percent, and the total area by 11.3 percent.  Government tax revenue 
from property transactions also took a 17 percent nosedive in the 
first four months of 2008 compared to the same period in 2007.  Yet, 
property prices in Cyprus have risen by 3.3 percent during the first 
quarter of 2008, with just a hint of a slow-down in March, defying 
the global pattern, at least for the time being.  Faced with a 
property slowdown, the Central Bank in early June lifted 
restrictions on property loans for second homes, imposed a year 
earlier when the property market was still booming. 
 
¶6.  (SBU) Tourism revenue, the life-blood of the Cypriot economy, 
recorded a 5.0 percent decrease during the first four months of 
2008, largely because of a 12.2 percent decrease in spending per 
head by British tourists who constitute Cyprus' main market. 
Cyprus' competitiveness in this crucial sector has been eroding over 
the last seven years, due to increasing overheads and increasing 
competition from such nearby markets as Turkey and Croatia. 
 
¶7.  (SBU) Meanwhile, retail consumer spending also seems to be 
slowing down.  According to the Cyprus Department of Statistics, the 
Value Index of Retail Trade fell from 147.5 points in January 2008 
to 145.4 points in February in a reversal from a multi-year upward 
trend. 
 
Loans and Foreign Travel Up 
--------------------------- 
 
¶8.  (SBU) At the same time, rather incongruously given the apparent 
slow-down in the economy, bank lending is at an all-time high. 
Credit expansion has been very strong since the beginning of the 
year, exceeding 30 percent.  By April 2008, total lending surged by 
a record 35.4 percent to Euros 44.5 billion in April 2008, compared 
to April 2007.  The two main components of this increase have been 
loans to businesses (non-financial institutions), which rose by 47.3 
percent and housing loans, which rose by 38.0 percent.  In 
particular, lending to businesses reached Euros 21.5 billion in 
April 2008, roughly twice the April 2006 level (Euros 12.7 billion). 
 According to banking sources, increased business lending went 
towards financing business development and expansion plans as well 
as to provide extra liquidity.  Interestingly, Cypriot businesses 
are borrowing at an interest rate of 6.63 percent - one of the 
highest in the EU, against a Eurozone average of 5.91 percent. 
Banks and analysts are warning businesses to be very mindful of the 
risks involved in increased borrowing, especially during a period of 
economic turmoil.  Over the same period, total bank deposits reached 
Euros 55.4 billion in April 2008, recording an increase of 24.5 
percent. 
 
¶9. (SBU) Another sign that the Cypriot economy is not in a recession 
is that travel abroad by Cyprus residents during the first four 
months of 2008 recorded a 15.2 percent increase, and there has been 
no increase in unemployment. 
 
Growth Down, Fiscal Surplus Vanishing Quickly 
--------------------------------------------- 
 
¶10.  (SBU) Against this backdrop, the Ministry of Finance recently 
revised downwards its economic performance targets for 2008.  The 
rate of growth, estimated at 4.0 percent in February, is now 
anticipated to reach only 3.5 percent.  This is still about twice 
the EU average but it marks a considerable deceleration from last 
year's 4.3 percent growth. 
 
¶11.  (SBU) Just a few months ago, the government was expecting a 
fiscal surplus of 0.5 percent for 2008, following last year's 
surplus of 3.3 percent.  In early June, Finance Minister Stavrakis 
said that ending 2008 with a surplus would be challenging. 
Government revenue from the once-booming property market, was down 
17 percent in the first four months of 2008.  On the expenditure 
side, the government paid out Euro 33 million to pensioners as an 
Easter bonus, as soon as it come to power.  The government will also 
need to spend Euro 30 million on a civil service pay increase and 
another Euro 40 million for the importation of water via tankers 
from Greece to deal with the current severe drought. 
 
¶12.  (SBU) In an effort to stay in the black, the government has 
turned its attention to past-due taxes amounting to Euros 480 
million.  However, up to a third of this is probably not recoverable 
since the businesses owing the taxes are now bankrupt.  The biggest 
debtor to the government, at least from the government's point of 
view, is the Church of Cyprus. 
 
Government Confronts Church Over Taxes 
-------------------------------------- 
 
¶13.  (SBU) In early June, the government and the Church had a very 
public confrontation over whether or not the Church owes the state 
any taxes.  The Ministry of Finance claims that the Church owes 
Euros 111 million in taxes (Euros 58 million property tax, Euros 
10.2 capital gains, and Euros 42.7 million in past taxes). 
Archbishop Chrysostomos stridently denied that the Church was a tax 
dodger, pointing to an agreement with the previous administration 
dated December 27, 2005, which, according to the Archbishop, settled 
this matter once and for all.  Chrysostomos concluded: "They are not 
getting a single Euro out of us; we do not owe them anything." 
During the exchange, both sides exchanged some rather pointed 
comments, including the Archbishop blasting the government for 
populist antics.  Previous administrations have also tried to get 
the Church to pay taxes, but this is the first time the 
confrontation between them has been so acrimonious. 
 
