D&B Country Report D&B Country Report Cyprus DB3a (Slight Risk)

Contents

Country Risk Analyst PART ONE: Executive Summary Markus Kuger Telephone: 01628 492438 Email: [email protected] Key Information 2

Risk Snapshot 3 Risk Snapshot 3 Outlook Summary 4 Sales Email: [email protected] PART TWO: Risk Outlook Telephone UK: +44 (0)1628 492700 US: +1 800 234 3867 Political Risk 6 Rest of world: contact your local Domestic Politics 6 office or call +44 1628 492700 Policy Agenda 7 International Relations 8

Economic Risk 10 Publisher Global Outlook 10 D&B Economic Performance 11 Marlow International Economic Policy 13 Parkway External Economic Risk 16 Marlow Bucks SL7 1AJ Commercial Risk 19 United Kingdom Business Performance 19 Tel: 01628 492000 Credit Risk 20 Fax: 01628 492929 Email: [email protected] Financial Sector Risk 21 Other Commercial Risks 22

Data Summary 23

While the editors endeavour to ensure the accuracy of all PART THREE: Risk Environment information and data contained in this D&B Country Report, Political Environment 24 neither they nor Dun & Political Overview 24 Bradstreet Limited accept Political System 25 responsibility for any loss or Political Forces 26 damage (whether direct or Security 28 indirect) whatsoever to the customer or any third party International Environment 28 resulting or arising therefrom. Economic Environment 30 Economic Overview 30 Economic Framework 30 Trade Profile 32 © All rights reserved. No part of Long-Term Economic Potential 35 this publication may be reproduced or used in any form or by any means graphic, Commercial Environment 36 electronic or mechanical, Overview 36 including photocopying, Physical Environment 36 recording, taping, or information Legal and Regulatory Environment 37 storage and retrieval systems Corruption 40 without permission of the Taxation 41 publisher. Trade Environment 43

Investment Environment 46

Additional Sources of Information 48 This D&B Country Report was prepared in September 2010. PART FOUR: User Guides

Glossary 49

Country Risk Indicator Definition & Report Guide 50

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Key Information

Basic Country Information

Surface area (sq km) 2,951 Capital Nicosia Country population (m) 0.8 Population of capital (m) 0.3 Official language(s) Greek, Turkish Timezone of capital GMT +2 hours Political Information

Political system Presidential democracy Ruling coalition AKEL, DIKO Head of state & govt. President Demetris Christophias Last election Parliamentary: 2006; Presidential: 2008 Next election Parliamentary: 2011; Presidential: 2012 Trade & Commercial Information

Trade terms Top 3 export goods (% of total exports) Minimum terms SD Manufactured products 60.0 Recommended terms SD Raw agricultural products 17.4 Usual terms 30-180 days Processed agricultural products 16.7

Transfer situation Top 3 import goods (% of total imports) Local delays 0-2 months Fuels & lubricants 28.0 FX/bank delays 0-1 months Transport equipment 25.4 Import cover 1.2 months Manufactured products 15.5

Export credit insurance cover Top 3 export markets (% of total exports) US Eximbank Full cover available Greece 23.8 Atradius Full cover available Other-EU 13.6 ECGD Full cover available Middle East 12.0 Euler Hermes UK Full ST cover available Top 3 import sources (% of total imports) International sanctions and trade restrictions Greece 20.0 None known Italy 11.0 UK 9.0 Economic Data

Key country data 2007 2008 2009 2010f 2011f GDP (current EURbn) 15,879 17,248 16,946 17,247 18,059 GDP (current USDbn) 21,752 25,364 23,537 22,399 23,454

Real GDP growth (%) 5.1 3.6 -1.7 -1.0 1.7 Inflation, annual average (%) 2.2 4.4 0.2 2.8 3.0 Government balance (% of GDP) 3.4 0.9 -6.1 -5.8 -5.2 Unemployment (% of labour force) 4.0 3.6 5.3 6.8 7.0 Current account balance (% of GDP) -8.4 -17.1 -8.1 -6.5 -5.8

Global data 2007 2008 2009 2010f 2011f World real GDP growth (%) 4.2 1.8 -2.0 2.7 2.6 US real GDP growth (%) 2.1 0.4 -2.4 2.0 1.7 Oil price, Brent Crude (USD/b) 72.3 97.9 61.8 77.4 83.2 Comparative Market Indicators

Cyprus Greece Italy Malta Portugal Income per capita (USD) 27,023 29,554 35,282 19,226 20,813 Country population (m) 0.9 11.2 59.9 0.4 10.7 Internet users (% of population) 49.8 44.5 48.8 58.9 48.3 Real GDP growth (% p.a., 2010-19) 2.0-3.0 1.5-2.0 1.0-1.5 3.0-3.5 0.5-1.5 Sources: Central Bank of Cyprus; Eurostat; Statistical Service of Cyprus; World Bank, World Development Indicators; D&B

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Risk Snapshot

Country Risk Indicator: DB3a (Slight Risk) Enough uncertainty over expected returns to warrant close monitoring of country risk. Customers should actively manage their risk exposures.

The DB country risk indicator is a comparative, cross-border assessment of the risk of doing business in a country. The indicator seeks to encapsulate the risk that country-wide factors pose to the predictability of export payments and investment returns over a time horizon of two years.

Risk Snapshot

• Cyprus’ political risk outlook has worsened since Dervish Eroglu was elected president of the Turkish Republic of Northern Cyprus in April 2010. Reunification talks have since reached deadlock and prospects for a permanent peace settlement on the divided island have receded due to unfavourable political conditions on both sides. We do not expect a reunification agreement in our forecast period.

• The effects of the financial crisis on Cyprus were not as severe as on other Mediterranean countries, but the economy is only slowly recovering from the negative shocks of the past two years; the construction and the tourism sectors in particular are suffering from low demand.

Positive Risk Factors

+ The leaders of the Greek-Cypriots and the Turkish-Cypriots might be able to reach agreement on some of the disputed topics, like citizenship and government structure, which would boost the prospects of the reunification talks.

+ The economy showed signs of recovery in 2010 and real GDP growth will return to positive levels in 2011.

+ The Greek debt crisis did not affect Cyprus as much as other Mediterranean countries and the government has not yet had problems financing its deficit (owing to low interest rates and low risk premiums on government bonds).

+ The country’s parliament rejected government proposals to increase corporation tax, maintaining Cyprus’ position as a very attractive destination for FDI.

Negative Risk Factors

− Political stability decreased further after a junior coalition partner left the government and a Supreme Court ruling weakened the president’s position.

− The election of Dervish Eroglu (the then party leader of the nationalist opposition) as president of the Turkish Republic of Northern Cyprus in April 2010 has made reunification very unlikely in the short term.

− The government has to reduce its high deficit by 2012 but has so far failed to agree on any noteworthy austerity measures.

− Austerity measures in several of Cyprus’ main trading partners create downside risks for the tourism- and export-oriented economy.

− Despite the favourable commercial environment, the island’s division is a major deterrent for investors, hampering investment activity in Cyprus.

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Outlook Summary

Cyprus offers a ‘slight risk’ operating environment for businesses, as reflected in its DB3a rating. The economy is small, but prosperous, and has been significantly reformed in recent years as a result of its EU accession in 2004 and the introduction of the euro in 2008. The commercial risk environment is favourable, while its benign investment climate, preferential corporate tax regime, flexible labour market conditions and modern infrastructure have helped Cyprus to develop into an important regional and international business centre. The economy has slowed significantly because of the global financial crisis and a further deterioration will take place in 2010. However, signs of a recovery in 2011 are clearly visible.

The still-unsolved political/geographical division of the island will weigh down investment activity in real estate in the forecast period, and it continues to handicap economic development. As a result, the key challenge ahead will be to find a sustainable solution to the island’s division. The current reunification negotiations are the best chance in many years for finding a workable political settlement and could lead to an upgrade to Cyprus’ country risk rating, which has not changed July 2009. However, this chance for reunification has decreased since mid-2009 because of the presidential election results in the Turkish-Cypriot part of the island and due to several developments in the Greek-Cypriot political landscape.

Comparative Risk Indicator Histories

Lowest 1 Risk

2

3

4

5

D&B Risk IndicatorRisk D&B Cyprus Greece Italy 6 Malta Portugal Highest Risk 7 2005 2006 2007 2008 2009 Latest

Source: D&B

Political Risk Outlook

The presidential elections in the Turkish Republic of Northern Cyprus (an entity that is not internationally recognised) in April 2010 had a significant impact on the outlook of the ongoing reunification talks between both ethnic groups. The more amenable President Mehmet Ali Talat was replaced by Dervish Eroglu, the then leader of the nationalist party in Northern Cyprus. This further reduced the chances of rapid reunification, as President Eroglu has no interest in making concessions to the Greek- Cypriot side. Eroglu’s hardline position was reinforced in local elections in July 2010, making it very unlikely that he will be more conciliatory in the ongoing talks.

Moreover, developments in the Greek-Cypriot part of the island also had a detrimental effect on the chances of reunification. The social democratic junior coalition partner left the government because of the compromises President Demetris Christofias made during the talks, leaving the government with only a single-seat majority in parliament. In addition to the loss of the social democratic party (EDEK) as a coalition partner, there are serious differences between the remaining business-friendly junior coalition partner and the senior coalition partner (the Communist Party), over further austerity measures to reduce the public deficit, as well as over the reunification process. The

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position of the pro-reunification president weakened in 2010 because of a ruling of the Supreme Court of Cyprus, which reduced his responsibilities and transferred power to parliament, necessitating closer co-operation between the president and the coalition partners in the future. There is a considerable risk that the government will break up in the forecast period.

Economic Risk Outlook

Cyprus’ navigated through the global and regional financial crises better than comparable states in the region. Most macroeconomic indicators deteriorated to a lesser extent than in other Mediterranean countries, although the Cypriot economy contracted in 2009 and will also shrink in 2010. For 2011, however, we expect real GDP to grow by 1.7%, based on higher private consumption. That said, the recovery still faces several downside risks: a slightly appreciated euro and higher domestic inflation rate will lead to a loss of competitiveness on the European and the global markets; moreover, austerity measures in Cyprus and its trading partner countries could lead to a decline in domestic demand (in Cyprus) and import demand (in the trading partner countries) and therefore to slower economic growth in the second half of 2010; in particular, spending cuts in Greece, Italy and other Mediterranean countries will have a negative spill-over effect on the Cypriot economy because of fewer exports to those countries, thus GDP will decline in Cyprus in 2010 and grow only modestly in 2011.

Nonetheless, the austerity measures will have some positive effects on Cyprus, too. Owing to reduced investment in the construction sector in China, we expect prices for steel and cement to decline on world markets; this will help to stimulate investment in the currently sluggish Cypriot construction sector and real estate market. Indicators for future investment in the construction sector already improved in Q2 2010, and a slower downturn in that important sector is very likely for 2011 (albeit at levels still far away from the boom years in the mid-2000s).

Commercial Risk Outlook

Cyprus offers a favourable commercial environment. A number of wide-ranging economic and structural reforms were promoted in the lead-up to its accession to the EU (and since), covering the areas of competition and the financial and business sectors. The FDI regime has been fully liberalised, tax reform has been implemented, and most investment restrictions have been lifted. The corporate tax rate remains at 10% (a plan to increase it by 1 percentage point was rejected by parliament in August 2010). Several indicators, such as the industrial production index, showed signs of recovery in the first half of 2010, and we expect them to improve further over the forecast period. The effects of the financial crisis on the Cypriot financial sector were relatively small because of its focus on traditional banking activities and conservative lending practices. The banks’ predominant reliance on more stable retail funding, negligible exposure to complex securities, high levels of liquidity, and strong supervision helped to shield it from the global crisis, and recent and ongoing stress tests carried out by the Central Bank of Cyprus indicate that the system has the capacity to absorb further shocks.

On the negative side, the payments performance of Cypriot firms has worsened since August 2009, and we fear a further deterioration. Concurrently, bankruptcy rates (both for companies and individuals) rose significantly in the first six months of 2010, thus making a further decline in payments performance very likely. The division of the island creates massive problems for the real estate sector in both the Greek-Cypriot and the Turkish-Cypriot parts of the island. The ownership of land and houses is often unclear because of displacement of the former owner, and it is therefore very difficult to acquire enforceable property rights (including deeds). Recent rulings from several European courts have increased the danger of investment in real estate that has an unclear background: this could reduce further investment until a trustworthy solution on property rights can be found in the reunification talks.

