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Economic activity in Cyprus significantly weakened with real GDP expected to have decreased by 2.3 per cent in 2012, in line with the autumn forecast. The deterioration was driven by a marked contraction of domestic demand against the background of falling domestic consumption and private investment. The largest fall in economic activity took place in construction and in the broad industrial sector, while financial services also showed sign of weakening activity. The fiscal consolidation implemented at the end of 2011, the significant deterioration in the labour market, and the prolonged high economic uncertainty concerning Cyprus's request for financial assistance in June 2012 have all weighted on private consumption.
Projections of the economic outlook for 2013 and 2014 point to a prolonged recession, due to further declines in domestic demand and investment activity. The effects of much-needed fiscal consolidation measures (including measures affecting public sector wages, social outlays, increases in employee contributions, and indirect taxes), coupled with increasing unemployment, are likely to weigh strongly on household disposable income. On the back of banks deleveraging and the deceleration of credit growth, gross fixed capital formation is expected to decline further, with the growth rates of the construction activity remaining negative over the forecast horizon.
The government deficit improved slightly despite the sizeable consolidation implemented in 2012. Revenues stagnated due to less tax-rich growth, lower corporate profitability and deteriorating labour market conditions. Expenditure reduction was lower than expected, in particular due to the increased number of early retirements and growing unemployment albeit investments were being reduced. In both 2013 and 2014, the deficit and structural deficit is set to decrease gradually thanks to the adopted consolidation measures. The debt-to-GDP ratio reached 86.5 per cent in 2012, due to the deficit, nominal GDP developments, and the participation in a bank recapitalisation.
Risks remain important and tilted to the downside. The conclusion of a macro-economic adjustment programme would be of paramount importance in stabilising the economy, but risks would remain on both the external environment and the domestic front. In spite of recent developments, the worsening of economic conditions in Greece remain a downside risk for Cyprus. On the domestic front, downside risks are associated with domestic credit conditions due to financial sector deleveraging, the worsening of labour market conditions, a stronger than expected fall in house prices, and a further loss of business and consumer confidence from prolonged economic uncertainty. Also, the restructuring of the Cypriot banking sector could have stronger effects on related professional business services. Upside risks for the economy may emerge in 2014 with higher investment activity in the energy sector.