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Document 52013SC0176
COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the budgetary situation in Cyprus following the adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end to the situation of an excessive government deficit Accompanying the document Recommendation for a COUNCIL RECOMMENDATION with a view to bringing an end to the situation of an excessive government deficit in Cyprus
COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the budgetary situation in Cyprus following the adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end to the situation of an excessive government deficit Accompanying the document Recommendation for a COUNCIL RECOMMENDATION with a view to bringing an end to the situation of an excessive government deficit in Cyprus
COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the budgetary situation in Cyprus following the adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end to the situation of an excessive government deficit Accompanying the document Recommendation for a COUNCIL RECOMMENDATION with a view to bringing an end to the situation of an excessive government deficit in Cyprus
/* SWD/2013/0176 final */
COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the budgetary situation in Cyprus following the adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end to the situation of an excessive government deficit Accompanying the document Recommendation for a COUNCIL RECOMMENDATION with a view to bringing an end to the situation of an excessive government deficit in Cyprus /* SWD/2013/0176 final */
|| EUROPEAN COMMISSION || Brussels, 7.5.2013 SWD(2013) 176 final COMMISSION STAFF
WORKING DOCUMENT Analysis by the Commission
services of the budgetary situation in Cyprus following the adoption of the
Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end
to the situation of an excessive government deficit Accompanying the
document Recommendation for
a
COUNCIL RECOMMENDATION with a view to
bringing an end to the situation of an excessive government deficit in Cyprus {COM(2013) 284 final}
1.
Introduction
On 13 July 2010, the
Council decided in accordance with Article 126(6) of the Treaty of the
Functioning of the European Union (TFEU) that an excessive deficit existed in
Cyprus and issued a recommendation to Cyprus in accordance with Article 126(7) of
the TFEU with a view to bringing an end to the situation of an excessive
government deficit by 2012[1].
In its recommendations, the Council established in line with Article 3(4) of
Regulation (EC) 1467/97 a deadline of 13 January 2011 for effective action to
be taken. Specifically, the Council recommended that Cyprus
brings the general government deficit below 3% of GDP by 2012 in a credible and
sustainable manner by taking action in a medium-term framework. To this end,
Cyprus was recommended to: "(a) take necessary measures to reduce the 2010
deficit to at most 6% of GDP and define an expenditure-driven consolidation
strategy in order to bring the deficit below the reference value by 2012; (b)
ensure an average annual fiscal effort of at least 1½% of GDP in 2011‑12,
also in order to contribute to bringing the government gross debt ratio back on
a declining path that approaches the reference value at a satisfactory pace by
restoring an adequate level of the primary surplus; and (c) specify and
rigorously implement the measures that are necessary to achieve the correction
of the excessive deficit by 2012, cyclical conditions permitting, and
accelerate the reduction of the deficit if economic or budgetary conditions
turn out better than expected at the time"[2].
On 27 January 2011, the Commission
(following an assessment of action taken by Cyprus, in
line with Art. 9(3) of Regulation (EC) No 1467/97) concluded that, on the basis
of information available at the time, Cyprus had taken action representing
adequate progress towards the correction of the excessive deficit within the
time limits set by the Council[3].
On 11 January 2012, the Commission confirmed that Cyprus
had taken effective action in compliance with the Council Recommendation of 13 July
2010 to bring its government deficit below the 3% of GDP reference value and
considered that no additional step in the excessive deficit procedure was
therefore necessary. This document provides an assessment of whether Cyprus has
undertaken effective action towards the correction of its excessive general
government deficit and considers the case for an extension of the time necessary
for a sustainable correction of the excessive deficit. In particular, the
document examines the budgetary developments since the Commission
Communications to the Council on action taken as of 27 January 2011 and of 11
January 2012. On 25 June 2012, Cyprus formally presented to euro-area Member
States a request for external financial assistance from the EFSF/ESM to contain
the risks to the Cypriot economy, notably those arising from the banking
sector. On 27 June 2012, the Eurogroup invited the European Commission (EC), in
liaison with the European Central Bank (ECB), the Cypriot authorities and the
International Monetary Fund (IMF) to agree on an economic adjustment programme, including the financing needs, and to take
appropriate action to safeguard financial stability, in light of the very
challenging external environment and spill-over effects from sovereign market
turbulence. On 23 November 2012, a provisional staff
level agreement was reached with Cyprus on the policy adjustments and
conditionality underpinning an economic adjustment programme, which were laid
down in a draft Memorandum of Understanding on Specific Economic Policy
Conditionality (MoU). On 16 March and 25 March 2013, the Eurogroup reached a
political agreement with Cyprus on the key elements of a programme, which
included the restructuring and substantial downsizing of the banking sector and
the reinforcement of efforts on fiscal consolidation, structural reforms and
privatisation. On 2 April 2013, staff level agreement
on the updated MoU was reached between Cyprus and the EC/ECB/IMF. On 25 April 2013, the Council adopted a decision under Article 136
TFEU containing the main elements of the macroeconomic adjustment programme to
be implemented by Cyprus. On 26 April 2013, a Memorandum of Understanding
consistent with the said decision was signed by the Cypriot authorities and the
Commission, acting on behalf of the ESM.
2.
Recent macro-economic and budgetary developments
More than a decade of sustained and strong economic expansion in
Cyprus came to an end in 2009. Economic activity in Cyprus fell by 1¾%, with
weak domestic demand and an adverse external environment weighing strongly on
growth. Economic activity recovered in 2010 with real GDP growth of 1.1%. The Cypriot economy grew by a modest 0.5% in 2011, 0.8 p.p. lower than projected in
the Commission services' 2010 Spring Forecast
underlying the Council recommendation of 13 July 2010.