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Political Risk

Outlook Summary: The election of Dervish Eroglu as president of the Turkish Republic of Northern Cyprus (an entity that is not internationally recognised) in April 2010 has made make the reunification process between the Greek and the Turkish parts of the divided island even more difficult. Moreover, the willingness to seek reunification is also shrinking on the Greek-Cypriot side: the Social Democratic movement (EDEK) has left the coalition government of President Demetris Christofias because of concessions the president made to the other side in the reunification talks. Consequently, negotiations between the two ethnic groups are in a deadlock at the time of writing, despite international assistance from the UN. It seems very unlikely that an agreement on reunification can be achieved during the forecast period.

Domestic Politics

The reunification The unresolved conflict between the Republic of Cyprus and the Turkish Republic of process remains the Northern Cyprus (TRNC, which is not an internationally recognised entity) still most important topic overshadows domestic politics. Since the division of the island in 1974, and even more in domestic politics so since the North unilaterally declared itself independent in 1983 (a move only recognised by the Republic of Turkey), the question of reunification has dominated all aspects of political life on the island. The repercussions of the 2004 ‘Annan Plan’ referendum, a referendum on a UN proposal to settle the Cyprus dispute, were evident in the last parliamentary election in 2006, influencing the election result such that anti- reunification parties were victorious in the poll (Political Overview, p24).

Parliamentary Standings Party House of Representatives Share of vote (%) Seats Progressive Party of the Working People (AKEL) 31.2 18 Democratic Rally (DISY) 30.3 18 Democratic Party (DIKO) 17.9 11 Movement of Social Democrats (EDEK) 8.9 5 European Party (EURO.KO) 5.7 3 Ecological - Environmental Movement-Green Party (KEP) 2.0 1 Other Parties 4.0 0

Total 100.0 56 Source: IFES, IFES Election Guide

In contrast, the Annan Plan referendum had almost no effect on the two-round presidential election in February 2008: the results of the election clarified the preferences of the Greek-Cypriot community, as over 65% of the electorate supported pro-unification candidates in the first round. Demetris Christofias, who is highly pro- reunification, won the second round of the election in a close race against the candidate of the centre-right DISY party, Ioannis Kassoulides. For the first time since independence in 1960, Cyprus is governed by a president from the communist party.

Presidential Election Result, February 2008 Candidate Share of vote (%) 1st Round 2nd Round Demetris Christofias (AKEL) 33.3 53.4 Ioannis Kassoulides (DISY) 33.5 46.6

Tassos Papdopooulos (DIKO) 31.8 - Source: IFES, IFES Election Guide

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In the first months of his presidency, Christofias appointed DIKO and EDEK party The government members to his cabinet and convinced the opposition DISY to re-enter the National coalition parties Council (the main consultative body on the reunification issue). However, following the disagree about the first year of Christofias’ administration, relations between the government coalition reunification parties have been anything but smooth. Both DIKO and EDEK have strongly objected process or expressed their disagreement over AKEL policies on a number of issues, such as AKEL’s (and President Christofias’) refusal to apply for accession to NATO’s Partnership for Peace programme, aspects of the educational reform, a bill on social security funds, measures to deal with the current economic downturn, as well as aspects of economic policy. More importantly, they have expressed their strong opposition to President Christofias’ handling of (and his policies towards) the reunification negotiation process.

The tensions between the coalition partners led to the withdrawal of EDEK’s ministers from the government in February 2010. EDEK party officials justified the decision by citing the too far-reaching concessions that President Christofias made to the Turkish- Cypriot side in the reunification talks. The pullout by EDEK reduced the government’s The president’s majority in parliament to the smallest possible majority of one seat. Frictions between position has AKEL and the remaining coalition partner, the DIKO party, have also increased. Some weakened… DIKO MPs demanded a vote within their party over whether they should leave the coalition or stay. Although DIKO party chairman Marios Garoyian managed to prevent the vote taking place, there are still groups in the centre-right party that strongly oppose President Christofias’ positions in the reunification talks. In July 2010, DIKO voted unanimously against Christofias’ proposals for the first time since they joined the government in 2008: the business-friendly party opposed several planned tax raises suggested by the communist president (see Fiscal Policy, p14). The president’s position was also damaged by a ruling by the Cypriot constitutional court in December 2009. President Christofias had appealed to the court because the parliament had reduced taxes against his will, but the court ruled that parliament had the right to reduce taxes, thereby shifting budgetary power from the president to the parliament for the first time since the country gained independence. Parliament can thus block the president’s budget decisions in the future, forcing President Christofias to co-operate more closely with AKEL and DIKO MPs.

There is a risk that the government could break up before the next election owing to the developments mentioned above. AKEL and DIKO disagree on several important topics, namely the reunification process and economic policy. All political parties (including those in opposition) are trying to enhance their profiles ahead of the next parliamentary …and there is a risk election in 2011, making it very unlikely that either AKEL or DIKO will be open to that the government compromise, and thus increasing the risk of the government breaking up. However, it is could break up relatively unlikely that either AKEL or DIKO will bring about the end of the coalition such a short time before the election for fear of damaging their public image. On balance, we expect the government to remain in office until the election in May 2011.

The struggles within the coalition also make a successful outcome to the reunification talks less likely (the talks restarted in September 2008, after the failed referendum in 2004). President Christofias, who is leading the negotiations for the Greek-Cypriot side, has to pay more attention to the view of DIKO, which is less unification-friendly than AKEL. In addition, the parliamentary elections in May 2011 could leave Christofias without a majority in parliament, making governance very difficult for any new government because of a deadlock between the president and the parliament.

Policy Agenda

The reunification issue will remain the most important problem for Cypriot policy makers. Since his election in 2008, pro-unification President Christofias has tried to The reunification speed up negotiations with his Turkish-Cypriot counterpart, and Christofias has already process has lost said that he will not run for a second term in 2012 if a reunification is not achieved momentum before then. Talks between Christofias and the then president of the TRNC, Mehmet Ali Talat, started in March 2008, the first attempt to achieve the reunification of the divided island since the failed referendum on the Annan-Plan in 2004. Six working groups and

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seven technical committees were established to facilitate the fully-fledged direct talks, which began officially in September 2008. Since then, meetings have been held, during which the chapters regarding governance and power sharing, property issues, EU and economic matters have been discussed. The talks ended without agreement shortly before the presidential elections in the TRNC in April 2010. In the elections, Talat was defeated and replaced by Dervish Eroglu, the then prime minister (he is from the nationalist National Unionist Party). Since then, the talks have been postponed or even cancelled several times and no substantial progress has been made in the few meetings that have been held. In addition, public opinion in the Greek part of the island has shifted towards a more reunification-sceptic point of view.

As mentioned above, the biggest problems in the reunification talks are the different positions on property rights (see Other Commercial Risks, p22), the organisation of the Reunification government and security guarantees. Those problems have increased since Eroglu has within the next two headed the delegation of the TRNC, as he does not feel committed to agreements his years is highly predecessor Talat achieved with the Greek-Cypriot side. After his election, Eroglu tried unlikely, despite UN to set up a deadline for the negotiations, possibly with the covert agenda that no pressure agreement on highly controversial topics could be reached such a short time. President Eroglu has stated that, should the talks fail, the international community should finally accept the division of the country and recognise the TRNC as an official state. However, thanks to Greek-Cypriot lobbyism a UN Security Council resolution of June 2010 was diluted, only saying that it is ‘desirable’ that the talks should come to an end by the end of 2010. Although there is no explicit deadline for the UN-monitored talks, there are signs that the UN is losing patience: the pressure on both sides was increased recently by a warning about the possible withdrawal of the UN peacekeeping force in Cyprus, which has controlled the buffer zone between the Greek and the Turkish parts of the island since 1964. With both sides unwilling to give up their positions on the crucial topics of property rights and security, it seems highly unlikely that an agreement can be reached within our two-year forecast period.

Another key priority is cutting back the costs of the policy measures that had been taken to mitigate the negative effects of the global financial and economic crisis on the Reducing the Cypriot economy. To this end, the government has announced a package of measures government deficit that should reduce the fiscal deficit (which stood at 6.1% of GDP at the end of 2009; see is another potential Fiscal Policy, p14). For example, the government decided to raise fuel taxes, eliminate trouble spot preferential VAT rates, and cut social transfers to those with household incomes above EUR60,000 per year. Those measures were carried by both coalition partners (the notionally communist AKEL and the more business-friendly DIKO). Despite the tax rises already announced, further measures still have to be taken, but there are disagreements between the coalition partners about the focus of such measures. AKEL prefers tax rises, especially in the business sector and for well-off Cypriots, whereas DIKO prefers to reduce social transfer payments, as well as job and wage cuts in the public sector (a traditional AKEL stronghold). As such, these plans are heavily disputed. In July 2010, AKEL unilaterally tried to raise corporate and property taxes, although DIKO decided to vote with the opposition against that proposal. As a result, AKEL’s proposal was short of a majority in the parliament and failed, causing more trouble for the already stressed government coalition.

International Relations

Cyprus’ international relations are friendly with almost every country, except Turkey. The Cypriot-Russian friendship is particularly deep, but relations with the US are also good. Cyprus makes efforts to secure support from its powerful allies for its position on the reunification process.

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Relations with Russia

We expect the warm relations between Russia and Cyprus to improve further over the forecast period. Russian tourists are becoming more and more important for the Cypriot Cyprus’ economy tourist industry and Cyprus has become the most important haven for Russian capital in benefits from the EU; however, some sources of Russian FDI are dubious and the Cypriot authorities Russian tourists and fear money-laundering activities. Cyprus is officially the third-largest foreign investor capital inflows in the Russian economy and Cyprus is used by a large number of large Russian businesses to create offshore firms. In 2009, the two countries signed a protocol on economic co-operation and a double-taxation avoidance agreement, thus removing Cyprus from the Russian tax blacklist (see Taxation, p41). Consequently, Cyprus will attract even more investments from Russia in the near future, thus increasing the island’s economic growth potential.

Relations with the US

Relations with the US deteriorated in June 2010, when a Russian spy escaped from the US and was later arrested by Cypriot police. Although US officials warned the Cypriot Relations between side in due time, the arrested person disappeared after he was released from prison on Cyprus and the US bail. US government officials accused the Cypriot side of favouring Russia by allowing deteriorated in June the spy to escape. However, the incident was minor and D&B expects the relations 2010 but should between both states to improve again, as Cyprus needs the support of the US in the recover reunifications talks and in the UN Security Council, while the US is interested in a high degree of political stability in the broader Middle East region. Cyprus can thus still rely on US pro-Cypriot lobbyism in the reunification talks. Furthermore, the US can positively (from a Greek-Cypriot point of view) influence the opinion of their ally, Turkey, and, via Turkey, the TRNC on the reunification topic. This strengthens the Greek-Cypriot side’s position in the talks.

Relations with Turkey

Relations between Turkey and the Republic of Cyprus are traditionally troubled. This is because of the Turkish invasion of the north of the island in 1974 (see Political The April 2011 Overview, p24). The Turkish government is still the only government that recognises elections in Turkey the TRNC (established in 1983) instead of the (Greek-Cypriot) Republic of Cyprus. The could worsen future of the relations is uncertain. On the one hand, the parliamentary elections in bilateral relations Turkey in April 2011 are likely to lead to a more nationalistic tone in the official statements of the Turkish government: Turkish Prime Minister Recep Erdogan will try to secure votes from the nationalist opposition parties and will therefore reject any settlement in the reunification talks. On the other hand, a referendum in Turkey in September 2010 reduced the influence of the army (a stronghold of nationalist and anti- reunification forces) in Turkish politics. If Prime Minister Erdogan wins the elections in April 2011, we expect his return to a more generous position in the reunification talks, thus leading to a higher likelihood of reunification. However, if the nationalist opposition wins the election (unlikely at the time of writing, but not impossible), D&B sees almost no chance for a positive settlement.

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Economic Risk

Outlook Summary: The austerity measures in Cyprus’ trading partner countries will lead to a decline in foreign demand and to slower economic growth in the second half of 2010. In particular, the spending cuts in Greece, Italy and the UK will have a negative spill-over effect on the Cypriot economy because of fewer exports to those countries, meaning that the economy will continue to contract in 2010 and grow only modestly in 2011. However, the austerity measures will also have some positive effects on Cyprus: owing to a reduction in investment in the construction sector in China, prices for steel and cement are expected to decline on world markets, which could help to stimulate investment in the sluggish Cypriot construction sector and real estate market.

