CYPRUS: GLOBAL ECONOMIC CRISIS FINALLY HITS

UNCLAS NICOSIA 000594 SENSITIVE SIPDIS DEPT FOR EUR/SE E.O. 12958: N/A TAGS: ECON EFIN CY SUBJECT: CYPRUS: GLOBAL ECONOMIC CRISIS FINALLY HITS REFS: (A) 08 NICOSIA 0932 (B) JUNE 23 CAROUSO-NETOS E-MAIL (U) This cable is sensitive but unclassified. Please protect accordingly. ¶1. (SBU) Summary: As we begin to see signs of recovery from the global economic crisis, Cyprus is just beginning to feel pain. For months the Finance Ministry (MinFin) minimized in its public statements the risks to the local economy posed by the international economic situation, but on September 12, Finance Minister Charilaos Stavrakis, presenting his 2010 budget, said Cyprus' economy would shrink by 0.5 percent in 2009. A recent IMF report on the Cypriot economy and a stream of other negative data had already contributed to the conclusion that Cyprus is experiencing a recession. In advance of submitting its budget to parliament in October, MinFin is currently focusing on deficit reduction, striving to keep the deficit under three percent to avoid EU supervision. In credit market developments, the GOC announced plans to issue three-year bonds to inject liquidity in the banking system and drive down high lending rates. Separately, Marfin, the island's second largest bank, reversed its decision to move its headquarters to Athens (Ref B). End Summary. Stavrakis: "Don't Use the 'R' Word!" -------------- ¶2. (SBU) In August 2009, the ROC Ministry of Finance revised downward its second quarter growth estimate to -0.5 percent, following -0.6 percent growth in Q1, signaling that Cyprus had technically entered a recession. This came on the heels of a sobering IMF report on the Cypriot economy that confirmed the global crisis had hit the island. The report warned of a highly leveraged private sector, large current account deficits, and a large exposure of banks to property prices. The IMF report also predicted that the Cypriot fiscal deficit would reach 3.9 percent in 2009 (compared to surpluses of 3.4 percent in 2007 and 0.9 percent in 2008). Left unattended, and given present trends, the fiscal deficit could grow to 8.3 percent by 2014, according to the IMF. Throughout the summer months, Cypriot Finance Minister Stavrakis downplayed the presence of serious problems in the Cypriot economy, pointing to economic indicators which were relatively buoyant until recently. Even confronted with the IMF report, Stavrakis put on a brave face, stating on August 27 it was "wrong to talk about recession; there is no recession, there is a significant slowdown triggered from abroad, and the less we talk about such things the better." This stance attracted fierce criticism, particularly from opposition party DISY. GOC Unveils 2010 Budget and Economic Plan -------------- ¶3. (SBU) Under pressure to produce results, Stavrakis unveiled a five-point plan in late August to contain the deficit and stimulate the real economy. His public discourse also began to reflect the need to take action. The components of his plan, outlined below, were incorporated into his 2010 budget proposal, unveiled on September 12. The GOC aims to: -- raise (one-off) revenue from a "town planning amnesty" designed to expedite the issuance of title deeds for thousands of properties held up by red tape; -- crack down on tax evasion; -- freeze civil service hirings for the next 18 months; -- target social benefits more effectively (recommended by the IMF); and -- cut down on "non-productive" public sector spending. ¶4. (SBU) Stavrakis' 2010 budget would provide Euros 7.9 billion of total spending with revenue of Euros 5.6 billion, resulting in a fiscal deficit of 4.5 percent of GDP. (Note: The current exchange rate is Euro 1.00 to USD 1.47.) Despite these grim numbers, Stavrakis said his government remained hopeful that its five-point plan would allow MinFin to decrease the fiscal gap by another Euros 285 million and contain the deficit to less than 3.0 percent in 2010, in order to avoid being placed under monitoring from Brussels. How Will the Numbers Add Up? -------------- ¶5. (SBU) The budget provides a relatively modest (3.1 percent) increase in total spending. The civil service payroll, however, making up fully a third of total spending, will rise at more than twice that rate -- 7.7 percent -- while social spending will rise by 6.4 percent. (Note: The number of civil servants has grown from 47,704 in 2005 to 51,893 at present). The government's budget calls for a 7.1 cut in operational spending, a first for the GOC. Stavrakis said, though, the government would continue spending money on development/infrastructure and would not impose new taxes unless mandated by the acquis. Development spending is down 9.2 percent, but this mostly reflects reduced funding for many projects rather than outright scrapping of significant projects in the pipeline. Some analysts this week are criticizing the proposed dip in infrastructure spending as too large, noting that those projects are exactly where any increases in spending should be targeted in order to stimulate the economy. The GOC expects total revenue to rise by 7.9 percent in 2010, largely fuelled by a rebound (9.2 percent) in indirect taxes - mainly VAT. During 2010, the GOC expects unemployment to rise to 6.5 percent from 5.5 percent this year and inflation to reach 2.5 percent, from around one percent this year. End of Year Bond Issue -------------- ¶6. (SBU) In developments on the credit front, Stavrakis announced September 2 that the GOC was planning to issue three-year bonds worth Euros 3 billion by the end of the year to boost liquidity in the banking system and reduce lending rates. Domestic commercial and cooperative banks will be able to use the government-guaranteed bonds as collateral to borrow from the European Central Bank (ECB). The move is intended to help reduce lending rates, which have remained obstinately high in Cyprus, by about one percent. Separately, in especially welcome news for the government on the public relations front, Marfin Bank announced September 15 its decision to stay in Cyprus. The island's second-largest bank reversed its earlier decision to move its headquarters to Greece, which had caused intense negative reaction when announced last May (Ref B). Marfin's leadership has initiated a dialogue with authorities domestically to enhance the institutional and regulatory framework of the financial services sector and minimize barriers to entrepreneurship. ¶7. (SBU) Comment: The government will be under scrutiny as it sets out to implement the 2010 budget, with observers watching not just the government's inclination, but also its ability to cut spending. The recent increases in social spending and public sector employment reflect the priorities of nominally-communist but dyed-in-the-wool leftist AKEL party that leads the government. Their plan to freeze hiring in the civil service for 18 months should not pose a hardship, given that there are reportedly 3,500 to 4,000 vacant positions in the civil service at any given time. Just prior to the release of negative economic data two months ago, the government added 1,100 positions to the state payroll. Cutting back in this area (and in turn limiting the patronage opportunities public sector jobs provide) will be difficult and unpalatable for AKEL. Any effort to tame the civil service payroll line item, which seems to have a life of its own, would have to come in the form of increasing civil service productivity (e.g. encouraging inter-changeability of positions) and, possibly, restricting future pay increases. Keeping the fiscal deficit below 3.0 percent for 2009 and 2010 will be challenging, and is likely to become considerably tougher in the future. (Note: The pressure may be taking its toll on Stavrakis, who stayed overnight in Nicosia General Hospital on September 15 complaining of chest pains; the 53-year-old minister attributed this to excessive stress over the last few days, but happily was given a clean bill of health and released.) URBANCIC