After a relatively strong first half year, when GDP increased by 1.5% (yoy),
economic activity was seriously affected by an accident in July 2011, which
destroyed the Vasilico power station. Significant
reductions in investment and private consumption were observed following the
explosion. Table 1: Macroeconomic developments
and outlook || 2011 || 2012 || 2013 || 2014 || 2015 || 2016 Outturn || SF10 || Programme Forecast (forecasted data) Real GDP (% change) || 0.5 || 1.3 || -2.4 || -8.7 || -3.9 || 1.1 || 1.9 Contributions to real GDP growth (pps): || || || || || || || Final domestic demand || -2.2 || 1.1 || -6.1 || -13.7 || -5.5 || 0.9 || 2.0 Changes in inventories || 0.5 || 0 || -0.8 || 0 || 0 || 0 || 0 Net exports || 2.2 || 0.3 || 4.4 || 5.0 || 1.6 || 0.2 || 0 Employment (% change) || 0.5 || -0.2 || -4.1 || -6.5 || -3.1 || 1.1 || 1.3 GDP deflator (% change) || 2.7 || 1.1 || 2.0 || 0.6 || 1.1 || 1.5 || 1.8 Output gap || 1.2 || -1.6 || 0.0 || -6.2 || -7.6 || -4.3 || -0.9 (% of potential GDP) Potential output growth || 0.3 || 0.7 || -1.3 || -2.6 || -2.5 || -2.3 || -1.6 (% change) Source: Commission services, SF10: Spring
Forecast 2010; Programme Forecast: Commission services' most recent forecast
underpinning the economic adjustment programme agreed in April 2013 At the same time, over the course of 2011 developments in the
financial sector and growing uncertainty regarding the public finances
position, including the impact of financial sector related contingent
liabilities started having a negative impact on consumer and corporate sector confidence
and economic activity. These adverse developments relate to the unwinding of
very serious private and public sector imbalances in the Cypriot economy as
well as the negative spill-over from financial and economic turmoil in
neighbouring economies. The onset of the deleveraging process was marked by tightening financial conditions and much-needed fiscal consolidation
measures, which compounded the negative effect on economic activity. This,
together with a high degree of economic uncertainty and the deterioration in
labour market conditions, took its toll on the growth of domestic demand in 2011, which registered -2.2% compared to the 1.1%
projected in the Commission's
2010 Spring Forecast. Private
consumption grew slightly (0.5%) and investment activity suffered a sharp
decline (-13.0%), both of which were significantly below the Commission's 2010
Spring Forecast (1.9% for private consumption growth and -3.8% for GFCF). The continued weakness of the international environment prevented
external demand from fully offsetting the subdued domestic demand even if a positive contribution to growth was
observed as a result of two good consecutive tourist seasons and a reduction in
imports in line with the fall of domestic demand. The Commission services' forecast which
underpins the agreed economic adjustment programme and thus incorporates the
agreed MoU measures, and being also the most recent Commission services'
forecast, (hereafter the Programme Forecast) projects a worsening of economic activity
in 2012, with real GDP declining by 2.4%. Private consumption is forecasted to
recede by 3.0%, while investment activity is expected to suffer a further sharp
drop (-23.0%). Although 2012 was beyond the forecast horizon at the time of the
Commission services' 2010 Spring Forecast underlying the Council recommendation,
higher growth than in 2011 was expected for 2012 at that time, under the
hypothesis of a gradual closure of the negative output gap. This was apparent
in the Commission's services 2010 Autumn Forecast which projected GDP growth
for 2012 at 2.2%, with positive private consumption growth of 2.2% and only a
small fall (-1.5%) in gross fixed capital formation. The main reasons for the
significantly worse 2012 outcome than earlier expected are found in a series of
events that affected the Cypriot economy adversely from the second half of 2011
onwards. These relate notably to the unwinding of Cyprus' unsustainable
economic imbalances, which led to a widespread loss of confidence among
economic agents and a loss of access to long-term market financing for both the
sovereign and major financial institutions, to the Cypriot economy's exposure
to Greece, the explosion of the major electricity plant, and the implementation
of much-needed fiscal consolidation measures. The Programme Forecast projects that the
economy would suffer an important output loss in 2013 and continue to contract
in 2014 due to a significant drop in private consumption and investments, as
well as weak export volumes. Developments are driven by the immediate
restructuring of the banking sector, temporary capital controls, the worsening
labour market outlook with rising unemployment and negative real wage growth,
the impact of fiscal consolidation and anaemic consumer and business confidence.
Public debt developments Public debt rose by almost 10 p.p. to 71.1%
of GDP in 2011. Debt developments were mostly driven by higher stock-flow
adjustments due to a bilateral loan granted from Russia in 2011 and the
government's participation in the recapitalisation of one commercial bank in June
2012. In addition, higher-than-expected deficit outcomes, partly arising from
higher borrowing costs due to Cyprus' difficulty in accessing international
markets, as well as the slowdown in the nominal GDP (through the denominator
effect) also increased the debt level. It is projected to reach 85.8% of GDP in
2012 based on the Programme Forecast. Table 2: Public debt developments 2009-2012 || 2009 || 2010 || 2011 || 2012 Gross debt ratio (% of GDP) || 58.5 || 61.3 || 71.1 || 85.8 Changes in the ratio (pps) || 9.6 || 2.8 || 9.7 || 14.7 of which || || || || (1) Primary balance (pps) || 3.6 || 3.0 || 3.9 || 3.1 (2) Snowball effect (pps) || 3.4 || 0.4 || 0.4 || 3.6 Interest expenditure (pps) || 2.6 || 2.3 || 2.4 || 3.2 Growth effect (pps) || 0.9 || -0.8 || -0.3 || 1.8 Inflation effect (pps) || 0.0 || -1.1 || -1.7 || -1.4 (3) Stock flow adjustment (pps) || 2.6 || -0.6 || 5.4 || 8.1 Source: Commission services
3.
