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Depressing outlook for Cyprus’ economy

On Thursday, the European Commission revised its forecasts for the Cypriot economy downwards and it expects that recovery will start in the second half of the year.

European Commission Interim forecast February 2012

Cyprus

The Cypriot economy grew by a modest 0.5% in 2011. After a good first half year when GDP rose by 1.5% year-on-year thanks to an exceptionally good tourist season, economic activity was badly affected by the accident in July that destroyed the Vassilikos electricity producing plant, which accounted for half of the total generating capacity of Cyprus.

Moreover, a worsening external environment and tightening financial and fiscal conditions compounded the adverse effect on economic activity.

Domestic demand, traditionally the main driver of growth, shrank in 2011. Tightening bank lending conditions along with a worsening labour market outlook and weakening confidence weighed on private consumption. In addition, weak foreign demand for housing and a restructuring of corporate balance sheets kept investment on a correction path for a third year in a row.

On the other hand, the external sector made a positive contribution to growth. Tourist arrivals and revenues posted an increase of 10% and 13% respectively. This was due to political instability in competing Mediterranean destinations and an increased flow of arrivals from developing markets such as Russia. Also, import growth decelerated, in line with the contraction in domestic demand.

GDP is projected to contract by 0.5% in 2012 due to weak domestic demand. The downward revision relative to the autumn 2011 forecast is explained by the worsening of the external environment and by the adoption of additional consolidation measures, not accounted for in the autumn 2011 forecast.

Furthermore, the deterioration in financial markets and the tightening of credit conditions may raise the cost of financing to the private sector and limit access to it. Leading indicators point to weak albeit improving consumer and business confidence. This suggests that recovery should set in slowly, during the second half of 2012, with the improvement of the external environment, the start of the tourist season and the resumption of investment projects as uncertainty dissipates.

Housing investment is expected to remain weak, while other construction investment is likely to benefit from reconstruction work in the destroyed Vassilikos power station and from other infrastructure projects. Moreover, the contribution of the external sector to growth is set to remain positive.

While slowing global trade and worsening economic prospects in Cyprus’ main trading partners is likely to weigh on exports of goods, this is expected to be partly offset by the healthy performance in business services and tourism. Imports are set to decline, against a backdrop of weak domestic demand.

The Harmonised Index of Consumer Prices (HICP) inflation is projected to decline to 2.8% in 2012 from 3.5% in 2011 on the back of easing commodity prices combined with weakening domestic demand. Furthermore, the base effect of increased electricity prices is set to dissipate in the last quarter of the year. Core inflation is forecast to remain contained at about 1.8%.

Overall, risks appear to be balanced. On the one hand, greater spillovers from potential worsening conditions in Greece, due to the large exposure of the financial sector, are substantial. Also, tightening credit conditions, coupled with already-higher financing costs and the high indebtedness of private agents, could delay the rebound in consumption and investment.

On the other hand, external demand may strengthen more than expected if the announced strategic plans by the Cyprus government for attracting more tourists and foreign investors succeed (e.g. plans for the introduction of new destinations, for tourist traffic growth, and incentive schemes for winter tourism). Investment, for its part, may be sustained through various announced construction and infrastructure projects.

For the whole of the Euro area, the Commission expects a recession of 0.3% compared with its initial forecast of a 0.6% growth.