Global Outlook

Policy measures China’s policy tightening, European fiscal austerity and the slow and fragile recovery in could slow down the the US could result in a renewed slowdown of the world economy in the latter half of economic recovery 2010. While we still expect 2.7% global real GDP growth, downside risks are elevated for the OECD as the fiscal orthodoxy needed to stem debt costs in Europe takes effect, and, in the US, as consumer retrenchment, a new downturn in housing and severe budgetary problems in the states are set to curtail demand. Meanwhile, policymakers in China are determined to deflate the property sector and rationalise the steel sector. All these factors will weigh on commodity prices in the next two quarters. We expect that the new financial stresses in Europe will result in increased funding costs as interbank margins increase, cutting credit and investment, and that growth in Europe and the US will remain mediocre at best.

Global Forecast Summary 2007 2008 2009 2010f 2011f Real GDP growth (%) World 4.2 1.8 -2.0 2.7 2.6 US 2.1 0.4 -2.4 2.0 1.7 Euroland 2.8 0.6 -4.1 0.8 1.1 Financial indicators US interest rate (Federal Funds, year-end, %) 4.25 0-0.25 0-0.25 0.50 0.75 Euroland interest rate (Refinancing, year-end, %) 4.00 2.50 1.00 1.00 2.00 EUR:USD exchange rate (annual average) 0.73 0.68 0.72 0.77 0.79 Commodity prices

Oil price (Brent dated, USD/b, annual average) 72.3 97.9 61.8 77.4 83.2 Sources: IMF, International Financial Statistics; World Bank, World Development Indicators; D&B

Drastic fiscal consolidation measures (such as sharp tax rises and reductions in public spending) across many developed countries remain a key downside risk to the global recovery. In their meeting in Toronto in June 2010, G20 leaders agreed to pursue ‘growth-friendly’ fiscal cuts, aiming to halve budget deficits by 2013 (Japan is exempt from this goal, although it has also made debt reduction a top priority). EU countries will see particularly sharp cuts amid the Greek debt crisis. Planned cuts in France, Italy and the UK will amount to around USD75bn (1.1% of their combined GDP) in 2010- 11. Outside the G20, the most vulnerable euro area members (Greece, Ireland, Portugal and Spain) plan to reduce their deficits by a sizeable USD82bn (4.5% of their combined GDP) by 2011. These cuts risk undermining demand in developed countries and, eventually, global growth prospects.

Spending cuts in For Cyprus, the planned spending cuts in Greece and the UK in particular will create Greece and the UK multiple downside risks because of the importance of both economies as key will reduce Cypriot destinations for Cypriot exports. Additionally, European fiscal austerity will reduce exports tourist arrivals from European states (see Trade Profile, p32).

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Economic Performance

More than a decade of sustained and strong economic growth in Cyprus came to an end in the second half of 2008, and real GDP fell by 1.7% in 2009.The downturn in gross fixed capital formation and exports, which both declined at around 12%, were the key factors behind the decline in GDP, but private consumption also fell considerably. Latest available data from the Cypriot statistics office show that the economy is still shrinking: real GDP fell by 1.5% in Q1 2010 and by 0.2% in Q2 year on year (y/y). However, the pace of the economic downturn has slowed: in Q4 2009, real GDP had fallen by 2.7% y/y.

Real GDP Growth

% Cyprus Malta 8.0 Portugal Greece

6.0

4.0

2.0

0.0

-2.0

-4.0 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Sources: Eurostat; D&B

The slowdown will We expect real GDP growth to decline modestly in the second half of 2010 because of ease in the second lower public and private consumption, leading to an overall decline of real GDP of 1% half of 2010 in 2010. Because of a recovery in household consumption and increased exports, we expect the economy to grow modestly by 1.7% in 2011, which is in line with the recovery in other Mediterranean countries.

Economic Activity Real % change 2007 2008 2009 2010f 2011f Private consumption 9.4 8.4 -3.0 -1.6 2.0 Government consumption 0.3 6.2 5.8 -1.2 -3.4 Gross fixed capital formation 13.4 8.6 -12.0 -9.9 -3.6 Exports 6.1 -2.1 -11.8 0.5 1.6 Imports 13.3 8.0 -19.8 -1.7 2.8 GDP 5.1 3.6 -1.7 -1.0 1.7

Consumer prices (year-average, % change) 2.2 4.4 0.2 2.8 3.0

Unemployment (% of labour force) 4.0 3.6 5.3 6.8 7.0 Sources: Eurostat; D&B

Household Consumption

Private consumption made up almost 70% of demand-side GDP in 2009 and has been the main driver of economic growth in recent years, growing by double-digit rates from Increased savings Q4 2007 until Q3 2008. This was supported by low levels of unemployment and low and decreased borrowing costs, as well as buoyant property and equity prices. However, since then, lending by the private consumption has been losing momentum, growing by only 1.9% and 4.5% y/y financial in Q4 2008 and Q1 2009. It has declined sharply since Q2 2009, with the latest data for institutions have Q1 2010 showing a dip of 10.8% y/y; this mainly reflects a deterioration in the labour reduced household market (see Industrial Relations and the Labour Market, p30). Furthermore, consumption households increased their savings because of the uncertain economic situation after

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mid-2009. For example, deposits by households held with monetary financial institutions increased by 13.6% y/y in June 2010, compared with 4.3% in June 2009. The increased savings rate goes hand in hand with a lower household consumption rate, as it also reduces disposable income.

We expect private consumption to decline considerably in 2010 because of persisting uncertainty, tighter credit conditions and the still-rising unemployment rate. For 2010, we expect private consumption to shrink by 1.6%, but for 2011 we forecast a modest recovery because of increased consumer confidence (which returned over the first eight months of 2010 and will increase spending after some delay), increased wages and improved lending conditions; private consumption will rise by 2.0% in 2011.

Gross Fixed Capital Formation

Gross fixed capital formation grew by high single-digit or even low double-digit figures from Q3 2003 until Q3 2008. This trend came to an end during the financial crisis. Investment declined Since Q4 2008, gross fixed capital formation has shrunk markedly; latest data for Q1 sharply in 2009 and 2010 show a decline by 13.4% y/y. Investment in equipment (including machinery) will not pick up deteriorated particularly fast: data for Q1 2010 show a decrease of 24.8% y/y. The until 2011 construction sector, representing a sizeable 66.3% of total investment, did not perform well in 2009 and the first half of 2010 either; Q1 2010 data show a decline in investment in housing and other construction by a further 8.5% y/y.

However, there are signs that the downturn in investment in real estate and construction will be lower in the near term. Reduced investment levels in China will lower prices for raw materials like steel and cement, thus lowering the costs for investment in construction. Additionally, the number of building permits, which is a significant indicator for future investment in construction, developed favourably in the first five months of 2010. During that period, 3,827 building permits were issued, registering an increase of 3.5% compared with the corresponding period of the previous year. The total value of these permits increased by 8.5% and the total area grew by 7.6%. Overall, D&B expects grossed fixed capital formation to shrink again in 2010 and 2011; we forecast a decrease of 9.9% in 2010, while for 2011 we forecast a further decrease of 3.6%. Thus gross fixed capital formation will not make a positive contribution to real GDP growth (although the negative impact will diminish significantly).

Net Exports

Reflecting a slowdown in private consumption and investment, import of goods and services declined by almost 20% in 2009, after having grown by 8%% in 2008. Data for Q1 2010 show that import growth had returned to a positive level, growing by 0.5% y/y. In addition, the deteriorating external environment had an adverse effect on exports, which declined by almost 12% in 2009 and 6.2% in Q1 2010 y/y. In 2008, exports had shrunk by only 2.1%. According to our estimates for 2010, imports will decrease by 1.7% because of sluggish private and public demand. Exports will grow slowly (by 0.5%), mainly because of higher revenues from tourism (especially during the summer holiday season) and also due to base effects. For 2011, D&B expects both imports and exports to grow modestly. We expect the effect of the improved tourism infrastructure to lead to a growth in exports of 1.6%. Nonetheless, austerity measures in many European countries (especially in Greece and the UK, which are important export markets for Cyprus, see Trade Profile, p32) and a slightly appreciated euro will prevent a higher increase of exports. D&B expects imports to grow by 2.8% in 2011, due to a modest pick-up in global oil prices and because of an increase in private consumption, leading to a higher import demand.

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Inflation

Latest available data from Cystat, the Cypriot statistics office, show that the Harmonised Index of Consumer Prices increased by 3.3% y/y in August 2010. This is Inflation increased significantly higher than the inflation rate in August 2009, when the CPI decreased by in the first half of 1.0%. The inflation rate increased over the first eight months of 2010, rising from 2.0% 2010 because of y/y in December 2009. The relatively sharp hike in Q1 and Q2 2010 resulted mainly higher energy prices from base effects (lower oil prices and a stronger euro in 2009 both put downward pressure on inflation in 2009). Changes in oil prices have a big effect on the Cypriot inflation rate because the country is heavily dependent on oil imports (it does not have any natural crude oil resources). For example, in April 2010 energy prices increased by 22.7% y/y, whereas in April 2009 they declined by 19.2% y/y. The prices for food remained pretty much stable in the first half of 2010; data for Q2 2010 show a decrease of 2.2% y/y. Prices for services also declined modestly in Q1 and Q2 2010. As a result, core inflation, which excludes the prices for energy and unprocessed food, showed a downward trend in the first six months of 2010, but this was nullified by the increase of the energy prices, leading to an increase in the CPI.

Inflation

% Cyprus Greece 6.0 Malta Portugal 5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Sources: Eurostat, D&B

For the second half of 2010 and for 2011, we expect the inflation rate to rise further because of further increasing oil prices and a general recovery of the economy, including rising nominal wages. For 2010, D&B expects an inflation rate of 2.8%, and for 2011 we forecast 3.0%. This is higher than the inflation target of the European Central Bank (see Monetary Regime, p32) and will undermine Cyprus’ competitiveness in the euro-zone export markets. Additionally, higher inflation rates lead automatically to higher wages in Cyprus because of the ‘cost of living allowance’ (COLA) scheme, which pegs wage developments to the inflation rate (see Industrial Relations and the Labour Market, p30). The rising inflation rate (in conjunction with the COLA scheme) could therefore lead to a wage-price spiral, leading to higher labour costs for companies, potentially creating negative effects on the Cypriot labour market and the profitability of companies at a time when the weak economic recovery is already squeezing company profits.

Economic Policy

By entering the euro-zone in 2008, Cyprus gave up all monetary policy instruments: monetary policy is managed and interest rates are now set by the ECB. Economic policy is therefore limited to fiscal policy and structural economic reforms, which also have to be in line with EU regulations. Compared with other Mediterranean states such as Greece, Spain (and to a lesser extent, Italy), Cyprus was not too severely hit by the financial crisis. The financial supervision system in Cyprus performed well and avoided a collapse of the banking sector without the need for government aid for suffering banks (see Financial Sector Risk, p21). However, the government deficit rose sharply in

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2008-09, reaching unsustainable levels of around 6% of GDP at the end of 2009. The consolidation of public finances will therefore remain the overall policy target for fiscal policy in the medium and long term, with a view to reducing public debt and thus ensuring the sustainability of public finances.

Fiscal Policy

To counteract the effects of the financial crisis, the Cypriot government introduced a series of economic stimulus measures in 2009, with a big direct budgetary impact. Thus, Measures will have the fiscal deficit increased to 6.1% of GDP by the end of 2009. Since the economic to be taken to recovery is in sight, the EU, which put Cyprus under an excessive deficit procedure in reduce the deficit to July 2010, has called for corrective measures to reduce the deficit to the 3% of GDP 3% by end-2012 benchmark stipulated in the Stability and Growth Pact (see Fiscal Framework, p31). According to the EU time schedule, the fiscal retrenchment has to be achieved by the end of 2012, but several measures will need to be taken in the second half of 2010.

Government Balance

% of GDP Cyprus Greece 9.0 Malta Portugal 6.0

3.0

0.0

-3.0

-6.0

-9.0

-12.0

-15.0 2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f

Sources: Eurostat, D&B

In this context, the government and the parliament approved a rise in VAT on previously zero-rated goods, like pharmaceuticals and certain food, to 5% by 1 January 2011 (while retaining the standard VAT rate at a low 15%). They also decided to introduce a petrol duty of EUR0.055 per litre. However, the main element of the austerity measures will be focused on the public sector payroll, which amounts to EUR2.24bn, or almost one-third of the budget. From 2011 until 2014, 4,000 jobs will be cut and senior government officials (including MPs, ministers and the president) agreed on a 10% pay cut.