Effective action
3.1. Background information In 2010, the year of the Council
recommendation, the general government deficit was reduced to 5.3% of GDP from
6.1% in 2009 due to discretionary revenue measures (in particular a deemed
dividend distribution fee of 15% on undistributed corporate profits, a rise in
the excise duties imposed on petroleum products and increased contribution
rates as part of a pension reform) and one-off revenues (the transfer of
higher-than-usual central bank profits). The increase in revenues was partially
offset by higher expenditures, in particular rising expenditure on social
benefits due to an increase in the unemployment rate and the enactment of
discretionary social policy measures. With a view to ensuring a fiscal effort in line with the Council's
recommendation, the Cypriot authorities put forward in autumn 2010 - in preparation
of the 2011 Budget Law - a fiscal consolidation package aimed at containing the
fiscal deficit at 4.5% of GDP in 2011. On the expenditure side, measures
included cuts in the government's operating expenditure (i.e., reduction in
intermediate consumption) and restraint in public investment and employment. On
the revenue side, measures included a phase-out of the tax relief on excise
duties and VAT, which was part of an earlier stimulus package of 2010. The 2011
budget also incorporated higher excise duties on petroleum products, foodstuff
and pharmaceuticals. In the second half of 2011, the government
adopted three further sets of fiscal measures. The first set of measures
adopted in August 2011 included additional contributions from public sector
employees to the Government Employees Pension Scheme, the inclusion of new
public sector employees in the general pension scheme under the social security
fund instead of the more generous public sector pension scheme, and the increase
of the withholding tax on interest accrued on deposits of credit institutions
operating in Cyprus, excluding subsidiaries and branches operating outside of
Cyprus, and branches in Cyprus of credit institutions and Member States of the
European Union and of branches of credit institutions from third countries. In
context of preparing the 2012 Budget Law, an additional set of measures contained,
inter alia, better targeting of social transfers, a hike in the VAT rate from
15% to 17%, a temporary reduction in the public sector wage bill by freezing
emoluments, and an increase of the tax rate on deemed dividend distribution
from 17% to 20% for a period of two years. On the day of adoption of the 2012
Budget Law, the Parliament voted last-minute amendments comprising a cut of
about 8% in selected government expenditure categories. In November 2012, in
context of the provisional staff-level agreement on an economic and financial
adjustment programme, Cyprus took steps to implement additional measures for
the remainder of 2012. In particular, a scaled reduction in emoluments of
public and broader public sector employees and pensioners was implemented for
the remaining salary payments in 2012 (salary payments of December and the 13th
salary), while general government received a one-off additional dividend income
collected from a semi-public organisation. 3.2. Earlier assessments of effective action On the basis of the 2011 draft budget
available at that time, the Commission services' 2010 Autumn Forecast[4] projected a deficit of 5.7% of
GDP for 2011. This forecast did not incorporate the additional consolidation
measures agreed by the Government and presented in context of the 2011 Budget
Law since the measures had not been yet adopted by the Parliament. The adoption
of the consolidation package was taken into account subsequently. As a result,
the Commission concluded on 27 January 2011 that Cyprus would ensure a fiscal
effort of at least 1½% of GDP in 2011 and had taken effective action with a
view to bringing an end to the situation of excessive deficit by 2012. The 2011 update of the Stability Programme
(SP) presented a headline deficit target of 4.0% of GDP for 2011 on the basis
of a lower-than-expected deficit outturn of 5.3% of GDP in 2010. In contrast to
the target of the SP, the Commission services' 2011 Autumn Forecast estimated the
budget deficit at 6.7% of GDP. The deviation from the national forecast was
mainly due to expected lower revenues (2¼% of GDP) and slightly higher
expenditures (½% of GDP). Based on its assessment of the adopted consolidation
measures, and taking into account cyclical conditions, the Commission concluded on 11 January 2012 that Cyprus had taken
effective action to correct the excessive budget deficit in a timely and
sustainable manner. 3.3. Current assessment of effective action The assessment of effective action should
be seen as the result of the comparison of the recommended fiscal effort in the
Council recommendation, the apparent fiscal effort, measured by the change in
structural balance, and the adjusted structural effort. The adjustment takes into
account: (i) the impact of revisions in potential output growth compared to
that underlying the growth scenario in the Council recommendation (alpha), and
(ii) the impact on revenue of revisions of the tax content of economic activity
(composition of economic growth) relative to what was assumed at the time of
the recommendation (beta). This top-down approach is complemented by a careful
analysis, including a bottom-up assessment of consolidation measures undertaken
by Cyprus. According to the Programme Forecast, which
incorporates the policy measures agreed in the MoU, the structural deficit was 5.7%
of GDP in 2010, 6.6% of GDP in 2011 and is projected at 6.7% of GDP in 2012. At the time of the Council Recommendation,
a steady economic recovery was expected to materialise over the adjustment
period. After a projected fall in GDP in 2010, real GDP growth in 2011 was
projected at 1.3% and was seen to strengthen thereafter (see section 2). In
terms of actual outturn, real GDP growth however weakened year-by-year over
2010-2012 and fell significantly short of projected in both 2011 and 2012
(Table 4). This was mainly due to less resilient domestic demand than expected,
in particular weaker private consumption growth and a larger contraction of
investment activity. For 2011, the shortfall in growth was marked by the loss
in output after the destruction of the Vasilico power plant. The Commission
services' 2011 Spring Forecast projected growth of 1.5% for 2011 compared to the
Commission services' 2011 Autumn Forecast of 0.3%, which took into account the
disruption of economic activity. For 2012, the more pronounced and protracted
recession than expected in the Commissions' services successive forecasts was
caused in particular by an abrupt drop in domestic demand and investment
activity, and a deterioration in the labour market, which had a negative impact
on disposable income and private consumption. The fall in investment and worse labour
market developments, depicted in successive Commission services' forecasts from
the time of the Council Recommendation in July 2010, also find evidence in the
considerable downward revisions in the estimate of Cyprus' potential growth
