The financial sector in Cyprus, which is large in size relative to the economy's annual output, has been affected by developments in Greece; domestic banks lost a significant amount of capital following their voluntary participation in the agreed haircut on Greek sovereign debt (PSI).
By June 2012, the commercial banks' solvency ratios may well reach the targeted minimum Core Tier 1 ratio of 9 per cent. To this end, banks are currently pursuing capital strengthening plans. Should the Cypriot banking system have to resort to government support for recapitalisation, the government debt ratio could rise to around 85 per cent of GDP, thus further weakening the long-term sustainability of public finances at a time when the sovereign itself is severely constrained in international bond markets.
GDP is projected to contract by 0.8 per cent in 2012 due to a fall in domestic demand and the weaker external environment, notably including persistent financial market uncertainty. Private consumption will be restrained by the squeeze in disposable income, mainly among public sector employees, exerted by the fiscal restriction incorporated in the Budget Law 2012 adopted on 16 December 2011, as well as by the rise in unemployment to unprecedented levels. The large exposure of the financial sector to Greece and the banks' need of recapitalisation will probably raise the cost of financing and limit private-sector access to it.
Demand for housing is also expected to remain sluggish, while other construction investment is likely to benefit from reconstruction work in the destroyed Vassilikos power station and from other infrastructure projects. Leading indicators point to weak, albeit improving, consumer and business confidence. This suggests that a recovery should set in during the second half of 2012, with the improvement of the external environment and the resumption of private investment as uncertainty slowly dissipates.
The contribution of the external sector to growth is set to remain positive. While slowing global trade and worsening economic prospects in Cyprus' main trading partners are likely to weigh on exports of goods, this should be partly offset by healthy performance of business services and tourism. Imports are set to decline against the backdrop of weak domestic demand, allowing the current-account deficit to narrow further to around 7.7 per cent of GDP. Economic activity is projected to recover only gradually in 2013, mainly driven by private investment, while domestic consumption will remain constrained by the need for further correction of economic imbalances.
Full forecast (Cyprus)
© European Commission
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