These measures will reduce government expenditure by EUR60m in 2010 and EUR90m in 2011, but are not sufficient to cut the deficit to the level requested by the EU. Consequently, the senior government coalition partner tried to increase corporate tax by 1 percentage point to 11%, but parliament rejected the plan in July 2010 (see Policy Agenda, p7). Thus, other austerity measures have to be taken to fulfil the requirements of the EU, otherwise Cyprus will not be able to achieve the EU targets, which demand a maximum public deficit of 3% of GDP per year. If the government cannot agree on spending cuts (or revenue increases), fear would grow of a sovereign default by Cyprus on the financial markets in the medium term. However, after the next parliamentary election in May 2011, another attempt to increase corporate tax could be made if the centre-left parties win the election and form a government (at the time of writing, polls indicate that this is unlikely). D&B does not expect an increase in corporate tax until the elections in May 2011, but other taxes could rise and there could be further public spending cuts. Hence, investors and traders with Cyprus should be aware of potential tax increases that could increase the risk of trading with/investing in Cyprus.

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Public Debt

In light of the so-far ineffectual austerity measures, D&B expects public debt to rise throughout the forecast period, breaking the 60% of GDP threshold that is set out in EU law. We forecast a public debt of 60.1% of GDP at the end of 2010, while for 2011 we predict a public debt of 63.7%. However, although the public debt is rising, the government as yet has no problems in financing its debt: government bonds are still massively oversubscribed and risk premiums remain at a low level. In the latest issue of government bonds (52-week Treasury bills, worth EUR250m) in July 2010, the interest rate was 1.7%. It is noteworthy that the interest rate has risen in the recent past; in January, before the Greek debt crisis, interest rates for Cypriot government treasury bills amounted to only 1.5%. However, risk premiums and therefore interest rates could rise in the second half of 2010 and in 2011, as fears of a government default still exist because the danger of a contagion from the Greek debt crisis is not yet over (although the IMF and the EU have announced assistance programmes in May 2010). Rating agency S&P put Cyprus on a negative credit watch outlook in July 2010 after the failed corporate tax rate increase (see Policy Agenda, p7). Cyprus’ government bonds could be downgraded by the end of November 2010 if no corrective actions to reduce the public debt are taken.

Monetary Policy

Cyprus has ceded monetary policy-making to the ECB, which aims primarily to safeguard price stability in the euro-zone (see Monetary Regime, p32). The ECB’s monetary policy will focus on two key areas in 2010-11: striking a balance between the risks to the economic recovery in the euro-zone (which has been boosted by low interest rates) and inflationary risks; and the role of the ECB’s non-standard lending measures in boosting liquidity in the financial system, especially in light of the Greek debt crisis.

We expect the ECB As far as inflationary risks are concerned, the ECB continues to regard inflation to increase its key prospects as moderate, with higher global price pressures (in light of higher commodity interest rate only prices) mitigated by weaker domestic inflation (amid a fragile recovery). In July 2010, modestly, starting in the euro-zone’s average inflation rate reached 1.7%, still well below the bank’s target of the second half of ‘close to, but below 2%’. We expect the average to remain below 2% in 2010-11, thus 2011 providing little reason for the ECB to raise its key interest rate substantially (from its current record low of 1.00%). Our forecast is that the ECB will not start raising the rate until the second half of 2011, possibly taking it to 1.50% by end-2011 when inflationary expectations might have strengthened slightly on the back of stronger economic activity in the euro-area.

The ECB’s non- With regard to financial stability, the ECB’s non-standard measures to ease liquidity conventional constraints in the economy in the wake of the global financial crisis have included: the measures have provision of unlimited liquidity at fixed interest rates at its one-week auctions; the supported bank provision of emergency lending at a reduced penalty rate; and the purchase of covered lending in the euro- bonds. These measures have supported bank lending by pushing down overnight and zone… longer-term market interest rates. This, in turn, has supported the onset of a recovery in Euroland since mid-2009. That said, the ECB’s bank lending survey for Q2 2010 shows that banks continued to tighten credit standards to firms and households.

…with further wide- In December 2009 the ECB started to withdraw its credit easing measures. The Bank is reaching measures concerned about the risk of rising inflation and the development of asset price bubbles if announced in May monetary stimulus measures are kept in place for too long. However, in response to the 2010 Greek debt crisis that has threatened to spread to other peripheral euro-zone countries, the ECB introduced further non-conventional measures in May 2010. First, the bank decided to help ease liquidity risks by lifting the collateral requirement for Greek debt so that it can still be used by financial institutions to access ECB liquidity. This decision has been a relief for Greek and other European banks (especially those that hold a large share of Greek government debt). Second, the ECB reintroduced unlimited offers of three-month and six-month liquidity. Third, the bank decided to reactivate FX liquidity swaps, particularly by buying US dollars in exchange for euros; this measure could help European banks access dollar funding more easily through the ECB. Finally, the ECB

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announced that it would start buying sovereign bonds (in particular those of Greece, Ireland, Italy, Portugal and Spain) to ease liquidity risks further. This measure is controversial as it could compromise the ECB’s perceived political neutrality.

Interest Rates

% p.a. ECB refinancing rate 7.0 Three-month inter-bank rate (EURIBOR, average)

6.0 Ten-year euro area government benchmark bond yield (average)

5.0

4.0

3.0

2.0

1.0

0.0 Jul Jul Jul Jul Apr Apr Apr Apr Oct Oct Oct Jan-08 Jan-09 Jan-10 Jan-07 Source: ECB

Monetary policy will Overall, the ECB’s credit-easing measures have demonstrated that the bank has at its remain broadly disposal a comprehensive toolkit to ease liquidity constraints in the euro-zone. Without supportive of the ECB’s measures, it is likely that the current volatility in equity, credit and money financial sector markets would be even higher. We expect the ECB to withdraw its non-conventional stability in 2010-11 measures only slowly and gradually, and it could even extend them until signs emerge of a firm return to financial stability. This means monetary policy will remain broadly supportive of financial sector stability in 2010-11.

External Economic Risk

External Accounts

The current account Cyprus’ balance of payments structure is characterised by a large trade deficit. This deficit has increased mostly reflects the county’s heavy dependence on imports, particularly on capital and gradually in recent consumer goods and energy (see Trade Profile, p32). Large surpluses in the services years sector have only partially offset the merchandise trade deficits; as a result, net direct investment inflows have been the main source of financing of the current account imbalances in recent years.

During the financial crisis, the current account deficit declined from 17.1% of GDP in 2008 to 8.1% in 2009, mainly as a result of the substantial improvement of the trade account. This development was mainly due to the strong decline in imports of goods owing to a significant fall in the value of oil imports (reflecting lower international oil prices) and declining domestic demand (leading to a reduction in imports of consumer and intermediate goods). Meanwhile, exports of goods have remained stable since 2008 and are projected not to change in the forecast period; therefore they will not have any impact on the trade account. The surplus in the services account, which has historically played an important role in reducing the current account deficit, recorded a decline from 2008 to 2009, owing to the decrease in tourism revenues and receipts from financial services, as well as the increase in the expenditure of residents travelling abroad. But revenues from tourism are picking up again and the services account surplus is expected to widen moderately from EUR5.8bn in 2009 to EUR6.0bn in 2010.

Modest import Overall, we forecast the current account deficit to decrease to 6.5% of GDP in 2010, growth will increase reflecting the incline in consumer demand and the increase in imports. The rising real the current account effective exchange rate (because of a higher inflation rate and a modest euro deficit slightly appreciation) and the austerity measures in Cyprus’ trading partners will reduce exports in 2010. However, this will be counteracted by higher revenues from the tourism sector,

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attributed to the improved infrastructure (we expect this effect to last into 2011 as well), thereby enlarging the services account surplus. Because of higher oil prices and increased household consumption, imports of goods will rise in 2011. The projected decline of the current account deficit (as a percentage of GDP) in 2011 is mainly caused by higher GDP and a higher services account surplus (counteracting the increased trade account deficit).

Current Account EURbn 2007 2008 2009 2010f 2011f Goods -6.5 -8.9 -5.9 -6.0 -6.4 Exports 1.5 2.1 2.1 2.0 2.0 Imports -8.0 -11.1 -8.0 -8.1 -8.4

Services 5.0 7.1 5.8 6.3 6.8 Credit 8.8 12.0 9.9 10.3 10.8 Debit -3.8 -5.0 -4.1 -3.9 -4.0

Income -0.4 -2.4 -1.5 -1.6 -1.6 Credit 4.2 4.1 3.4 3.4 3.5 Debit -4.5 -6.4 -4.9 -5.0 -5.1

Current transfers 0.0 -0.1 -0.3 -0.2 -0.1 Credit 0.8 0.9 0.6 0.7 0.8 Debit -0.8 -1.1 -0.9 -0.9 -1.0

Current account -1.8 -4.3 -1.9 -1.5 -1.4

Current account (% of GDP) -8.4 -17.1 -8.1 -6.5 -5.8 Sources: Central Bank of Cyprus; D&B

External Debt and Default Risk

The latest data show that total external debt rose from USD43.2bn in Q1 2009 to USD49.5bn in Q1 2010. While the external debt of the private non-banking sector decreased modestly over that period, it grew significantly in the public sector (22.0%) and even more in the banking sector (62.9%), increasing the Cypriot economy’s vulnerability to spill-over effects from external shocks. More positively, the composition of Cyprus’ external debt is still more favourable than before the financial crisis, making the economy more resilient against a credit crunch in foreign countries. The share of long-term external debt (defined as debt with a maturity of over two years) has increased significantly since the financial crisis. Between Q2 2008 and Q1 2010, it grew from 34.9% to 43.5% of total external debt, while short-term external debt (with a maturity of less than one year) has decreased from 56.1% to 48.7%. However, the second half of 2009 showed an increase of short-term external debt and a decrease of long-term external debt (albeit with levels still far away from those seen in the pre-crisis period).

Cyprus’ net foreign debts (based on the country’s international investment position) have also improved since the outbreak of the financial crisis. At the end of Q1 2010, External liquidity Cyprus’ net international investment position amounted to EUR6740m (up from a risks are very low as negative position of EUR40.6m before the crisis in Q2 2008). Although Cyprus’ public most foreign debt is debt rose sharply after mid-2008 because of the costs of the financial crisis, it still has euro-denominated one of the smallest public debt stocks in the EU. The majority of the public debt is domestic: liabilities are long term and practically exclusively euro-denominated, which means that they are not subject to currency fluctuations. Overall, despite external financing difficulties as a result of the global crisis, the risk of a public sector (or large- scale private sector) default on Cypriot foreign debt is low. Cyprus’ government bonds are still rated with ‘A+’ by S&P and ‘AA-’ by Fitch, while risk premiums are still at a low level.

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Exchange Rate Risk

The weaker euro Cyprus adopted the euro (see Exchange Rate Regime, p32) in 2008. Since late 2009 will continue to ease and early 2010 mounting concerns over the public finances of Greece and other pressure on euro- countries on the periphery of the euro-zone have led to a marked, broad-based zone exporters depreciation of the euro, particularly against the US dollar and the Japanese yen. The key risks to exchange rate stability in 2010-11 derive from the uncertain outlook for the economic recovery in the euro-zone as well as the risk of further contagion from the Greek debt crisis and its impact on the euro. With regard to the recovery in Euroland, we only expect meagre growth of 1.3% in 2010 and 1.2% in 2011. The recovery in the US and many emerging markets in Asia, for example, will be much stronger, according to our forecasts. Hence, interest rates in the euro-zone will remain subdued (see Monetary Policy, p15). These factors mean that the economic outlook and monetary policy will provide little boost for the euro.

As to the Greek debt crisis, exchange rate volatility has remained a source of concern despite the adoption of a large rescue package by the EU, ECB and IMF (worth around EUR750bn) in May 2010 to help alleviate debt financing risks in the euro-zone. The euro could continue the tentative appreciation trend seen since June 2010 if concerns about public finances in the euro-area ease further. However, the euro might also depreciate again in the near term if fears about sovereign debt and financial sector stability re-emerge. A large part of Euroland’s banking system remains under- capitalised and liquidity risks remain a source of concern; many banks still rely heavily on cheap ECB liquidity as they struggle to raise funds on the international capital markets. On balance, we expect the exchange rate to average EUR0.77:USD in both 2010 and 2011; the euro had been much stronger in 2008 (EUR0.68:USD) and 2009 (EUR0.72:USD). The elevated risk of volatility in the short term weakens predictability in trade and investment dealings with businesses in the euro-zone. Currency hedging might be a useful strategy for companies to protect against rising volatility.