(Table 3). At the time of the Council Recommendation, 2011 potential output
growth was estimated at around 0.7% compared to the current estimate of 0.3% in
the Programme Forecast. Actual growth for 2011 turned out well below what was
originally projected in the forecast underpinning the EDP recommendation. Together
with revisions to potential growth in preceding years this has resulted in the estimated
output gap to now be considered positive, while it was estimated to be largely
negative at the time of the Council Recommendation. However, despite the
significant revisions in the level of output gap, the year-on-year change in
the output gap in 2011 has only been slightly revised. For 2012, the Commission services' Autumn
2010 forecast estimated potential output growth to be in the order of 1%
compared to the current estimate of -1.3% in the Programme Forecast. The
significant revisions of the estimates of the potential growth underlie also
the large changes in the estimates of the output gap in 2012, which from being
largely negative have progressively being projected as more positive. This is
the case also for recent forecasts, where the projection of actual growth has
been stable, while the estimate of potential growth has changed. The year-on-year change in the output gap has also been
significantly revised in the direction of depicting worsening cyclical
conditions. Table 3: Comparison of potential growth
estimates for 2011 and 2012 Swings in potential growth estimates are
quite strong in the case of Cyprus, related to the revisions to actual growth
and real economy variables. This is seen by variation over successive forecasts
in the contributions to potential growth stemming from total labour, capital
accumulation, and productivity (TFP). Revisions to the contributions concern both
their share in potential growth and in some cases the sign of the contribution
to potential growth (i.e. positive or negative) for 2011-2012. Correcting the apparent
change in the structural balance for the impact of revisions in potential
output growth ('alpha') compared to that underlying the growth scenario in the
Council recommendation of July 2010, the average annual change in the
structural balance over the period 2011-2012 would be around 0.5% of GDP. Table 4: Comparison of budgetary
adjustment || 2010 || 2011 || 2012 outturn || COM 2010 SF || outturn || COM 2010 SF || Programme Forecast || COM 2010 AF % of GDP || % of GDP || % of GDP || % of GDP || % of GDP || % of GDP Revenue || 40.9 || 41.2 || 39.7 || 41.3 || 40.0 || 40.5 of which: || || || || || || - Taxes on production and imports || 15.4 || 15.0 || 14.5 || 15.2 || 14.8 || 15.8 - Current taxes on income, wealth, etc. || 11.1 || 11.2 || 11.7 || 11.2 || 11.1 || 10.8 - Social contributions || 8.9 || 9.6 || 8.7 || 9.6 || 9.1 || 8.8 - Other (residual) || 5.5 || 5.4 || 4.8 || 5.3 || 5.0 || 5.0 Expenditure || 46.2 || 48.3 || 46.0 || 49.0 || 46.3 || 46.2 of which: || || || || || || - Primary expenditure || 43.9 || 45.6 || 43.6 || 46.1 || 43.1 || 43.7 of which: || || || || || || - Compensation of employees || 15.8 || 15.9 || 16.0 || 16.0 || 15.8 || 16.1 - Intermediate consumption || 5.6 || 5.8 || 5.3 || 5.8 || 5.1 || 5.0 - Social payments || 14.4 || 15.2 || 14.6 || 15.7 || 15.1 || 15 - Subsidies || 0.4 || 0.4 || 0.5 || 0.4 || 0.5 || 0.4 - Gross fixed capital formation || 3.8 || 4.1 || 3.5 || 4.1 || 2.7 || 3.7 - Other (residual) || 3.9 || 4.2 || 3.7 || 4.1 || 3.9 || 3.6 - Interest expenditure || 2.2 || 2.7 || 2.4 || 2.9 || 3.2 || 2.4 || || || || || || General government balance (GGB) || -5.3 || -7.1 || -6.3 || -7.7 || -6.3 || -5.7 Primary balance || -3.0 || -4.4 || -3.9 || -4.8 || -3.1 || -3.3 One-off and other temporary measures || 0.0 || 0.0 || -0.2 || 0.0 || 0.4 || 0 Cyclically-adjusted balance || -5.7 || -6.3 || -6.8 || -7.1 || -6.3 || -5.4 Structural balance || -5.7 || -6.3 || -6.6 || -7.1 || -6.7 || -5.4 Change in structural balance || 0.8 || 0.0 || -0.9 || -0.8 || -0.1 || -0.4 Corrected change in structural balance due to revision of potential output growth ('alpha') || || || 0.1 || || 0.5 || Real GDP growth || 1.3 || -0.4 || 0.5 || 1.3 || -2.4 || 2.2 GDP deflator || 1.9 || 2.1 || 2.7 || 2.4 || 2.0 || 2.5 Nominal GDP || 3.3 || 1.5 || 3.3 || 3.6 || -0.5 || 4.8 Source: COM 2010 SF: Commission Services'
2010 Spring Forecast; Programme Forecast; COM 2010 AF: Commission Services'
2010 Autumn Forecast, which was the first forecast to include projections for
2012. Table 5: Change in the structural balance corrected
for revisions in potential output gap and revenue windfalls/shortfalls Uncorrected fiscal effort (ΔS) || Fiscal effort corrected for α and β (ΔS*) || Required fiscal effort in the latest 2010 Council recommendation (R) || Deadline for correction 2011 || 2012 || 2011 || 2012 || 2011 – 2012 || 2012 -0.9 || -0.1 || 2.2 || 2.4 || 1½ Source: Commission services The less tax-rich growth composition in
2011 and 2012, marked by lower-than-projected final domestic demand and lower
imports, and the stronger deterioration in the labour market also led to major
revenue shortfalls, notably in indirect taxes. For 2011, the difference between
the projected revenue ratio underpinning the Council Recommendation and the
actual outcome is around 1.5 p.p. of GDP. This was in particular due to: (i)
the loss in output after the destruction of the Vasilico power plant; (ii)
growth composition effects leading to lower revenue collection, e.g. due to
lower activity in the construction sector and lower collection of revenues from
income taxation and social contributions due to the reduction of compensation
of employees in the public sector; (iv) reduced corporate profitability as a
consequence of the economic slowdown. For 2012, the total revenue ratio turned
out closer to projected, but indirect tax collection was particularly weak,
showing a shortfall of 1 p.p. compared to what was projected in autumn 2011. In
addition to the factors that impacted on 2011, this was in particular due to:
(i) tightening bank lending conditions and weakening
confidence weighing on private consumption, (ii) subdued foreign demand for
housing, (iii) restructuring of corporate balance sheets which kept investment
on a strong downwards correction path and (iv) less tax rich growth, e.g. exports
of tourism gaining relative weight while final domestic demand posted a
negative drag to GDP of around 6% of GDP. Moreover, a further worsening of the labour
market caused a certain shortfall in social contributions compared to the
projected. As a result, despite the adoption and
implementation of discretionary revenue measures, overall revenue collection turned
out weaker than expected. The deterioration of the expectations about
economic developments, and therefore revenue collection, is also reflected in
the downward trend in successive Commission services' forecasts since spring
2011. After revising upward the forecast of the
2011 nominal GDP between the 2010 spring and autumn forecasts, nominal GDP was
substantially revised downwards in three successive forecasts and then revised
upward again in the autumn of 2012. In parallel, the forecast of total revenues
was also adjusted downwards, even in the last forecast of autumn of 2012.
