CYPRUS ON TRACK TO ADOPT EURO ON JANUARY 1, 2008

UNCLAS NICOSIA 002033

SIPDIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EUN CY
SUBJECT: CYPRUS ON TRACK TO ADOPT EURO ON JANUARY 1, 2008


(U) This cable is sensitive but unclassified. Please treat
accordingly.


1. (SBU) Summary.

The Cypriot economy continues to perform well within the Maastricht
criteria, and the European Union is expected in June 2007 to invite
Cyprus to adopt the Euro as its currency effective January 1, 2008.
The European Commission, however, has criticized the GoC's technical
preparations for the transition for lacking detail and has urged
Cyprus to be more proactive in addressing public fears over expected
price increases. The latest Eurobarometer poll showed 58 percent of
Cypriots "very or rather unhappy" about losing the Cypriot pound,
compared to 52 percent in April. A public information campaign,
however, has been delayed until at least January as unsuccessful
bidders for the lucrative contract have challenged the results of
the tender.


2. (SBU) The communist AKEL party, the largest party in the
governing coalition, continues to make occasional noises about the
desirability of delaying Euro adoption for a year. This, however,
is widely dismissed as political posturing, and the Council of
Ministers (including those Ministers appointed by AKEL) continues to
unanimously back the January 1, 2008 target date. The adoption of
the Euro will remove any debate over what currency a future united
Cyprus should use, removing at least one of the many contentious
issues that help keep Cyprus divided. While some in the Turkish
Cypriot community have suggested that the north should
simultaneously adopt the Euro, this has received little support from
the Turkish Cypriot authorities, Turkey, or even the EU. That said,
retailers in the north will gladly accept Euros, Cypriot and British
pounds, or any hard currency rather than Turkish lira. End Summary.


Euro Adoption in 2008 "now a near certainty"


3. (SBU) The latest Economist Intelligence Unit report on Cyprus
noted that Cypriot adoption of the Euro on January 1, 2008 is "now a
near certainty." Senior Cypriot officials remain very confident
that, barring any unexpected sharp increase in fuel prices,
inflation can be kept under control, and Cyprus will continue to
meet all the prerequisites necessary to qualify for Euro adoption.
These prerequisites are known commonly as the Maastricht criteria.



4. (SBU) Finance Minister Michalis Sarris told us that Cyprus will
formally apply for Eurozone membership only in February, honoring
Economic and Monetary Affairs Commissioner Almunia's request to
allow more time for Malta to catch up. The European Commission will
then prepare a recommendation that will be considered first by the
European Council's Economic and Financial Committee and then by
ECOFIN. A final invitation will need to be endorsed by the
Parliament and EU Heads of State. Finance Minister Sarris told the
Ambassador that he hoped to have the whole process wrapped up at the
June 2007 European Council meeting. Central Bank officials told us
that Cyprus frequently has asked for and received assurances from
the EU that Cyprus's adoption of the Euro will not be delayed should
Malta prove unready, and that each country will be allowed to go at
its own pace.

Cyprus Comfortably Meeting All Five Maastricht Criteria


5. (SBU) Rapid adoption of the Euro has been the main economic
priority of the Papadopoulos Administration and has led to a degree
of fiscal discipline previously unheard of in Cyprus. Supported by
strong economic growth of nearly 4 percent annually since 2004, the
GoC has succeeded in cutting its budget deficit from over 6 percent
of GDP in 2003 to an estimated 2 percent in 2006 -- well below the
Maastricht criterion of 3 percent or less. The GoC has also
significantly cut its national debt from 72 percent of GDP in 2004
to 65 percent in 2006. (Note: The Maastricht criterion requires 60
percent of GDP or a "sufficiently declining trend." While there is
no clear definition of what "sufficiently declining" means, Cypriot
Central Bank officials tell us that Commission officials assure them
that Cyprus meets it. End note.)


6. (SBU) At present, Cyprus is also comfortably meeting the
Maastricht criteria for inflation (being under 1.5 percentage points
above the average of the Eurozone's three best performers) and
interest rates (having the interest rate on ten-year bonds plus two
percentage points fall below the average ten-year interest rate of
the Eurozone's top three inflation performers). Cyprus's current
rolling 12-month inflation rate of 2.3 percent easily falls below
the current Maastricht reference rate of around 2.7 percent, as does
Cyprus's 4.2 percent long-term interest rate (compared to the
current Maastricht reference value of 6.1). On May 2, 2007, Cyprus
will have also completed the necessary two years within the Exchange
Rate Mechanism II (ERM II). So far, Cyprus has successfully
maintained its parity of 0.585274 Cypriot pounds to the Euro well
within the permitted band of 2.5 percent either way.

Concern Over Pace of Technical Preparations


7. (SBU) While the European Commission has applauded Cyprus's
progress toward meeting the Maastricht criteria, it has not been shy
to criticize the GoC's technical preparations for the transition to
the Euro. The GoC envisages a "big bang" scenario with a dual
circulation period for both the euro and the Cyprus pound for a
period of one month after January 1, 2008. Commercial banks will
exchange Cyprus pound banknotes and coins free of charge until June
30, 2008. The Central Bank will exchange national coins free of
charge until the end of 2009 and national banknotes until the end of

2017. Dual pricing in Cypriot pounds and Euros will be mandatory
from September 1, 2006 until July 31, 2008. Though utilities and
large retailers are displaying both currencies, few of the
ubiquitous small businesses are doing so. Central Bank Officials
expect that the final rate at which the Cypriot pound will be
converted to the Euro will be set in May 2007. Cyprus has also been
receiving technical assistance from the Governments of Ireland and
Greece.