Exchange Rates

EUR:USD EUR:USD FX rate (left-hand axis, inverted) Index: 2005=100 Nominal effective exchange rate (right-hand axis) 0.60 110 Real effective exchange rate (right-hand axis) 108 0.65 106

104 0.70 102 100 0.75 98

0.80 96 94 0.85 92 Jul Jul Jul Jul Apr Apr Apr Apr Oct Oct Oct Jan-07 Jan-08 Jan-09 Jan-10

Source: IMF

Cyprus will suffer Cyprus’ real effective exchange rate (REER), which accounts for the country’s currency due to euro relative to a basket of currencies of major trade partners, depreciated steadily during the appreciation and first half of 2010 due to lower inflation recorded in Cyprus, as well as to the weakening higher inflation of the euro against the US dollar. We expect the euro to appreciate slightly once more rates against several other currencies, namely the US dollar and the pound sterling; therefore Cyprus’ REER will increase again in the near future, leading to a loss of competitiveness in global markets. Additionally, a higher inflation rate in Cyprus compared with other euro-area countries will negatively effect Cyprus’ position and competitiveness in intra-euro-area trade.

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Commercial Risk

Outlook Summary: Stress tests carried out by European and domestic institutions in mid-2010 show that the domestic financial sector is healthy, sound and adequately supervised. In addition to the sound banking system, company failures are low, although the payment performance of Cypriot companies is less favourable that their European peers, and we expect it to worsen further. Moreover, the absence of a political settlement and the ongoing division of the island pose inherent risks for businesses, especially for those interested in investing in real estate. Recent rulings from several European courts have increased that risk significantly.

Business Performance

Cyprus’ industrial sector started showing signs of sluggishness in 2008 as a result of the international financial and credit crisis; since the beginning of 2009 it has experienced a The construction more pronounced downturn, which is continuing. In particular, after growing by 9% and industrial year on year (y/y) in the second half of 2007, the construction sector has been sectors experienced decelerating sharply. Latest data for Q1 2010 show a decline of value added to real a pronounced GDP of 9.1% y/y. The number of building permits (which is an indicator for future downturn in 2009… investment in housing and non-residential buildings) decreased too, especially in Q4 2009, when it fell by 33% y/y. Not even a 2% decrease in the input materials price index in 2009 could counteract the downturn in the construction sector.

Like the construction sector, industrial production is showing signs of a sharp deceleration (despite strong growth of 3.2% in 2008). The general index of industrial production shrank by 9.6% in 2009 but then slowed, albeit still declining by 5.0% y/y in Q1 2010. The industrial confidence indicator also worsened in 2009, shrinking by 24% in that year. In addition, the industrial turnover index for 2009 recorded a decrease of 10.8% y/y, including a fall by 20% in consumer durables turnover.

The outlook for the construction sector is reasonable. Residential property prices are falling and the number of building permits picked up by almost 3% y/y in the first five …but there will be months of 2010. In particular, the outlook for the construction of office buildings an improvement improved sharply: in Q1 2010, the number of permits in this category grew by more during 2010 and than 80% y/y. Further decreases in prices for raw materials like steel and cement 2011 (because of lower investment in emerging Asian markets) could lead to further investment in Cyprus’ construction sector in the forecast period (although still far below the pre-crisis levels seen in the mid-2000s). The outlook for the manufacturing sector is ambiguous. Industrial production is still shrinking, but at a slower pace than in 2009. In Q1 2010, it shrank by 2.3% y/y, compared with 9.6% in 2009. The industrial confidence indicator is also improving: in the first six months of 2010 it improved by 3.8% y/y, compared with a decline of 28% in the first half of 2009. That said, the manufacturing sector will face some difficulties in coming quarters: austerity measures in several economies and the appreciation of the real effective exchange rate (see Exchange Rate Risk, p18) will lead to a lower industrial production growth. Overall, we expect it to grow moderately in the next two years because of base effects and further investment in infrastructure projects to boost the Cypriot tourism industry.

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Credit Risk

Business Failures

One of the basic characteristics of the Cypriot economy is the large number of small and medium-sized enterprises (SMEs) as a proportion of all enterprises: there are almost 52 SMEs per 1,000 inhabitants in the country, well above the EU average of 40, while micro-enterprises (five employees or less) account for 92.3% of total SMEs. As a result, insolvency legislation is divided into two parts: the insolvency legislation for companies and the insolvency legislation for natural persons.

Company The Official Receiver conducts bankruptcy proceedings, while the law provides for a bankruptcy levels second start-up in the case of bankrupt persons. Nevertheless, the number of individual will rise during bankruptcies has been steadily rising since 2003, reaching a record high of 1,329 in 2010 2009. In contrast, company failures remain very low: in 2009, 159 business failures were recorded, up from 135 in 2008. By end-May 2010, 81 companies had gone bankrupt, compared with 51 during the corresponding period in 2009. Although this is still low in absolute terms, it constitutes a considerable increase and we believe that the number of company bankruptcies will continue to rise at a faster pace in the remainder of 2010, very likely reaching a higher level than in 2009 due to the effects of the financial crisis (i.e. worse payments performance, less access to finance, and sluggish real GDP growth).

Payments Experience

Indicators show a Payments performance worsened in 2009 because of lower profitability of companies further due to the effects of the financial crisis. According to the 2010 Intrum Justitia Payment deterioration of Risks Survey, the payment performance of Cypriot companies compares unfavourably payments with that of their European peers. Payment delays have developed ambiguously. On the performance one hand, the payment loss (receivables that were not paid) in Q1 2010 remained at 3% and amounted to the same as the year before. Some 29% of the receivables were paid within 30 days and 31% between 31 and 90 days, compared with 30% and 37% respectively one year before. On the other hand, the part of receivables that were paid after 90 days increased sharply from 33% (2009) to 40% (2010). Additionally, the central bank’s 2009 annual report shows a year-on-year (y/y) increase of 100% for bounced cheques, indicating bigger payments delays and even payment loss in the future. Bankruptcy rates also increased significantly compared with the previous 12 months, worsening the payments performance of Cypriot firms (and individuals). In addition, credit conditions became more stringent in Q1 2010. As a consequence, traders with Cyprus should be wary of increased payment loss and a further deterioration in payments performance.

Trade Terms: D&B recommends SD terms on business dealings with Cyprus, while usual terms currently run at 30-180 days. In accordance with the 2000 EU directive on combating late payments implemented into national law on July 2003, the payment of penalty interest starts automatically in the event of payment delay. The penalty interest rate charged is the ECB’s main refinancing rate plus at least 7 percentage points.

Export Payment Indicators Trade terms Transfer situation Minimum terms SD Local delays 0-2 months Recommended terms SD FX/bank delays 0-1 months

Usual terms 30-180 days Import cover 1.2 months Source: D&B

Transfer Situation: Transfer risk is minimal owing to Cyprus’ membership of the euro- zone. For vendors requiring payment in euros, no transfer risk exists. Import cover in the euro-zone is low at an estimated 1.2 months, but is largely immaterial within the currency union. In general, export credit agencies offer full cover on trade with Cyprus.

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Export Credit Agencies US Eximbank Full cover available Atradius Full cover available ECGD Full cover available

Euler Hermes UK Full ST cover available Sources: Export credit agencies

Financial Sector Risk

The banking system Prompted by EU accession and, more broadly, by developments in financial markets has improved in worldwide, the financial sector has been undergoing substantial transformation in recent recent years years. The banking sector plays the most significant role in the financial sector, representing approximately 80% of total financial sector assets; its assets represented 875% of GDP in 2009. The sector is very concentrated: three large banking groups active in all three sectors (banking, insurance, and securities) dominate the system, controlling around 63% of total assets. The soundness of the banking sector has improved since 2003: the banks’ asset quality has continued to progress, with the ratio of non-performing loans (NPLs) to total loans to non-financial corporate sector steadily decreasing over recent years. The most recent data (for September 2009) show a ratio for NPLs of 6.9% (compared with 7.2% in March 2009 and levels around 13% in 2006). Although the loan loss provisions as a percentage of NPLs shrank from 60.9% in September 2008 to 53.6% in September 2009, levels of provision are still sufficient.

However, during 2009 global economic conditions deteriorated as a consequence of the financial crisis that erupted in the US in 2007. The adverse effects of the crisis on the Cypriot economy had a significant negative impact on the profitability of the banks supervised by the Central Bank of Cyprus (CBC), reducing the return on equity of the consolidated banking sector from 15.2% in 2008 to 13.4% in 2009. The unfavourable economic conditions led to a significant increase in the provisions for doubtful debts, while the low level of interest rates in the euro-area and the US, the sharp increase in the cost of deposits and the sharp deceleration in the growth of credit restricted higher profits in the banking sector.

However, the banking sector remains sound, helped by its focus on traditional and conservative banking activities. The banks’ predominant reliance on more stable retail Bank profitability funding, negligible exposure to complex securities, high levels of liquidity, and strong and capital supervision helped to shield it from the global crisis, and recent and ongoing stress tests adequacy remain at carried out by the national central bank indicate that the system has the capacity to satisfactory levels absorb further shocks if any occur. In the latest stress test conducted by the EU, in co- operation with the national supervisors, in July 2010, both Cypriot banks that were involved in the test (Marfin Popular and Bank of Cyprus) fulfilled the criteria. Deposits have continued to grow thanks to confidence in the banking system and its strength relative to the rest of the region. Banks and supervisors responded appropriately to the recent slowdown in economic activity and higher spill-over risks from Greece and other Mediterranean countries. Furthermore, banks are taking steps to strengthen capital and liquidity. Data from December 2009 show that capital buffers rose from 3.0% in 2008 to 4.4% in 2009, while banks’ Tier 1 capital ratio (defined as common stock plus disclosed reserves) increased from 8.3% to 9.6% over the same period.

Additionally, supervisors have stepped up their vigilance and taken steps to strengthen the regulatory framework since 2008. There has been significant progress in implementing EU directives and recommendations from the IMF’s 2008 Financial Sector Assessment Programme. The forthcoming introduction of a legal framework for covered bonds will improve banks’ access to liquidity from the markets and the ECB and will reduce financial sector risk further.

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Given the large size of the banking sector relative to the economy and the comparatively high concentration ratios, if problems emerge in the financial sector they could quickly escalate to systemic proportions, with serious spill-over potential for the There are plans to rest of the economy and for the public finances, creating higher risks for the Cypriot improve the economy as a whole. Therefore, Cyprus (and the EU) plans several reforms to financial strengthen financial supervision in addition to the already implemented measures (see supervision system Financial Sector Oversight, p40). For example, co-operation with Greece and other Southeastern European supervisory authorities will be increased because of Cyprus’ extensive financial linkages.

Other Commercial Risks

Property issues are closely linked to the political situation. As a result, the absence of a political settlement poses an inherent risk for foreign investors interested in buying or leasing property in the Greek-Cypriot South, in the Turkish-Cypriot North and across the buffer zone (see Policy Agenda, p7). Investors are well-advised to consider the Investment in real practical, financial and legal implications of investing in real estate, taking into account estate is risky the possible consequences for property of a future settlement, and the many thousands because of unclear of claims to ownership from people displaced in 1974. In addition, there is a risk that property rights purchasers would face legal proceedings in the courts, as buying, selling, renting, promoting or mortgaging a property without the permission of the owner is a criminal offence (see Judicial Environment, p38). A UK court of appeal ruling in February 2010 stated that British buyers had to demolish their house, which stands on the property of a Greek-Cypriot in north Cyprus, return the land and pay compensation and legal costs. Although the demolition and the handover could not be executed (because the Turkish-Cypriot government refused to take any action), it established a new precedent, whereby any Greek-Cypriot who owned land in the northern part of Cyprus can now seek financial redress through international European courts; the EU will enforce those rulings. The once-booming property market plunged after the ruling, having already been hit by the wider economic crisis.