Finally, total revenues collected in 2011 were only slightly higher than in
2010 in spite the 3.3% growth in GDP. Abstracting from one-offs, this was
driven by developments in taxes on production and imports and in social
contributions rather than current taxes on income and wealth, which were higher
in 2011 compared to 2010 and also higher than projected in 2010. Looking deeper
into the reasons for this underperformance in taxes on production and imports
results in a mixed picture. A comparison of 2010 with 2011 shows that the weak
performance cannot be explained by developments in the tax bases. However,
compared to the forecast underpinning the Council Recommendation, the tax base
for indirect taxes, which constitute more than 80% of taxes in production and
imports, indeed turned out much lower. In addition, excise duties on motor
vehicles also performed considerably worse than in 2010. The downward revision
of expected social contributions is partially explained by a downward revision
of compensation of employees. For 2012, nominal GDP has been revised
downward by close to 7% from EUR billion 19.2 (and nominal GDP growth of 4.8%)
in autumn 2010 to 17.9 (and nominal GDP growth of -0.5%) in the spring forecast
of 2013, with a parallel deterioration of the forecasted tax bases as well.
Compared to 2011, the overall performance of revenues was slightly better than
expected. Despite the 0.5% decrease of nominal GDP from the previous year,
revenues increased by 0.2%. However, eliminating the effect of one-offs and
discretionary measures, revenues would have gone down by around 3%. Contrary to
2011, the source of underperformance does not lie in indirect taxes. Despite a
decrease in total consumption, collection of taxes on production and imports
went up compared to 2011. This is partially explained by discretionary
measures, also considering that some of the 2011 measures came into full effect
only in 2012, but is also linked to the weak performance in 2011. For taxes on
income and wealth, the picture is different. They deteriorated more than what
standard elasticities would suggest. Looking into a breakdown of revenues gives
a mixed picture. While personal income tax performed roughly as expected,
corporate income tax underperformed substantially compared to developments in
its tax base (gross operating surplus). Increased capital write-offs could have
contributed to this underperformance. The parallel deterioration of collection
from the special defence contribution by roughly 10%, despite a tax rate
increase on dividend and interest income, is likely due to substantially lower
pay-outs of dividends. Other revenues in the category taxes on income and
wealth that deteriorated substantially are capital gains taxes, which are likely
linked to the deteriorating real estate market, and penalties, which are
probably due to the tax amnesty that was decided at the end of 2011. Social
contributions in 2012 seem to have performed well since collection of social
contributions went up by 4.3% despite a stronger than expected contraction of
the revenue base. The additional collection is partially explained by the
introduction of a 3% contribution on public sector salaries, but the increase
may have been large also due to the weak performance of social contributions in
2011. Accounting for the impact of revisions to
the composition of economic growth and shortfalls of revenue, the adjusted
average annual improvement of the structural budget balance over 2011-2012 would
be around 2.4% of GDP. This is above the minimum average annual fiscal effort
of at least 1½% of GDP over 2011-2012 required by the Council recommendation.
Cyprus can therefore be considered to have taken
effective action. This analysis is confirmed by the bottom-up
assessment of Cyprus having adopted sizeable consolidation measures over
2011-12. As described in section 3.1, the Cypriot
authorities have undertaken in all five sets of fiscal consolidation measures
impacting on 2011-2012, which have, however, been ineffective in containing the
continued deterioration in public finances caused by shortfalls in indirect
taxation and social contributions. A first set of measures accompanied the
2011 Budget Law (Table 6) which amounted to an estimated impact of 1% of GDP on
the 2011 fiscal outcome (0.4% GDP deriving from expenditure measures and 0.6%
of GDP from revenue measures). The measures were implemented as of October
2011. The adoption of the package of consolidation measures in August 2011 is
estimated to have had a deficit-reducing impact of 0.3% of GDP in 2011 and an
additional impact in 2012 of 0.8% of GDP (equally distributed between
expenditure and revenue). The additional set of measures prepared for
implementation via the 2012 Budget Law is estimated to have had a fiscal impact
of 2.9% of GDP in 2012 (2.1% expenditure side and 0.8% revenue side). The
last-minute amendments to the Budget Law 2012 produced an additional fiscal
impact of 0.3% of GDP in 2012. All measures were implemented as of January 2012
with the exception of the increase of the standard VAT rate from 15% to 17% on
1 March 2012. Finally, in November 2012, in the context
of the provisional staff-level agreement reached, Cyprus took steps to
implement additional measures with a fiscal impact of 0.3% of GDP for the
remaining part of 2012. In sum, the Cypriot authorities have
adopted consolidation measures with an estimated direct deficit-reducing impact
in 2011 of around 1½% of GDP. For 2012, the Cypriot authorities have adopted
consolidation measures with an estimated direct deficit-reducing impact of
around 4¼% of GDP. Table 6: Main discretionary budgetary
measures in 2011 and 2012 || 2011 (% GDP) || 2012 (% GDP) 2010 (2011 Budget Law) measures (expenditure) || · Reduction of operational expenditures and current transfers (-0.4%) · Containment in the rate of growth of capital expenditure (-0.2%) · Temporary mitigating measures in view of the application of a reduced VAT on foodstuffs and pharmaceutical products (0.1%) || · Termination of the mitigating measures in view of the application of a reduced VAT on foodstuffs and pharmaceutical products (-0.1%) 2010 (2011 Budget Law) measures (revenue) || · Increased excise duties on petroleum products in line with the acquis (0.4%) · Application of a reduced VAT on foodstuffs and pharmaceutical products (0.3%) · Termination of the application of reduced VAT on hotels and restaurants (0.2%) · Termination of the reduced excise duty on heating oil during the winter season (0.1%) || 2011 measures (expenditure) || · Reduction in the government's social security contribution on gross earnings of broader public sector employees (-0.1%) · Public sector wage cut in the form of a temporary contribution on gross earnings of broader public sector employees and pensioners (-0.1%) · Transfer to CY Airways due to extra costs related to embargo of airspace use (0.1%) || · Reduction in the government's social security contribution on gross earnings of broader public sector employees (-0.2%) · Public sector wage cut in the form of a temporary contribution on gross earnings of broader public sector employees and pensioners (-0.1%) · The reverse effect of the transfer to CY Airways due to extra costs related to embargo of airspace use (-0.1%) 2011 measures (revenue) || · Bank levy at a rate of 0.095% of bank’s deposits excluding intra-bank deposits (0.4%) · Application of increased excise duties on tobacco products (0.1%) · Introduction of a levy on registered companies (0.1%) · Return of penalty imposed by the national competition authority on petroleum companies (-0.2%) · The reverse effect of 2010 extraordinary dividends from the Central Bank of Cyprus (-0.5%) || · Introduction of a levy on registered companies (0.1%) · Effect of the 2011 reduced revenue due to the return of penalty imposed by the