The EC also expects the debt to GDP ratio to drop to 105.4% in 2017, while the budget will retain positive primary balance of 2.2% and 2.4% respectively.
That is the main macroeconomic scenario described in the spring economic forecast of the European Commission, as presented recently in Brussels by Commissioner Pier Moscovici.
Risks remain positively balanced and despite headwinds from the external environment, export growth is forecast to strengthen further. The strong growth in the tourist sector observed in 2015 has extended into the first part of 2016, benefiting from geopolitical tensions in neighbouring countries. Bookings from British tourists appear strong despite the depreciation of the pound. In 2017, growth should gain further strength.
According to the EC, labour market conditions in Cyprus are forecast to improve further. Wage growth is expected to remain moderate, as suggested by the recent collective agreement for the hotel industry.
Oil prices continue to remain low and are forecast to weigh further on energy prices in 2016, due to base effects. Excluding the more volatile components such as energy and unprocessed food, consumer prices are forecast to decline marginally in 2016.
The Commission notes that growth has resumed in Cyprus and is expected to slowly gain strength with labour market conditions improving in parallel. The economy continues to benefit from low energy prices.
Service exports, in particular tourism, appear resilient to the challenging external environment. The general government balance is also expected to improve, supporting debt reduction.
Cyprus’ economy emerged from recession in 2015, with real GDP growth reaching 1.6%. In 2015, nominal spending by households stabilised but declining consumer prices allowed households to consume more in real terms, providing a significant boost to real GDP growth.
Investment, particularly in transport equipment, increased rapidly in 2015, mainly reflecting an elevated number of ship-registrations, which, however, was completely offset by an associated increase in imports of ships. The weaker euro, combined with ongoing structural reforms in the tourism sector, provided significant support to service exports. Labour market conditions improved but continued slack in the economy and declining energy prices kept HICP inflation in negative territory in 2015.
In detail, the spring forecast on Cyprus cites that:
Real GDP growth is forecast to remain broadly unchanged in 2016 before picking up to 2.0% in 2017. The support from declining consumer prices and the weaker euro is expected to abate. Debt servicing is expected to increase, due to a higher pace of restructuring of bad loans. This should help reduce non-performing loans but weigh on private consumption. Investment should benefit from the recent stabilisation of the housing market and a further normalisation of credit intermediation to businesses. Investment activity should nevertheless remain constrained by the high deleveraging needs of the economy. Furthermore, following the large ship-registrations in 2015, investment growth is expected to slow down in 2016.
As the downward pressure from energy prices abates and demand picks up, HICP inflation is forecast to return to positive territory in 2017.
On the upside, declining consumer prices could support consumption and exports more than expected. On the downside, the continued weakening of external demand and developments in the pound sterling may weigh more on export growth than envisaged. The modest improvements in labour market conditions and the slow pace of reducing non-performing loans in the banking sector may lead to a prolonged period of tight credit conditions, which would dampen the recovery.
In 2015, the general government primary balance continued to improve. It reached a surplus of 1.8% of GDP, with a general government deficit of 1.0%. This incorporates a one-off effect from the 2015 recapitalisation of cooperatives (1% of GDP). Excluding the effect of banking recapitalisations, in 2015, the primary balance improved marginally (by 0.2 percentage points (pps) of GDP to 2.8%), on the back of continued control on public expenditure and despite negative factors beyond the control of the government, notably new location rules regarding VAT on e-commerce services, lower taxes on interest due to reduced deposit rates and a decrease in dividend income from the Central Bank of Cyprus (CBC). In parallel with the primary balance, the headline balance also improved marginally (by 0.2 pps of GDP to 0.0%).
The general government primary surplus, excluding the effect of banking recapitalisation, is forecast to decrease to 2.2% in 2016 and then increase to 2.4% of GDP in 2017. The decrease in 2016 is largely driven by a drop in revenue related to the continued normalisation in the banking sector. Given the expected continued reduction in deposit interest rates, taxes on interest are forecast to continue to fall. The reduced level of the emergency liquidity assistance is expected to continue reducing CBC dividend income.
In 2017, the improvement in the general government primary surplus is largely based on the improving economic outlook. In 2016, total primary expenditure is expected to remain constrained by the continued freeze of pensions and wages, while in 2017, this expenditure is expected to grow by less than the nominal economic activity due to the revised mechanism of its indexation. In 2016 and 2017, interest expenditure is forecast to decrease.
The structural balance in 2016 is expected to worsen, as it is less supported by the cyclical component, reflected in the output gap. The latter narrows in 2016 and eventually turns positive in 2017. The headline balance improves by less than the economic cycle.
The debt-to-GDP ratio is projected to gradually decline, reaching 105.4% in 2017. This reduction is supported by economic growth and primary surpluses.