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Data Summary

2002 2003 2004 2005 2006 2007 2008 2009 2010f 2011f Gross domestic product Nominal GDP (EURm) 10,980 11,761 12,654 13,462 14,435 15,879 17,248 16,946 17,247 18,059 Nominal GDP (USDm) 10,358 13,215 15,622 16,828 18,044 21,752 25,364 23,537 22,399 23,454 GDP per capita (USD) 12,835 16,175 18,890 20,129 21,354 25,471 29,425 27,023 25,453 26,382 Population (year-end, m) 0.8 0.8 0.8 0.8 0.8 0.9 0.9 0.9 0.9 0.9

Components of demand (real % change) Private consumption 1.3 2.1 6.5 4.2 4.7 9.4 8.4 -3.0 -1.6 2.0 Government consumption 6.9 6.0 -5.5 3.4 7.4 0.3 6.2 5.8 -1.2 -3.4 Gross fixed capital formation 8.6 2.4 11.6 4.1 10.2 13.4 8.6 -12.0 -9.9 -3.6 Exports -4.9 -0.5 5.5 4.9 3.5 6.1 -2.1 -11.8 0.5 1.6 Imports -0.2 -0.3 10.3 3.7 6.7 13.3 8.0 -19.8 -1.7 2.8 GDP 2.1 1.9 4.2 3.9 4.1 5.1 3.6 -1.7 -1.0 1.7

Components of demand (% of GDP) Private consumption 64.6 64.1 64.5 64.6 64.4 66.4 69.5 68.7 68.4 68.5 Government consumption 18.2 19.7 17.8 18.0 18.6 17.4 17.9 19.9 19.8 18.8 Gross fixed capital formation 18.1 17.6 19.0 19.3 20.6 22.0 23.3 20.4 18.7 17.7 Change in inventories 0.7 -0.2 1.2 0.6 0.2 0.4 0.8 -3.2 -2.0 0.3 Exports 50.8 47.0 47.8 48.3 48.0 47.9 44.8 39.4 39.9 39.9 Imports 52.3 48.2 50.2 50.9 51.8 54.2 56.2 45.2 44.8 45.3

Contributions to real GDP growth (percentage point) Private consumption 0.8 1.3 4.1 2.7 3.0 6.1 5.7 -2.1 -1.1 1.4 Government consumption 1.3 1.2 -1.1 0.6 1.3 0.1 1.1 1.0 -0.2 -0.7 Gross fixed capital formation 1.5 0.4 2.1 0.8 2.0 2.7 1.9 -2.8 -2.0 -0.7 Change in inventories 1.0 -0.9 1.5 -0.6 -0.5 0.3 0.4 -4.0 1.3 2.4 Net exports -2.5 -0.1 -2.4 0.5 -1.7 -4.0 -5.5 6.2 1.0 -0.7

Labour market Working age population (m) 0.4 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 Activity rate (% of working age population) 72.9 74.4 74.6 74.4 74.8 75.9 75.9 76.2 76.2 76.2 Employment rate (% of working age population) 73.4 74.3 74.4 74.2 74.5 74.3 75.4 74.3 75.7 75.7 Unemployment rate (% of labour force) 3.6 4.1 4.7 5.3 4.6 4.0 3.6 5.3 6.8 7.0

Fiscal and monetary indicators General government balance (% of GDP) -4.4 -6.5 -4.1 -2.4 -1.2 3.4 0.9 -6.1 -5.8 -5.2 General government debt (year-end, % of GDP) 64.6 68.9 70.2 69.1 64.6 58.3 48.4 56.2 60.1 63.7 Consumer prices (year-average, % change) 2.8 4.0 1.9 2.0 2.3 2.2 4.4 0.2 2.8 3.0 Official interest rate (year-end, % p.a.) 2.75 2.00 2.00 2.25 3.50 4.00 2.50 1.00 1.00 1.50 Three-month inter-bank rate (year-average, % p.a.) 3.32 2.33 2.11 2.18 3.08 4.28 4.63 1.23 0.80 1.55 Ten-year government bond yield (year-average, % p.a.) 5.70 4.74 5.80 5.16 4.13 4.48 4.60 4.60 4.80 4.95 Exchange rate (year-average, EUR:USD) 1.06 0.89 0.81 0.80 0.80 0.73 0.68 0.72 0.77 0.77

Current account Merchandise trade account (USDm) -2,883 -3,183 -4,049 -4,247 -4,942 -6,474 -8,933 -5,908 -6,029 -6,371 Services account (USDm) 2,789 3,135 3,591 3,796 4,221 5,039 7,052 5,814 6,331 6,766 Income account (USDm) -401 -390 -537 -612 -765 -383 -2,359 -1,543 -1,566 -1,613 Net current transfers (USDm) 117 144 168 92 206 -14 -108 -278 -201 -143 Current account (USDm) -378 -294 -827 -971 -1,280 -1,832 -4,348 -1,915 -1,465 -1,361 Current account (% of GDP) -3.6 -2.2 -5.3 -5.8 -7.1 -8.4 -17.1 -8.1 -6.5 -5.8

External liquidity FX reserves (year-end, USDm) 247 224 212 185 197 215 219 284 295 305 Import cover (months) 2.5 1.9 1.5 1.2 1.1 1.0 0.9 1.4 1.2 1.0 Sources: Central Bank of Cyprus; Eurostat; IMF; Statistical Service of Cyprus; D&B

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Political Environment

Political Overview

The Establishment and Breakdown of the Bi-communal State

The constitutional Cyprus gained its independence from British colonial rule in 1960, after a five-year crisis that broke out struggle by the Greek-Cypriot EOKA (National Organisation of Cypriot Fighters), a in 1963 led to the guerrilla group that desired political union (enosis) with Greece. The Zurich-London breakdown of the Agreements, signed by the UK, Greece, Turkey and the Cypriot communities’ leaders, newly established provided the legal framework (along with the Cypriot constitution) for the function of a state bi-communal state. Shortly after the founding of the republic, serious differences arose between the two communities about the implementation and interpretation of the constitution: the Greek-Cypriots argued that the complex mechanisms introduced to protect Turkish-Cypriot interests acted as obstacles to efficient government.

For this reason, in November 1963 Archbishop Makarios, the country’s first president, advanced a series of constitutional amendments designed to eliminate some of the special provisions for the Turkish-Cypriots that he considered impediments to the functioning of the government. The Turkish-Cypriots reacted strongly to these changes and the confrontation prompted widespread inter-communal fighting in December 1963, after which Turkish-Cypriots ceased to participate in the government. As a result of the violence, many Turkish-Cypriots and Greek-Cypriots living in mixed villages began to move into enclaves, and a UN peacekeeping force was deployed on the island in 1964. Following another outbreak of inter-communal violence in 1967-68, a Turkish-Cypriot provisional administration was formed, while inter-communal talks for a solution to the constitutional crisis during the ten-year period from 1964 to 1974 were all unsuccessful.

The 1974 Crisis and the Division of the Island

In July 1974, the military junta in Greece sponsored a coup, led by EOKA, against the government of President Makarios, citing his alleged pro-communist leanings and his The island was perceived abandonment of enosis. Following Makarios’ overthrow, Turkey, asserting its effectively divided right to protect the Turkish-Cypriot minority under the Zurich-London Agreements, following Turkey’s intervened militarily in the island, occupying 37% of its territory in the northeast. The military intervention operations led to the widespread displacement of Cyprus’ ethnic communities, dividing the island between a Turkish-Cypriot North and a Greek-Cypriot South. In the aftermath, the Turkish-Cypriots’ leadership declared a separate political entity in the form of the Turkish Federative State of Cyprus and by 1983 had made a unilateral declaration of independence as the Turkish Republic of Northern Cyprus (TRNC), which was recognised only by Turkey. The ceasefire lines achieved after the 1974 events formed the basis for a buffer zone separating the two communities, manned by the UN Peacekeeping Force in Cyprus (UNFICYP), which has been in place since 1964.

In Search of a New Political Formula

All negotiations for In the immediate aftermath of the 1974 crisis, UN-led inter-communal talks were held, a settlement of the initially limited to humanitarian issues, such as the exchange of population between the political problem two sides of the island. However, attempts to make progress on the substantive issues, since the 1980s have such as territory and the nature of the central government, failed to produce results. failed Negotiations for a settlement through the creation of a new federal republic continued in the late 1980s and in the 1990s, but none were successful.

The EU’s decision to open up accession negotiations with Cyprus in 1997 created a new catalyst for a settlement. In January 2002, direct talks between the leaders of the two communities started under UN auspices, with the goal of reaching a settlement before Cyprus’ entry into the EU. UN Secretary-General Kofi Annan released a comprehensive settlement proposal, the ‘Annan Plan’. Under its final revision, the ‘United Republic of Cyprus’ would be created, a loose confederation of two component states, the Greek-

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Cypriot state and the Turkish-Cypriot state, joined together by a minimal federal government apparatus. In April 2004, dual referendums were held, with the Greek- Cypriot side overwhelmingly rejecting the plan and the Turkish-Cypriot side voting in favour. On 1 May 2004, a week after the referendum, Cyprus joined the EU.

The progress of the For more than two years following the Annan Plan referendums, the island saw little reunification talks progress towards reunification. However, a change in leadership in both communities started in 2008 has generated a new momentum for the resumption of negotiations. In September 2008, been slow and the fully-fledged reunification talks began between the Greek-Cypriot president, Demetris outlook is negative Christofias, and his then Turkish-Cypriot counterpart, Mehmet Ali Talat. However, since Dervish Eroglu (the former leader of the nationalist party in Northern Cyprus) took over the presidency in April 2010, the chances for a reunification have diminished because of Eroglu’s position on the property issue (see Domestic Politics, p6).

Political System

Constitutional Arrangements

The constitutional structure of Cyprus comprises the constitution itself, together with two Annexes (the Treaty of Guarantee and the Treaty of Alliance), as laid out by the Zurich-London Agreements (see The Establishment and Breakdown of the Bi- communal State, p24). The 1960 constitution, amended in 1964, remains in force despite the island’s 1974 division and provides for a presidential system of government with a strict segregation of powers between the executive, legislative and judicial The constitution is branches. It is very rigid, detailed and complicated, as it was designed to protect the extremely rigid and interests of both Greek- and Turkish-Cypriots through a system of checks and balances, complex procedural and substantive safeguards, guarantees and prohibitions. The House of Representative (parliament) has the right to amend the constitution, except its basic articles, i.e. those provisions that determine the form of government as a presidential republic, as well as all those provisions ensuring the bi-communal character of the state and the principle of separation of powers; the remaining articles can be amended by a law passed by a majority vote comprising at least two-thirds of the total number of MPs.

The Legislature

The legislature Legislative power is exercised by the House of Representatives, the unicameral exercises legislature of Cyprus. Following a constitutional amendment in 1985, the House has 80 parliamentary seats, of which 56 are assigned to Greek-Cypriots and 24 to Turkish-Cypriots; the seats control through the that correspond to Turkish-Cypriots remain vacant because of the political situation (see approval of state Political Overview, p24). The religious groups of Maronites, Armenians and Latins are budgets also represented: each group elects one member who attends meetings, though without a right of participation in the deliberations. The deputies are elected for a five-year term by universal, direct suffrage via a simple proportional representation system. Under the electoral law Cyprus is divided into six constituencies; the distribution of parliamentary seats for each constituency is determined by law. The electoral system is designed to give smaller parties the potential to be represented in the House of Representatives: a party must gain 1.8% of the vote to qualify for entry into parliament.

The legislature is a strong check on the executive’s authority. The House of Representatives’ legislative power is exercised by voting on the bills put before it by the government and proposals for laws put forward by members, as well as the approval of regulative administrative acts tabled by the executive. The government must secure a simple majority vote to pass legislation, except in the case of modification of the electoral law, the adoption of any law relating to the municipalities or of any law imposing duties or taxes (which need a two-thirds majority). However, parliament’s fragmented composition often undermines its efficiency. Apart from its legislative function, the House exercises parliamentary control through the approval of the state budgets and of the main legal persons of public law, as well as the submission of written questions to ministers. The body’s (self-appointed) examination of various matters submitted by members or parliamentary committees, which examine these matters, is also considered as the exercise of indirect parliamentary control.

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The Executive

The president is both head of state and head of government, is elected by universal suffrage for a five-year term of office, and may serve unlimited terms. The president The ability of the exercises executive power through a council of ministers that he/she appoints. The executive to ministers may be chosen from outside the House of Representatives; MPs who are implement policies appointed as ministers must resign their seats in accordance with the principle of the is constrained by a separation of powers. The president has the right of final veto on any law passed by the strong legislature House that concerns foreign affairs, defence and security. However, as far as all other types of legislation are concerned, the president has only a delaying power: if the House persists in its decision to pursue its legislation against executive branch delays, the president is bound to promulgate the law or decision in question. The strong position of the legislature, which cannot be dissolved by the president, constrain the ability of the executive to implement policies, thereby encouraging a consensual approach to decision-making, especially on controversial issues.

Executive power at local government level is exercised by municipal and community councils and groupings of communities. There are 24 municipalities and 352 community councils and groupings of communities. The municipal councils provide services and have administrative powers in the cities and in two or three large rural areas in which municipalities have been established, and the community councils manage local government affairs in the villages. The councils are independent bodies, and their members are elected by universal suffrage every five years, while their finances derive from municipal taxes, fees and duties as well as state subsidies.

The Judiciary

Cyprus has a fair and independent judiciary, which scrutinises legislation effectively. The legal system is based on English law, but has been heavily modified since independence. Cyprus has a two-tier court system: First Instance Courts and the Supreme Court. The principal first instance courts are the District Courts operating in every district of Cyprus, with the exception of the occupied areas, and hearing both criminal and civil cases. The other first instance courts are the Assize Courts; the Military Court; the Industrial Disputes Court; the Rent Control Courts; and the Family Courts. The Supreme Court is the final court of appeal and is also vested with jurisdiction to determine the constitutionality of laws, rules and regulations, and has sole competence and exclusive jurisdiction to review the legality of acts, decisions or omissions emanating from the exercise of executive or administrative authority.