national competition authority on petroleum companies (0.2%) 2012 (2012 Budget Law) measures (expenditure) || || · Targeting of all social schemes based mainly on income and economic criteria. (-0.8%) · Freezing of emoluments including pensions in the public sector for a period of two years (this includes COLA effect) (-0.7%) · Reduction of the number of personnel in the broader public sector by 5,000 over the next five years (one recruitment for every four retirees) (-0.1%) 2012 (2012 Budget Law) measures (revenue) || || · Increase of the standard VAT rate from 15% to 17%. The inflationary impact of this measure on the calculation of the COLA index will be excluded (0.6%) · Increase of the tax rate on deemed dividend distribution from 15% to 17% (0.3%) · Application of the reduced VAT rate on purchases or construction of primary residences (0.3%) · Revenue from rights issue of one of the banks (0.2%) · Temporary contribution on gross earnings of private sector employees and pensioners: 0-€2500 0%; €2501 - €3500 2.5% (0.1%) Note: A positive sign implies that revenue / expenditure increases. Only measures yielding more than 0.1% of GDP are listed. Source: Commission services Table 7: Consolidation measures for 2012 in the MoU 2012 measures (expenditure) || · Scaled reduction in emoluments of public and broader public sector pensioners and employees including employees of private organizations as follows: €0-1000: 0%, €1001-1500: 6.5%, €1501-2000: 8.5%, €2001-3000: 9.5%, €3001-4000: 11.5%, €4001: 12.5% (-0.2%) 2012 measures (revenue) || · Dividend from a semi-government organization (0.2%) Note: A positive sign implies that revenue / expenditure increases. Source: Commission services
4.
Proposed new adjustment path
Despite the significant fiscal
consolidation undertaken in 2011-2012, Cyprus did not correct its excessive
deficit by the deadline established in the Council Recommendation of 13 July
2010 due to the deterioration in the budgetary position resulting from the
weaker overall position of the economy. 4.1 Macroeconomic outlook Looking ahead, the Cypriot economy is
expected to face strong headwinds in the coming years, with a projected return
to growth only in 2015 (Table 8). Under the Programme Scenario, the weakness of economic activity is expected to persist over the
first years of the programme period. It is projected
that domestic demand will continue to contract up to and including 2014, due to
a drag on economic activity from both falling household consumption and investment.
The immediate restructuring of the banking sector, which will impact on net
credit growth, the rapid deterioration in labour market conditions and the high
degree of economic uncertainty are together expected to weigh heavily on
domestic demand. Furthermore, there is a continued need to deleverage corporate
and private sector balance sheets. In addition, the temporary restrictions
required to safeguard financial stability are expected to hamper international
capital flows and to reduce business volumes in both domestic and
internationally oriented companies. The bail-in of uninsured depositors causes
a loss of wealth and will have short-term confidence effects, which will reduce
private consumption and business investment. This, compounded by the impact of
fiscal consolidation already undertaken and new measures agreed, is expected to
result in a considerable fall in domestic demand. Little reprieve can be
expected from exports amid uncertain external conditions and a shrinking
financial service sector. Growth is projected to rebound mildly in
2015 and stronger in 2016. The fiscal consolidation is expected to restore the
confidence of consumers and investors, while the result of deleveraging of both
household and corporate balance sheets over time would create the conditions
for more balanced growth. At the same time, the restoration of a sound and
well-capitalised banking system is expected to gradually loosen the tight
credit conditions in the economy. In 2015, first positive effects of the economic
adjustment programme are expected to be supported also by an improved external
environment and a gradual normalisation of labour market conditions. In 2016,
the economy is expected to build on the positive momentum set up in 2015 with
private consumption again driving economic activity, as economic sentiment
improves. Also, in the outer years 2015-2016, investment projects related to
the exploitation of natural gas should contribute increasingly to economic
growth. The recent reform of Cyprus' wage-indexation system (COLA) will
contribute to align public wages with developments in economic activity,
improve competitiveness, and support the economic recovery. This is expected to
have a positive impact on the external balance, with the current account
deficit contracting over the programme period and external debt, in particular
related to external liabilities of financial institutions, projected to
decline. Macroeconomic risks remain important and
tilted to the downside. On the domestic front, downside risks are associated
with domestic credit conditions and further deterioration of confidence in the
banking system. Moreover, there is a non-negligible risk of a cycle of
household and corporate defaults propagating through the economy, leading to
further banking sector losses, worsening of labour market conditions, stronger
than expected fall in house price and a prolonged loss of business and consumer
confidence. Also, the deep restructuring of the Cypriot banking sector could
have strong spill-overs on related professional business services and financial
services exports. More generally, the transition to a more diversified growth
model will be challenging for the economy in the coming years and will imply a
re-allocation of economic resources across sectors, which may take time and
will require flexible factor and product markets. Upside risks for the Cypriot
economy are limited, relating mainly to higher investment activity in the
energy sector and possible improvements in the external outlook, should the euro
area economic activity strengthen beyond expected. Table 8: Forecast of key macroeconomic and budgetary
variables under the Programme Scenario Source: Commission services p:provisional data; f:forecasted data 4.2 Government deficit and public debt trajectory An ambitious but achievable fiscal adjustment path over the
medium-term is essential to make Cyprus' public debt sustainable. For this
reason, a key objective of the fiscal strategy and the agreed consolidation
measures in the MoU is to achieve a strengthening of the primary balance over
the programme period, with primary balance targets of -2.4% of GDP in 2013,
-4.3% of GDP in 2014, -2.1% of GDP in 2015 and 1.2% of GDP in 2016. The
attainment of these targets is consistent with headline deficit targets of 6.5%
of GDP for 2013, 8.4% of GDP for 2014, 6.3% of GDP for 2015, and 2.9% of GDP in
2016 The adoption and implementation of fiscal-structural measures are
critical to achieve a permanent consolidation and maintain a primary surplus at
high level over the longer-term, leading to a primary balance surplus of 3% of
GDP in 2017 and 4% of GDP in 2018, which should be maintained at such level
thereafter. The range of fiscal-structural and structural reforms agreed in the
MoU include establishing a medium-term budgetary framework, undertaking
pension, health care and welfare system reform measures, enhancing revenue
collection and tax administration, and ensuring improvement to the public
finance management and the functioning of the public sector. The majority of the
fiscal adjustment measures for 2012-14 agreed in November 2012 are already
enacted. Some measures agreed
in November 2012, amounting to around 0.6% of GDP, are not yet implemented,
notably the revision of the property tax and of the social housing schemes.