8. (SBU) In its regular, bi-annual Convergence Report, dated
November 10, 2006, the European Commission criticized Cyprus's
changeover plan for being short on detail, especially on issues such
as distributing Euros to commercial operations prior to the
changeover and how to handle the backflow of national cash. It also
warned that a relatively protracted period of free exchange of
Cyprus pounds by commercial banks sent an ambiguous message to
consumers, thus risking a prolonged changeover. Central Bank
officials blame some of the criticism on a bureaucratic error that
led to an outdated report being sent to Brussels, but assured us the
GoC was taking the criticism seriously. They noted, however, that,
unlike in Malta where government officials had been assigned to
coordinate Euro adoption full-time, Cyprus had opted for a large
number of inter-agency committees. Government officials were
expected to serve on these committees in addition to their regular
jobs, causing concern that this might lead to bureaucratic inertia
and unnecessary delays.


9. (U) For more information on the changeover plans please see
Cyprus's Euro website at www.euro.cy and the EU's fourth report on
the practical preparation for the future enlargement of the euro
area available at: http://ec.europa.eu/
economy_finance/publications/ euro_related/2006/
eurorelated_enlargement_euroarea_en.htm

Public Skepticism


10. (SBU) But by far the European Commission's biggest concern has
been the growing skepticism of the Cypriot public toward the Euro.
A recent Eurobarometer poll showed that the percentage of Cypriots
"rather unhappy" or "very unhappy" about the planned change from the
Cypriot pound to the Euro had grown six percentage points (to 58
percent) since April. Almost all Cypriots have friends or family
in Greece who have told them horror stories about Greece's difficult
transition. Most Cypriots appear convinced that adoption of the
Euro will lead to an acceleration of prices and have little
appreciation of the benefits involved.


11. (SBU) A planned government information campaign designed to
address these fears, however, has been slow to get off the mark.
The Finance Ministry's award of a CYP one million (USD 2.3 million)
contract to a private firm, Epistele, to help launch the public
information campaign has been shrouded in controversy. Three of the
losing firms, including Marketway, which is owned by the wife of the
Foreign Minister, obtained a court order to delay signing of the
contract until at least December 28. There are also press
allegations that Epistele is a front company for Marketway.


12. (SBU) Cyprus's largest political party and largest member of the
governing coalition, the Communist AKEL, has also been questioning
the timeline for Euro adoption. Arguing that fiscal discipline
should be relaxed in favor of increased social spending, AKEL has
proposed delaying Euro adoption until at least 2009. Analysts
universally dismiss this as political posturing, and note that the
Council of Ministers, including those Ministers appointed by AKEL,
unanimously adopted and continue to support the January 1, 2008
goal. Nevertheless, AKEL's public stance is doing little to help
increase public confidence in the new currency.

Economic Benefits of EU Adoption


13. (SBU) Despite AKEL's criticisms and the public's fears, the GoC
remains firmly behind adopting the Euro in January 2008. Central
Bank officials have noted to us the tremendous benefits of Euro
adoption for a small country like Cyprus, including a higher degree
of price stability, lower interest rates, reduction of currency
conversion costs and exchange rate risk, and increased competition
through greater price transparency. Giving up the ability to pursue
an independent monetary or exchange-rate policy is not that big a
sacrifice, they note. Cyprus never used the latter and any graph of
Cyprus's business cycles would closely mimic that of the EU as a
whole.

Political Benefits of Euro Adoption
--------------

14. (SBU) Even Finance Minister Sarris has noted publicly that
Cypriot adoption of the Euro should make resolution of the seemingly
intractable Cyprus issue a bit easier by removing any doubt over
which currency would be used in any future united Cyprus. What
currency to use and how to handle the transition were two of the
many contentious issues within the controversial Annan settlement
plan.


15. (SBU) Suggestions, however, that the Turkish Cypriot community
should simultaneously adopt the Euro as well on January 1, 2008,
have gained little support among the Turkish Cypriot or Turkish
leadership or even the EU, despite significant economic (and
political) advantages. For instance, over the past three decades,
high interest rates and the lack of a stable currency have been
major impediments to economic growth. Turkish Cypriot adoption of
the Euro is seen by many as a political rejection of Turkey, which
supplies roughly USD 450 million a year in aid to the north --
including directly subsidizing a third of the "TRNC's" budget. It
would also mean that any future aid would require Turkey to use its
foreign exchange reserves, lessening the likelihood that Turkey
would continue being quite so generous. While the long-term
advantages to the north's development of removing the "TRNC's" soft
budget constraint are significant, this is not a step that either
Turkey or the Turkish Cypriot community appear ready to make.


16. (SBU) The EU -- the Turkish Cypriot community's second largest
aid donor with a 259 million Euro, multi-year aid program -- also
appears to oppose adopting the Euro in the north prior to a
settlement. Although technically he would not be able to stop it,
Economic and Monetary Affairs Commissioner Almunia is reportedly on
record as opposing Euro adoption by any entity that has not gone
through the Maastricht criteria process, including the Turkish
Cypriot community. (Note: While all of Cyprus, including the north,
is technically part of the EU, the EU has suspended the acquis in

the area administered by the Turkish Cypriots -- i.e., the area
outside of the effective control of the Government of Cyprus. End
note.)

American Co-designs Cypriot Euro Coins
--------------

17. (U) At a recent ceremony, the Central Bank unveiled the winning
designs for the national side of the Cypriot euro coins. The
winning artists were a two-person design team consisting of an
American and Greek Cypriot couple.

SCHLICHER