Financial centre holds out against the storm

Stelios Orphanides

Although Cyprus has become a thriving financial centre in the eastern Mediterranean, the economy has not been immune to the problems affecting its EU neighbour, Greece, and there have been recent concerns about the outlook for the island’s key tourism industry

After the downturn that hit all European Union (EU) economies in 2009, Cyprus was among those countries that managed to return to economic growth in 2010. After shrinkage of 1.7 percent in 2009, growth of 0.9 percent was recorded in 2010, and the forecast for the current year is for a still modest 1.5 percent. Helping the economy to weather the storm triggered by the global financial crisis has been the country’s growing financial sector. This now comprises seven domestic banks, more than 30 foreign banks and nearly 100 licensed investment firms. Even in the difficult year of 2009, the financial sector managed to buck the downward trend and register growth of 4.7 percent.

A combination of factors lie behind this phenomenon. Cyprus boasts an advanced business service sector, with professional law and accounting offices, and a robust banking system, plus the country has been a member of the euro area since 1 January 2008. Cyprus also has double taxation agreements with 45 countries, enabling overseas companies with operations on the island to benefit from the low-tax environment.

The renewal of the double taxation agreement with Russia, a key partner, was an important boost to the financial service sector. Nearly one-third of the €70 billion overall deposits in the island’s banking system currently belongs to non-residents, mainly Russian and other eastern European citizens or entities, who use Cyprus as a base for financial transactions with Russia. In 2008, investment in Russia through Cyprus peaked at $34 billion.

“Cyprus is an open economy based on services and in particular on the extroversion of the banks,” says Michalis Sarris, a former Minister of Finance who helped the island state adopt the euro. “This allowed us to enjoy relatively high growth rates over a long period of time. And in order to do that, you must expose yourself to certain risks, but at the same time you need to have sound public finances to inspire confidence in investors that the government will be in position, if needed, to support the banks.”

Cyprus’s overexposure to the problems of the Greek economy has, however, raised inevitable concerns. Loans to Greek clients of the three major Cypriot banks amounted to 41 percent of their total portfolio last June and non-performing loans were expected to rise substantially.

Cyprus’s own public finances have also been affected by the recent economic slowdown. Even though the government managed to slash the fiscal deficit to 5.5 percent of GDP in 2010, down from 6.1 percent the year before, rating agencies have remained sceptical. The further narrowing of the budget deficit to around 4 percent in 2011 may be unattainable as the government appears hesitant to cut the public payroll and social spending, which make up two-thirds of total government expenditure. But a scenario in which Cypriot banks need fiscal support remains remote, according to the International Monetary Fund. “If problems emerge, they are more likely to be related to liquidity rather than solvency,” Wes McGrew, deputy division chief at the IMF said in February. Such problems, he added, could be dealt with through extra liquidity from the European Central Bank.

A more direct impact of the global financial crisis on the Cypriot economy came via the economic slump in the UK, Cyprus’s main source of holiday home-buyers and tourists. In 2009, the number of property transactions involving foreigners fell to almost half of the2008 levels, before recovering tentatively in 2010, thanks to an increase in Russian buyers. The number of British travellers, who make up roughly half of total arrivals, fell by 14 percent in 2009 resulting in a decrease in overall tourist numbers and revenue from spending of 11 percent and 17 percent respectively. In 2010, a further decline in the number of visiting Britons was offset by a 51 percent increase in arrivals from Russia – Cyprus recorded a 1.5 percent rebound with almost 2.2 million visitors.

Directly or indirectly, tourism comprises around a quarter of the Cypriot economy but the industry’s prospects may not depend on economic factors alone. Politics, especially following the recent uprising in several Arab countries and the uncertainty this has caused in the region, could play an important role in the island’s economic performance. “Let us hope that these events will not affect the eastern Mediterranean’s image in the eyes of tourists,” said Alecos Orountiotis, chairman of the Cyprus Tourism Organisation, the state-sponsored tourism board.

Uncertainty also characterises Cyprus’s energy policy as the country urgently looks to reduce its reliance on heavy fuel oil for power generation. The share of renewable energy sources is very small, with the first wind farm only just joining the grid. In December, the Natural Gas Public Company (DEFA) set out plans for a natural gas supplier to cover future power generation needs. Meanwhile, the state-owned Electricity Authority of Cyprus (EAC), owner of 50 percent of DEFA, has been looking for a strategic partner for a planned degasification terminal, the building of which could cost around €500 million. But such moves have been stalled since the Israeli Delek Group proposed the construction of a pipeline linking Israel’s offshore gas findings to a liquefaction plant to be constructed on Cyprus’s southern coast. The planned installation of a drilling well in Cyprus’s exclusive economic zone by the US-based Noble Energy Inc – scheduled for completion by the end of the first quarter of 2012 – may also further delay the decision-making process, as probable natural gas findings here could change the picture once more.

“There is lack of planning in the energy policy,” former finance minister Michalis Sarris said, expressing doubts about whether power producer EAC will have the funds to embark on such ambitious projects. “Even following the recent increases in basic electricity tariffs, the EAC will still have to borrow money to finance its investments.”

Cyprus is blessed with natural resources and an ingenious business community, which helped transform its agrarian economy into a modern, service-oriented one. Yet, the island will have to carry out more economic reforms if it is to start, once again, to produce quality jobs and combat unemployment, which has now risen above the 7 percent mark for the first time in three decades.

Its politicians will also have to find a way to reunify the island, something that will offer the economy a substantial peace dividend. Cyprus’s maritime industry, which constitutes around 5.5 percent of the economy, currently suffers under the Turkish ban on Cypriot shipping. This could be one of the sectors that would benefit the most from reunification, especially since the European Commission has approved the island’s fully revised shipping taxation system. But, for the moment at least, it is only a hope for the future.

About the author:

Stelios Orphanides is a journalist based in Nicosia


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