These measures will be legislated and implemented before disbursement of the
first tranche of financial assistance. Moreover, as part of the 16 and 25 March
2013 Eurogroup political agreements, additional fiscal consolidation measures
for 2013 of around 1.5% of GDP will be legislated and implemented before
disbursement of the first tranche of financial assistance, namely (i) increase
in the statutory corporate income tax to 12.5%, (ii) increase in the interest
income withholding tax to 30% and (iii) increase in the bank levy to 0.15%. Finally,
some further measures, in particular additional public sector wage cuts and a
contribution by public sector employees to their health care scheme, will also be
implemented as prior actions. The total additional fiscal measures in 2013
therefore amount at minimum to 2.5% of GDP. The fiscal consolidation
implies that the improvement in the primary balance over 2013-16 will
contribute to reducing the debt ratio substantially within the programme
period, in spite of the rather strong debt-increasing effects from interest
expenditure and the projected recession (Table 9). Public
debt developments are projected to be largely influenced by the financial
assistance granted to finance the general government deficit, the redemption of
maturing medium- and long-term debt and the recapitalisation of some financial
institutions, notably the cooperative credit sector. Debt is projected to jump
from 85.8% of GDP in 2012 to around 128% of GDP in 2015. Thereafter, on the back
of solid primary surpluses and the projected return to positive GDP growth
rates, the debt-to-GDP ratio will start falling to around 124% of GDP in 2016. Medium-term downside
risks to the projected debt developments are, however, material and linked to:
(i) a possible stronger contraction of the economy and further worsening of the
labour market outlook, which would affect expenditure and revenue collection
and have a negative denominator effect, (ii) non-attainment of the agreed
primary surplus targets established in the programme, (iii) insufficient
structural fiscal measures to underpin sustained high primary surpluses, iv) a
less tax-rich composition of growth and possible stronger sensitivity of
revenues to the structural adjustment of the Cypriot economy, (v)
lower-than-expected privatisation proceeds; (vi) a worsening of the economic
situation in trade-partner economies, (vii) lack of success in regaining market
access at a reasonable borrowing cost following the programme period. Table 9: Public debt trajectory 2013-2016 under the
Programme Forecast || 2013 || 2014 || 2015 || 2016 Gross debt ratio (% of GDP) || 109.5 || 124.0 || 127.9 || 123.9 Changes in the ratio (pps) || 23.6 || 14.5 || 3.8 || -4.0 of which || || || || (1) Primary balance (pps) || 2.4 || 4.3 || 2.1 || -1.2 (2) Snowball effect (pps) || 11.7 || 7.4 || 1.0 || -0.4 Interest expenditure (pps) || 4.1 || 4.2 || 4.2 || 4.2 Growth effect (pps) || 8.1 || 4.5 || -1.3 || -2.4 Inflation effect (pps) || -0.5 || -1.2 || -1.8 || -2.2 (3) Stock flow adjustment (pps) || 9.6 || 2.9 || 0.6 || -2.4 Source: Commission
services 4.3 Extension of the EDP deadline In view of the distance at end-2012 to the
3% of GDP reference value, and taking into account the current adverse
macro-economic circumstances and the perspective of a
longer-lasting deleveraging of the economy, it would appear that four additional
years will be necessary for a sustainable correction of the excessive deficit. Fully-specified consolidation measures of around 4¾% of GDP in 2013
are agreed in the MoU. This consolidation effort
includes, as described above, additional fiscal measures in 2013 therefore of
around 2.5% of GDP, due to (i) the additional consolidation measures decided by
the Eurogroup as part of the political agreement on 16 and 25 of March 2013, (ii)
the remaining 0.6% of GDP of measures to which Cyprus agreed in November 2012
and which are not yet legislated (i.e. on property taxation and expenditure
cuts in housing schemes) and (iii) the public sector wage
cuts and contribution by public sector employees to their health care scheme,
amounting to about 0.4% of GDP. The Commission services' Winter 2013
forecast did not take into account these measures and nevertheless estimated an
improvement in the structural balance from 2012 to 2013 of 1.8% of GDP. Against
the background of a worse-than-expected deficit outcome in 2012 and substantial
revisions to the macroeconomic outlook and potential output estimates, the
improvement in the structural balance from 2012 to 2013 is now estimated at
around 1.3% of GDP. On the basis of the Programme Forecast of deteriorating
macroeconomic conditions, the headline deficit in 2013 is projected to increase
marginally to 6.5% of GDP. In 2014, fully-specified further consolidation measures amount to around
1¾% of GDP and are projected to improve the structural balance by 0.3% of GDP. It should be noted that these policy measures for 2014 have remained
unchanged compared to those that were laid down in the November 2012 draft MoU.
