CYPRUS APPLIES TO JOIN EUROZONE

UNCLAS NICOSIA 000144

SIPDIS

SENSITIVE

SIPDIS

E.O. 12958: N/A
TAGS: EFIN ECON EUN CY
SUBJECT: CYPRUS APPLIES TO JOIN EUROZONE

REF: 06 NICOSIA 2033

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


1. (SBU) Summary. On February 13, Cyprus took the historic step of
applying formally to adopt the Euro as its official currency
effective January 1, 2008. Cyprus's economy continues to perform
well within the Maastricht criteria for Euro adoption. As a result,
the EU is widely-expected to approve Cyprus's membership in the
Eurozone at the June 21-22 European Council summit. In late June or
early July, the Cyprus pound is expected to be locked to the Euro at
or near the current parity rate of 0.585274 (or 1.7086). Although
rapid adoption of the Euro has been the Papadopoulos
Administration's main economic goal, the GoC has been slow to launch
its public information campaign and finalize all the technical
preparations for the transition. Polls show that a majority of
Cypriots remain skeptical about the advantages of giving up the
Cypriot pound and fear the adoption of the Euro will lead to price
increases. End Summary.


2. (U) On February 13, the Republic of Cyprus (ROC) applied
formally to the EU to adopt the Euro as its official currency as of
January 1, 2008. The application was submitted in the form of a
letter by Finance Minister Michalis Sarris to European Central Bank
President Jean-Claude Trichet and European Monetary Affairs
Commissioner Joaquin Almunia.


3. (U) Since May 2005, Cyprus has taken part successfully in the
EU's Exchange Rate Mechanism (ERM) II, the pre-cursor to the Euro.
During this period, the Cyprus Pound (CYP) has traded well within
the 2.25 percent band allowed from the main reference rate of
0.585274 (or 1.7086) against the Euro. (Note: This is the same
reference rate at which Cyprus pegged the pound to the ECU in 1992.
End note.) Currently, the CYP trades at around 0.5790 (1.7274)
against the Euro, which is about 1.1 percent stronger than the
central rate, as it has done for most of the past two years.


4. (U) Cyprus is also easily meeting the other Maastricht criteria
for adopting the Euro. The GoC has succeeded in cutting its budget
deficit from over 6 percent of GDP in 2003 to 1.5 percent in 2006 --
well below the Maastricht criterion of 3.0 percent or less. The GoC
has also significantly cut its national debt from 72.0 percent of
GDP in 2004 to 64.7 percent in 2006. (Note: The Maastricht
criterion requires 60.0 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.)



5. (U) Cyprus also continues to meet comfortably 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 inflation rate
at the end of 2006 was 2.2 percent, falling 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).


6. (U) The European Commission will now prepare a report on
Cyprus's application. Should it find, as expected, that Cyprus
meets all the Maastricht criteria, it will make a final
recommendation to the European Council following consultations with
the European Parliament. The final decision on Cyprus's application
is expected to take place at the European Council (EU summit) in
Brussels on June 21-22. Should the decision be positive, the
European Council, after consulting the European Central Bank, will
adopt the final rate at which the Cypriot pound will be converted
into Euro. Cyprus Central Bank Head Christodoulou had strongly
denied any chance that the CYP might be devalued prior to Eurozone
entry - and most analysts believe that the rate will be set at or
very near the existing parity.


7. (SBU) Despite public assurances to the contrary, many Cypriot
consumers remain concerned about the possibility of price hikes
after adoption of the Euro, drawing their conclusions mainly based
on the negative Greek experience. It is still unclear when the
government's public information campaign will start in earnest.
Already several months behind schedule, the government campaign took
another blow, when the Supreme Court recently overturned a key
contract to a private promotional company on technical grounds.
Polls show as many as 58 percent of Cypriots are unhappy or very
unhappy about giving up the Cypriot pound. For more on the public
reaction and government transition plans, please see ref a.)


8. (U) While the Government has been slow to finalize its transition
plans and educate the public, the private sector has been picking up
the slack. Many businesses are already showing prices in both CYP
and Euro, although this will not be mandatory until the fall.
Several banks and business groups have also prepared their own
educational materials.


9. (SBU) Comment: Cyprus's adoption of the Euro on January 1, 2008
now appears all but certain, barring any major external economic
shock. The remaining question is how smooth the transition will be.
Cyprus's has several advantages -- it is a relatively small country
and it can learn from the experiences of those who came before it.
It is already consulting with Ireland and Greece on how best to
ensure the success of the former and avoid the problems associated
with the latter. Ref a detailed several of the EU's concerns about
the lack of detail in Cyprus's technical transition plans. While
progress has been made since then, the GoC's plans are still a work
in progress. While Euro adoption will most likely go smoothly,
there is a chance that if Cyprus does not fully get its act
together, Cyprus could be in for a bumpy ride.

SCHLICHER