Political Forces

Political parties Cyprus has a multi-party system, with three or four strong parties that generally represent a wide dominate the political landscape. Political parties are stable and inclusive in character, spectrum amid deep revolving around ideological platforms rather than personalities and representing a ideological broad spectrum of ideologies. Ideological polarisation runs deep, and most people have polarisation a strong sense of belonging to the right or the left. Voting patterns are relatively stable.

Political Parties

Coalition Government Parties

AKEL, the leading Progressive Party of Working People (AKEL): AKEL was founded in 1941 as a party in parliament, successor to the Communist Party. Despite being banned, it re-appeared as Cyprus is still a declared achieved independence in 1960. It has since occupied a prominent place in the political communist party landscape and is currently the largest party in parliament. It supports an independent, demilitarised and non-aligned Cyprus, and a federal solution of the internal aspect of the Cyprus problem. AKEL has traditionally adopted the most accommodative approach towards the Cypriot issue and through the trade unions has maintained contact with the Turkish north. While still a declared communist party, its economic policy is more akin to Western social-democratic norms. AKEL has supported Cypriot EU membership since the mid-1990s, but is considered moderately eurosceptic.

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Democratic Party (DIKO): Established in 1976 by Spyros Kyprianou and people that were strongly involved in the enosis struggle (i.e. union with Greece), DIKO positions itself as a centrist party. However, it is often regarded as an extreme-right party owing to the way in which it has, since mid-1980s, rejected all proposals for solutions to the Cyprus issue. It was also the only party to uniformly reject the Annan Plan put forward DIKO was the only in a referendum in 2004 (see Political Overview, p24). Nevertheless, the party supports party to uniformly a settlement of the Cyprus problem based on UN resolutions and has accepted the idea reject the Annan of federation. It favours Cypriot EU membership and has remained the third-largest Plan party in parliament since 1990. Following the defeat of its candidate, former President Tassos Papadopoulos, in the first round of the February 2008 presidential election, DIKO announced its support for AKEL candidate Demetris Christofias in the second round. In parliament, DIKO is the junior coalition partner of AKEL, but there are tensions in the coalition concerning economic policy and the reunification process (see Domestic Politics, p6).

Opposition Parties

Movement of Social Democrats (EDEK): Established in 1969, EDEK is a centre-left social democratic party. It supports an independent and united Cyprus within a federal system with a strong central government and a settlement based on UN resolutions and the implementation of human rights for all its citizens. The party is strongly in favour of EU membership, which is considered a security mechanism against Turkish advancement on Cypriot territory. EDEK backed Demetris Christofias of AKEL in the second round of the February 2008 presidential election, but left the coalition government (formed with AKEL and DIKO) in February 2010 because of disagreement on the reunification talks.

Democratic Rally (DISY): Founded by veteran politician Glafkos Klerides in 1976, DISY is a centre-right political party, led by Nicos Anastasiades. Its political platform focuses on less state involvement in the economy (combined with a greater social role of the state), as well as a solution to the Cyprus problem on the basis of a bi-zonal, bi- communal federation. It is pro-Western, pro-NATO and pro-EU. DISY was represented in parliament for the first time in 1980 and became the largest party five years later. In the 1991 and 1996 parliamentary elections, DISY joined forces with the Liberals, who finally merged with the party in 1998. The leaders of DISY supported the Annan Plan for the re-unification of Cyprus. Following its rejection by the Greek-Cypriot community, four MPs who had opposed the party line were expelled and formed a new party, while a number of members voluntarily resigned.

European Party (EURO.KO): This is a centrist party founded in 2005, largely out of the New Horizons party, and is led by Demetris Syllouris. It believes that the solution to the Cyprus problem should be compatible with the European acquis communautaire (the entire body of EU laws) and based on UN resolutions as well as human rights. In this respect, it supports the idea that the results of the 2004 referendum on the Annan Plan should be fully respected. It is also in favour of closer EU involvement in finding a solution to the problem, to ensure, inter alia, that the European principle of abolishing artificial divisions is respected and that Greek-Cypriots and Turkish-Cypriots live together in a united island without any ethnic or other segregation.

Ecological-Environmental Movement (KEP): Also known as the Cyprus Green Party, this is a green political party founded in March 1996 and led by George Perdikis. It is opposed to any geographical division of the island and the people of Cyprus based on ethnic origin or religion, while it is not in favour of any arms build-up.

Interest Groups

Greek-Cypriot Refugees: The 170,000 Greek-Cypriot refugees in the south of the island remain a potent political force. They have formed associations, non-governmental Greek-Cypriot organisations and unions calling, among other things, for the removal of Turkish troops refugees are a and the repatriation of colonists. The absolute right of all refugees to return is an potent political force emotive issue that virtually no Greek-Cypriot politician has yet had the courage to

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question. The Greek-Cypriot refugees were at the forefront of the ‘no’ campaign leading up to the April 2004 referendum (see Political Overview, p24), while they have brought several cases to the European Court on Human Rights, where their right to return to their homes and properties in the Turkish-Cypriot North has been legally recognised

Greek-Cypriot Orthodox Church: The powerful Greek-Cypriot Orthodox Church has been very influential and has played an active role in the political sphere since the The Church is very establishment of the Republic of Cyprus: in fact, the first elected president of the new influential and is state was Archbishop Makarios III, who stayed in power for 17 years. The Church has involved in efforts to been actively involved in all major developments concerning the efforts to reach a resolve the island’s settlement of the division of the island: in 2004, it was very influential in harnessing political problems opposition to the Annan Plan (see Political Overview, p24), while, since the launch of the new reunification talks in September 2008, Archbishop Chrysostomos II has held regular meetings with all Greek-Cypriot political leaders, as well as foreign officials involved in the process, in order to be informed and to express the views of the Church.

Security

Cyprus is generally a safe country with low crime rates, with the main risk stemming from pick-pocketing and other street theft. However, the volume of serious offences has been rising in recent years, the majority of which are financial offences. Cyprus’ success as an international offshore centre makes it vulnerable to international money- laundering activities. Even though the authorities have made some effort to tighten up the rules, the reporting system for suspicious transactions is weak.

Another source of concern for Cyprus, closely linked to money-laundering activities, is organised crime, both foreign and domestic: Russian organised crime, in particular, is Money-laundering using Cyprus extensively to launder money. The Russian ‘mafia’ owns nightclubs and and organised crime dominates criminal operations, such as prostitution and illegal gambling. Bombings are sources of linked to vendettas occur in Limassol and Nicosia, and may affect third parties. In concern addition, its geographic location (see Natural Environment, p36) makes Cyprus a convenient transit point for illicit drugs and destination of human trafficking, especially women trafficked into the sex industry. The authorities are trying to address the problem, but have not yet made significant progress.

Despite the continued division of the island and occasional tensions between extremist groups, the threat of inter-communal violence is limited. A UN peacekeeping force (UNFICYP) continues to patrol the ‘Green Line’, a cease fire line, which marks the start of the 180-kilometre demilitarised zone that divides the island’s two communities. In June 2010, the UN Security Council voted to extend the UN peacekeeping mandate on Cyprus for another six months (until 15 December 2010), welcoming the progress in the ongoing talks between the leaders of the two communities that began in September 2008 aimed at reunifying the island. However, since the election of Dervish Eroglu as President in the Turkish-Cypriot part of the island in April 2010 the talks have developed less favourably. Meanwhile, UN officials have mentioned the possibility of a withdrawal of the peacekeeping mission, due to the stable situation on the island and the UN’s need to use the budget on more important operations.

International Environment

Relations with Russia

Relations between Russia and Cyprus are traditionally friendly. This is largely due to the coincidence or proximity of their positions on important international issues, as well Cyprus can count as in the consistent and valuable support of Russia in the efforts to find a just, viable on Russia’s support and comprehensive solution to Cyprus’ division on the basis of the relevant resolutions in the reunification of the UN Security Council. As the EU is a strategic partner of Russia, another talks dimension was added to Cyprus-Russia relations with Cyprus’ membership: within the EU, Cyprus has opposed proposals for energy ‘unbundling’ and blocked proposals for increasing European involvement in the post-Soviet space, and has often taken the lead in defending Russia’s position on issues such as energy or the ‘Eastern neighbourhood’.

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Relations with the US

The US extends diplomatic recognition only to the Republic of Cyprus and its Greek- Cypriot government, with which it works closely in the ‘war against terrorism’. The US encourages However, the US also maintains close and regular contacts with the Turkish-Cypriot the reunification administration. The Greek-Cypriot administration is always displeased when US talks representatives meet Turkish-Cypriot officials (this last happened in April 2009). Since 2004 the US has channelled an USD30.5m assistance programme to the Turkish- Cypriot North aimed at assisting economic development in the Turkish-Cypriot community. It also provides approximately USD15m annually to reduce tensions and promote peace and co-operation between the two sides.

Relations with Turkey

Turkey flatly refuses to recognise the government of the Republic of Cyprus, stating that the Republic (as established by the Constitution of 1960) ceased to exist when the Relations between inter-communal violence that started in December 1963 ended Turkish-Cypriot Cyprus and Turkey participation in the Cypriot government (see Political Overview, p24). In 1983, Turkey are historically recognised the independence of the northern part of the island, and since then more than troubled 100,000 settlers from the Turkish mainland have emigrated to the TRNC. In addition to the Turkish settlers, there are around 40,000 Turkish soldiers based on the island. Cyprus’ entry into the EU has caused further tensions between the two countries, as it had a negative impact on Turkey’s accession negotiations. Turkey’s refusal to fully implement an EU customs union agreement (allowing Greek-Cypriot ships and planes to use Turkish ports and airports) has resulted in a partial suspension of its accession negotiations.

International Affiliations

Historically, Cyprus has followed a non-aligned foreign policy. Directly after its independence it joined the Non-Aligned Movement (NAM), becoming a high-profile member. However, Cyprus withdrew from the NAM after joining the EU, retaining observer status (since membership of the EU does not permit it to maintain, in parallel, its membership of the NAM).

The chief foreign Since 1974, the chief aim of the foreign policy of the Republic of Cyprus has been to policy aims are the secure the withdrawal of Turkish forces and the reunification of the island under the withdrawal of most favourable constitutional and territorial settlement possible. This campaign has Turkish forces and been pursued primarily through international forums, such as the UN and the EU (and reunification through the NAM previously).

Cyprus is a member of the UN and its specialised agencies, the Commonwealth of Nations, World Bank, IMF and Council of Europe. In addition, the country has signed the General Agreement on Tariffs and Trade (GATT) and the Multilateral Investment Guarantee Agency Agreement (MIGA).

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Economic Environment

Economic Overview

The country’s Following the post-independence period (see Political Overview, p24), the Cypriot advanced economy economy gradually shifted from agriculture to services and light manufacturing. The is based primarily successful transformation of Cyprus into an advanced economy is attributed, inter alia, on services to the adoption of a market-oriented economic system, the pursuance of sound macroeconomic policies, and the existence of a dynamic and flexible entrepreneurship alongside a highly educated labour force. Moreover, the economy has benefited from close co-operation between the public sector and the social partners, and has undergone significant economic and structural reforms in the lead-up to and following its accession to the EU.

These achievements are all the more striking bearing in mind the severe economic and social dislocation created by the Turkish military intervention of 1974 and the continuing division of the island (see Political Overview). The military intervention and the resulting division inflicted a serious blow to the Cypriot economy and in particular to agriculture, tourism, mining and quarrying: 70% of the island’s wealth-producing resources were lost; the tourism industry lost 65% of its hotels and tourist accommodation; the industrial sector lost 46% of its capacity, and mining and quarrying 56%. The loss of the port of Famagusta, which handled 83% of general cargo, and the closure of Nicosia International Airport, in the buffer zone, were additional blows. However, over the past years Cyprus has witnessed high levels of growth that have led to rising living standards, as shown by the high level of convergence with the EU. From 1997 until 2009, GDP per capita (in purchasing power terms) grew from 86% of the EU27 average to 98%.

At present, the tertiary (services) sector makes up the largest (and fastest growing) area of the economy. Cyprus is markedly dependent on the tourism sector, making it High dependence on particularly vulnerable to swings in tourist arrivals caused by political instability on the the tourism sector island, currency variability (with many tourists coming from Russia and the UK) and makes the economy fluctuations in economic and political conditions in Western Europe and the Middle vulnerable to East. However, it has also developed an important financial and business services external shocks sector, which is gaining in importance as the relative contribution of the tourism sector declines. In particular, Cyprus’ entry into the EU appears to have accelerated the growth of the non-tourism sector. Reforms imposed by EU membership, such as the liberalisation of telecommunications and energy, have already lowered costs and boosted Cyprus’ appeal as an international business centre. Nevertheless, tourism, as well as medical and ‘wellness’ activities, development projects in the field of natural resources (gas, oil) and R&D are among the most promising sectors for future development and investment.