¶14.  (SBU) As a result of the confrontation, the Church felt 
compelled to call a press conference and disclose, for the first 
time ever, the full picture of its finances.  According to this 
disclosure, at the end of 2007, the Church had fixed assets of Euros 
1.1 billion, including Euros 600 million in property holdings; Euros 
58 million in hotels, and Euros 383 million in shares and other 
investments.  By the Archbishop's own admission, the property figure 
is based on older valuations; a more current valuation would raise 
the property figure to "billions of Cyprus Pounds."  Comment: The 
issue seems to revolve around whether property taxes are payable by 
the Church on its vast (for Cyprus) unutilized property holdings. 
The Church had previously agreed to pay taxes on income earned from 
its holdings in brewery, hotel, winery, and banking operations on 
the island. End Comment. 
 
Government Eyes Central Bank Gold 
--------------------------------- 
 
¶15.  (SBU) On June 7, Finance Minister Stavrakis met with officials 
from several parties regarding the economy.  Stavrakis warned 2009 
would be a hard year for the economy.  He explained that a fiscal 
surplus would be unlikely for 2009, and the government was focusing 
on keeping the deficit to a minimum.  Stavrakis noted further that, 
based on current conditions, the government would be in a position 
to undertake only about 40 percent of the development programs it 
had pledged to carry out for the next five years. 
 
¶16.  (SBU) Stavrakis used this as an introduction to recruit 
cross-party support to the government's effort to require the 
Central Bank to sell off its gold reserves, which amount to Euros 
250 million.  According to the press, the government has been trying 
for the past two months (initially behind the scenes, but publicly 
since the story was leaked to the press on June 8) to convince the 
CB to sell off its gold reserves to "realize a profit."  Existing 
legislation stipulates that, if the CB sells off reserves, the 
proceeds are to be divided as follows: 80 percent to the 
government's consolidated fund, and 20 percent to the CB's reserves. 
 Based on this provision, the press speculated that the government 
intended to keep Euros 200 million for itself, and give the CB the 
remaining Euros 50 million.  The government quickly responded that 
this was not its intention at all and that it wanted to sell the 
gold in order to help pay off the public debt to alleviate the 
burden on the economy.   (Comment: This excuse is probably nothing 
but an afterthought on the part of the government.  At Euros 8.6 
billion or 52.5 percent of GDP, Cypriot public debt is quite 
manageable and on its way down without any extra help.  It is also 
within the Maastricht ceiling of 60 percent.  End Comment.) 
 
¶17.  (SBU) The CB has resisted this effort.  (Some have even 
suggested that this refusal was the real reason behind the recent 
tension between the government and CB Governor Orphanides, and not 
his suggestion to amend the COLA.)  With the exception of the ruling 
AKEL party and its coalition partner DIKO party, none of the parties 
expressed support for selling off gold reserves.  Opposition party 
DISY, in particular, launched severe criticism against the 
government's intention.  Challenged to comment on why the government 
was pursuing this issue at this point in time, Stavrakis responded, 
"We are a new government; we have every right to start with a clean 
slate and examine things critically." 
 
¶18.  (SBU) We asked a senior CB contact for comment.  He responded 
that the CB's main policy guideline when it came to managing its 
reserves, vis-`-vis the European Central Bank, was that the CB 
maintained "adequate" reserves to conduct its business and meet its 
obligations.  He stressed further that the CB was not a speculative 
institution - it manages Cyprus' reserves with a view to hedge 
against risk and to keep enough for a rainy day, in case of a real 
catastrophe.  (Cyprus' official international reserves were around 
Euros 4.0 billion at the end of 2007; gold makes up only about 6.0 
percent of this.)  He described the government's suggestion to sell 
off gold now to realize a "profit" as "misguided" at best, given 
that the government is not facing an immediate or dire fiscal 
deficit.  He also commented that the debate over the gold reserves 
should have been kept away from the public domain.  If nothing else, 
the media are often not sufficiently informed about these issues. 
Furthermore, he noted, to even call this a "profit" (given that gold 
now sells for USD 900 an ounce, compared to USD 40 an ounce when 
acquired in 1963) - as the papers have done quoting AKEL sources -- 
betrays a basic lack of understanding of the CB's role. 
 
¶19.  (SBU) Comment: When this administration won the February 24 
election, the Cypriot economy was in a clearly enviable state.  Less 
than four months later, this is true only in relative terms:  high 
inflation, a quickly-vanishing fiscal surplus, restrained 
consumption, and a rapidly-slowing growth rate make up the present 
picture.  It may be tempting to blame the present administration for 
the significant deterioration in the economy since the February 24 
Presidential elections.  However, the truth is that the government 
took over just at a time when the Cypriot economy was already poised 
to decelerate due to the deteriorating external circumstances. 
 
 
¶20.  (SBU) Comment Continued.  Far from being in a recession, the 
Cypriot economy continues to grow at a satisfactory level, 
especially compared to the rest of the EU.  So the real issue here 
is not so much how bad the economy is but rather with what confusion 
the government seems to be reacting to its first unfolding economic 
crisis.  By most people's reckoning, its reaction so far can only be 
described as "clumsy."  Simultaneously pressing the hot buttons of 
both the Church and the Central Bank has unified those from a very 
broad political spectrum to question the new government's economic 
management skills. Most disturbingly, the Finance Minister, who as a 
senior banker was brought in to lend his economic credentials to the 
nominally communist regime, is seen by many as failing to restrain 
the non-orthodox economic tendencies of his government.  End 
Comment. 
 
SCHLICHER