The Commission services' Winter 2013 forecast took into account these measures
and indicated an improvement in the structural balance from 2013 to 2014 of
around 1.4% of GDP. Based on the Programme Forecast, the structural balance is
now set to improve only by 0.3% of GDP. This lower projected improvement of
structural balance in 2014 – in spite of an unchanged set of consolidation
measures – can be explained by (i) the deterioration of the tax base of the
permanent measures introduced in 2013, which implies that some of these
measures are projected to have a decreasing impact in 2014. An example of this
is the increase in the withholding tax on interest income from 15% to 30%,
which is projected to yield EUR 138mn in 2013 but only EUR 83mn in 2014, due to
the reduction of the deposit base and of the interest rate paid. Albeit a
permanent measure, it shows up as a deterioration of the structural balance due
to a year-on-year reduction of the measure's budgetary impact by around EUR
55mn (0.3% of GDP). The same is the case for the increase in the bank levy;
(ii) the downward revision of the impact of some of the consolidation measures
already taken in light of the worse macroeconomic conditions throughout the
programme period; (iii) a projected reduction of revenue collection in 2014
of some tax measures (e.g. collection of income taxation and VAT), since their
revenue depends on economic activity of 2013 when the economy is projected to
contract by 8.7% and, (iv) the fact that the standard elasticity used to
determine the split between the cyclical component and the structural balance
may not capture well the erratic economic developments. This may imply that the
negative impact from the cyclical conditions is underestimated, which for a
given headline deficit would arithmetically reduce the calculated structural
effort. The bottom-up forecast of individual measures, item-by-item, may under
the highly uncertain macroeconomic conditions give a more appropriate view of
the fiscal effort, not least in a situation of significant shifts in actual and
estimated potential output. The amount of fiscal consolidation measures is on
average above 3% of GDP for the years 2013-2014. Albeit significant, the
corresponding improvement in the structural balance is only around ¾% of GDP on
average and remains insufficient to reduce the headline deficit. It should also be noted that in light of the substantial additional
consolidation measures for 2013 agreed in the Eurogroup meetings of 16 and 25
March and the adverse and highly uncertain macroeconomic conditions, inter alia
due to the imposition of temporary capital controls, loss of confidence and
financial sector instability, programme partners found that an ex-ante obligation
to implement further fiscal consolidation measures for 2014 (additional to the
measures adopted in December 2012 with effect from 1 January 2014) would not represent
an appropriate fiscal policy stance. However, an obligation of the Cypriot
authorities to stand ready to preserve the programme objectives by taking
additonal measures in the event of underperformance of revenues or higher
social spending, taking into account adverse macroeconomic effects, is laid
down in the economic and financial adjustment programme. High-quality permanent measures will be needed in 2015-2016 and
beyond to achieve the annual budgetary targets as set out in the MoU. For
2015-16, an additional around 2½% of GDP of measures would be required to
achieve the MoU targets of a primary deficit of 2.1% of GDP in 2015 and a
primary surplus of 1.2% of GDP in 2016. In line with the overarching principle
of an expenditure based adjustment, the measures should include, in particular,
reducing growth in expenditure on the public sector wage bill, social benefits
and discretionary spending, while minimising the impact of consolidation on
vulnerable groups and preserving the good implementation of Structural and
other EU Funds. Based on the macroeconomic projection and estimated interest
payments, the headline deficit is expected to be below the reference value in
2016.
5.
Conclusions
On current information, the average annual improvement of the structural budget balance over
2011-2012, after correction for the effects of revised potential output growth
and less tax-rich growth is estimated to be 2.4% of GDP. This is above the
minimum average annual fiscal effort of at least 1½% of GDP required by the
Council Recommendation, which is an important indication for the assessment of
whether Cyprus could be considered to have taken
effective action in line with the Council
recommendations. This is supported by a careful
analysis that shows that Cyprus adopted sizeable consolidation measures over
2011-12, with an estimated direct deficit-reducing impact of around 1½% of GDP
in 2011 and around 4¼% of GDP in 2012, based on a bottom-up assessment. For the period 2013-2016, Cyprus has committed
to a detailed consolidation path as outlined in the agreed MoU, which is fully
underpinned by specified measures for 2013-2014, most of which were already
legislated in the 2013 Budget Law or legislated as prior actions before the
disbursement of the first tranche of financial assistance. The 2013 Budget Law
was accompanied by a three-year Medium Term Budgetary Framework that embedded
the agreed deficit targets for 2013-2016. According to the MoU, the total
amount of fiscal consolidation measures amounts to about 4¾% of GDP in 2013 and
around 1¾% of GDP in 2014. Overall, the measures included in the agreed MoU are
expected, on the basis of the realistic macro-economic scenario underpinning
the MoU to lead to a sustainable correction of the excessive deficit situation
by 2016. The substantial deterioration in the
budgetary position resulting from the worse-than-expected economic downturn and
the weaker overall position of the economy than envisaged at the time of the
Council Recommendation implies that a new deadline for correction of the
excessive deficit by Cyprus is needed. In view of the projected distance at
end-2012 to the 3% of GDP reference value for the deficit, after taking into
account the current adverse macro-economic circumstances and the perspective of
a longer-lasting deleveraging of the economy, it would appear that four
additional years will be necessary for a sustainable correction of the
excessive deficit. Granting four additional years for the
correction of the excessive deficit would be commensurate with intermediate headline
deficit targets of 6.5% of GDP for 2013, 8.4% of GDP for 2014, 6.3% of GDP for
2015, and 2.9% of GDP in 2016. The underlying improvement in the structural
budget balance implied by these targets is 1.3% in 2013, 0.3% in 2014, 0.7% in
2015, and 1.8% in 2016. This would correspond to an average annual fiscal
effort of 1% of GDP over 2013-2016 in order to bring the headline government
deficit below the 3% of GDP reference value by 2016. Table
10: Comparison of key macroeconomic and budgetary projections [1] OJ 115, 9.5.2008, p. 99–102. All EDP-related documents for Cyprus
can be found at the following website: http://ec.europa.eu/economy_finance/sgp/deficit/countries/cyprus_en.htm. [2] Council Recommendation to Cyprus with a view of bringing an end to
the situation of an excessive deficit procedure, 11296/10, Council of the
European Union. [3] Communication from the Commission to the Council - Current state of
the excessive deficit procedure in the Member States and assessment taken by Cyprus,
Finland, Bulgaria and Denmark in response to the Council Recommendation of 13
July 2010 with a view to bringing an end to the situation of excessive
government deficit - COM(2011) 22 final. [4] The Commission
services’ 2010 Autumn Forecast was published on 29 November 2010. The data
cut-off date was 15 November 2010.