According to recent press release published by EYCyprus, the main risk to the outlook is a slide into deflation, which would have an adverse impact on the growth outlook. According to the spring EY Eurozone Forecast (EEF), the GDP is expected to contract by 4% this year and by 0.5% in 2015, before a return to growth in 2016, a year earlier than the forecast had expected in Winter. Nevertheless, the headwinds facing the economy remain strong. Consumption is still under pressure from rising unemployment, fiscal consolidation and falling wages. The EEF expects consumer spending to return to growth until 2016, by which time it will be more than 15% lower than its pre-crisis peak.
Investment is also suffering from fiscal consolidation efforts. Sharp cuts in public capital expenditure alongside restricted access to credit due to a fragile financial system caused investment to drop by an estimated 20% in 2013, with a further 8% decline expected in 2014. The fiscal consolidation program remains on track, with the authorities receiving positive comments from the major credit agencies and even an upgrade from Standard & Poor’s in November. However, against the backdrop of sharply declining economic activity, implementation risks to the program remain, particularly if Cyprus experiences the levels of social unrest seen in other countries that have undergone painful adjustments.
While the prospects are not as bleak as initially thought, the outlook remains highly uncertain. In particular, the financial system is still vulnerable, due to the high level of non-performing loans. Banks’ continuing efforts to shrink their balance sheets could also delay the fragile recovery. With the external accounts now improving, the main risk to the outlook is a slide into deflation, which would have an adverse impact on the growth outlook because of the high levels of debt in the public and private sectors.