Economic Framework

Industrial Relations and the Labour Market

Although severely hit by the effects of the global financial crisis, the labour market in Cyprus is relatively flexible and well-functioning, and is characterised by a high The labour market employment level, outperforming the EU average on all fronts; in particular, in 2009 the is relatively flexible employment rate was the highest among the member states that joined the EU in 2004 and well- and 2007, and well above the EU average. In addition, Cyprus has a relatively high functioning employment rate for women and a low youth unemployment rate. Employment expanded until the beginning of the financial crisis in mid-2008, sustained, to a considerable extent, by continued inward immigration and the employment of Turkish- Cypriots following the partial lifting of restrictions on movement between the two communities in 2004.

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A decisive contributing factor to the increase in employment during the pre-crisis period (and particularly since 2003) was the government’s decision to allow the temporary employment of foreign workers in certain sectors of the economy, given the labour market shortages created by fast economic growth.

The Cypriot labour market has a tradition of social dialogue and a well-developed institution of free collective bargaining. The labour market is characteristically highly unionised: approximately 70% of the labour force is unionised (in some sectors, such as the public sector and banking, unionisation rates reach virtually 100%) and is covered by collective bargaining. Collective agreements regulate employment conditions, such as remuneration, working hours, health and safety, annual holidays and a provident fund, and usually have a duration of two to three years.

Most labour The Industrial Relations Service of the Ministry of Labour and Social Insurance acts as disputes are the national mediator for the settlement of labour disputes in the private and semi- resolved without government sectors of the economy, adhering to the provisions of the Industrial resort to industrial Relations Code, which is a voluntary agreement signed by the social partners in 1976, action providing for procedural provisions for dealing with disputes over rights and disputes over interests. The Service mediates in around 250-300 labour disputes every year, with more than 95% of these disputes settled without any side resorting to industrial action: in fact, the incidence of industrial action has fallen steadily since 2006.

Wages are Wage determination in Cyprus is the result of bargaining between the most determined on the representative employer and trade union organisations at the sectoral and industry basis of labour levels, without, however, any operational co-ordination between the two levels. Labour productivity and an productivity is the basic factor used for calculating the level of claimed wages. Another automatic factor affecting the level of wage increases is the implementation of the COLA system indexation (cost of living allowance, see Inflation, p13), which provides for the automatic mechanism adjustment of wages on the basis of general changes in price levels. Specifically, under the current system the gross earnings of workers are revised at the end of every six months (i.e. on 1 January and 1 July) on the basis of the CPI percentage increase of the preceding six-month period.

The existence of this automatic wage indexation mechanism is a divisive issue in Cyprus: until recently, it has been considered a non-negotiable issue during collective bargaining, enjoying the strong support not only of trade unions but also of successive governments, despite opposition from the employer organisations. Recently, the Governor of the Central Bank repeated his call for changes to COLA, but some parties, such as the governing coalition, consisting of the Progressive Party of Working People (AKEL) and the Democratic Party (DIKO), have strongly objected to COLA being totally abolished or even lowered. One of the basic arguments against the COLA system is that it undermines the flexibility and competitiveness of the labour market, while its uniform application does not allow wages to reflect productivity differences across economic sectors. Moreover, at times of strong inflationary pressures it can impede the stabilising role of fiscal policy, an even more significant danger within the context of the European Monetary Union.

Fiscal Framework

Following the Turkish military intervention in 1974, Cyprus’ policy of balanced budgets was replaced by expansionary fiscal and monetary policies aimed at stimulating The EU Stability economic activity, which led to unsustainable fiscal deficits and high public debt. EU and Growth Pact membership and the country’s entry into the European Exchange Rate Mechanism sets the framework (ERM II) in 2005 brought fundamental reforms to the fiscal policy framework. Under for fiscal policy the requirements of the Stability and Growth Pact (SGP) and the Maastricht convergence criteria, a tight fiscal policy was adopted that enabled the gradual reduction of the fiscal deficit (which turned into a surplus in 2007) and the return of public debt to a sustainable path. However, that path was abandoned during the financial crisis when revenues decreased sharply and expenditures, especially for the unemployed, rose sharply. This led to a fiscal deficit of 6.1% of GDP in 2009, more than twice as much as the SGP allows.

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The prime reference framework for fiscal policy in Cyprus is still the EU’s SGP. Cyprus, which is currently under an EU ‘excessive deficit procedure’, has to reduce its fiscal deficit to 3% of GDP or lower by the end of 2012, with the first steps in this direction needing to be complete by end-2010. In this context, medium-term fiscal plans are submitted to the European Commission every year. As fiscal consolidation is the main priority of the government’s economic policy, adherence to the SGP has been relatively strict.

Monetary Regime

Following its accession to the euro-area in 2008, Cyprus ceded monetary policy-making to the ECB, which aims primarily at safeguarding price stability in the euro-zone, The ECB’s defined as inflation of ‘close to, but below 2%’. However, the ECB does not operate a monetary regime formal inflation-targeting regime, but bases its interest rate decisions on a ‘two-pillar’ has helped to strategy. The first pillar consists of an analysis of monetary variables, such as money subdue inflation and credit growth. The second pillar involves the ECB’s monitoring of developments in expectations the real economy and financial markets, such as wages, productivity, fiscal policy, asset prices and exchange rates, with a view to identifying short-term inflationary pressures created by the interplay of supply and demand. The ECB’s monetary regime has helped to subdue inflation expectations, and the ECB has also demonstrated its willingness to adopt non-standard measures, such as the purchase of covered or state bonds, in order to improve credit conditions in the euro-area (see Monetary Policy, p15).

Exchange Rate Regime

Since adopting the euro, Cyprus has had no monetary or exchange rate policy of its own. The euro floats freely against the other major currencies. Some smaller countries have pegged their currencies to the euro, or their central banks keep currency movements against the euro within small bands. The FX reserves of euro-area member states such as Cyprus are also now managed by the ECB. The euro-area’s large FX reserves make it unlikely in theory that a euro-zone member will get into serious external financing problems. However, EU law stipulates that ECB FX reserves cannot be used to help a euro member state pay off its national foreign currency debt. A country in major debt-financing difficulties, would, as in the case of Greece, be expected to receive financial support from other member states, but would not be guaranteed to avoid default, particularly if this were to threaten the existence of the single currency project or would lead to ‘moral hazard’ problems.

Trade Profile

Manufactured International trade has always played a crucial role in the development of the economy. products constitute Exports are vital in supplementing aggregate demand for Cypriot agricultural, mineral the bulk of Cyprus’ and manufacturing products, due to the small size of the domestic market. exports Manufactured products constitute the bulk of Cyprus’ total merchandise exports with a 60.0% share in 2009, up from 58.3% in 2008. Cyprus’ merchandise exports still include a large proportion of agricultural products, a sector in which Cyprus faces increasing competition from North African and Asian countries. Moreover, the structure of Cyprus’ export profile makes the country vulnerable to global price shocks, as more than half of Cyprus’ exports are re-exports, such as petroleum-related products, which are subject to price fluctuations.

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Export Mix, 2009

Other 6% Processed agricultural products 17% Manufactured products 60%

Raw agricultural products 17%

Source: Statistical Service of Cyprus

The EU is by far the most important market area for Cyprus. Exports to the EU27 countries amounted to 56% of total exports in 2009, up from 53% in 2008. In 2009, Most Cypriot exports to Greece, Cyprus’ most important individual country export market, increased exports are directed to 24% of total exports (from 20% in 2008), although exports to Greece decreased in to the EU absolute terms, from USD336m down to USD297m. Euro-zone countries received 41% of Cypriot exports in 2009, compared with 38% in 2008. The second-most important group, the Middle Eastern countries, absorbed around 12% of Cyprus’ exports during 2009, picking up from 10% in 2008; major markets in this group are Lebanon and the United Arab Emirates. Exports to Asian countries increased sharply during 2009, while, in contrast, Russia’s share declined marginally. Despite this level of export diversification, Cyprus’ further integration into the euro-zone economy might lead to a further expansion of trade with the EU/euro-zone.

Export Markets, 2009

Greece Other 24% 32%

Germany 9%

Middle East UK 12% 9% Other-EU 14%

Source: IMF, Direction of Trade Statistics

Cyprus lacks sufficient raw materials, energy resources and heavy industry for the production of capital goods, which necessitates the importation of such input. In order to satisfy its growing domestic market and industrial needs, Cyprus also imports large quantities of durable consumer goods and capital equipment. The country imports food and most raw materials mainly from the EU, and oil from neighbouring Middle East countries; as a result, Cyprus is vulnerable to global commodity price fluctuations.

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Cyprus is particularly vulnerable to oil price volatility, as it is not energy-self-sufficient Cyprus is vulnerable and has to import most of its oil. However, this could change in the near future: oil has to oil price volatility recently been discovered in the seabed between Cyprus and Egypt, while the seabed as it imports most of separating Lebanon and Cyprus is believed to hold significant quantities of crude oil its oil and natural gas. Talks are underway between Cyprus, Lebanon and Egypt to reach an agreement regarding the exploration of these resources.

Import Mix, 2009

Other 8% Fuels & lubricants 28% Food & beverages 11%

Construction & mining 12%

Transport Manufactured equipment products 25% 16%

Source: Statistical Service of Cyprus

The EU is the main source of imports for Cyprus. In 2009 almost 72% of its total imports came from the EU27 countries, up from almost 69% in 2008. In particular, imports from Greece increased from 2008 to 2009, from 17% to 20%. Within the EU, Greece, Italy, the UK and Germany remain the most important suppliers of imported goods.

Import Sources, 2009

Greece Other 20% 15%

Other-EU 23% Italy 11%

UK 9% China 6% Germany Israel 9% 7%

Source: IMF, Direction of Trade Statistics

Outside the EU, Asian countries are the second-most important group of suppliers (with their share marginally increasing in 2009), followed by Middle Eastern countries, while China and Israel are the two major import sources from these groups: in 2009 imports from China increased moderately (by 4%) while imports from Israel skyrocketed by 460%. Israel supplies Cyprus with mineral fuels and oils, household plastics, machinery and mechanical appliances, iron/steel/stone/plaster/cement products and glass, while Cyprus’ imports from China comprise mostly manufactured goods and machinery.

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Long-Term Economic Potential

Over recent years Cyprus has enjoyed strong economic growth and exhibited rising living standards, as shown by the high level of convergence with the EU: GDP per We forecast 2.0- capita stood at 94.0% of the EU27 average in 2009, rising from 92.6% in 2008. Cyprus’ 3.0% annual growth long-term growth potential has been boosted significantly by the structural reforms in the next ten years initiated to ensure that the country achieved EU membership in 2004 and entry into the euro-zone in 2008. D&B expects Cyprus’ potential annual average real GDP growth rate over the next ten years to be around 2.0-3.0%.

In the lead-up to EU accession, Cyprus dismantled most investment restrictions, attracting increased flows of FDI, particularly from the EU. According to the latest UN Conference on Trade and Development (UNCTAD) World Investment Report 2009, Cyprus ranks among the world’s leading countries per capita in terms of attracting FDI. In 2009, the inflow of FDI reached USD5.78bn, compared with USD4.02bn in 2008. The majority of the FDI inflows were directed towards the construction and real estate sector. The long-term trend is positive and Cyprus has the potential to attract even higher FDI levels.

Labour market conditions in Cyprus have generally been favourable, while the workforce is skilled and well-educated: in 2009, 36.5% of 25-64 year olds had a tertiary qualification, 2 percentage points more than a year before. However, near-full employment and institutional rigidities have limited improvements in competitiveness. Nonetheless, the quality of Cyprus’ labour force will continue to benefit from EU membership and the free movement of labour from fellow EU countries, which enhances the island’s opportunities to attract highly-qualified workers for its expanding service economy. This could strengthen productivity in the long term and stabilise economic growth in the future.

The country’s population profile will change significantly over then next 50 years: the share of people over 65 years of age is expected to double by 2050, and the absolute The government has number of people over the age of 80 is set to quadruple between 2004 and 2050, more taken measures to than tripling their share in the total population. At the same time, the share of the address the costs of working population (aged 15-64) will fall to 61% from 68% over the same period. The a rapidly ageing rapidly ageing population and lower labour participation rates of those within the population working-age bracket has long-term implications for the social security system and public finances, but the government took measures in 2009 to address the implications of the country’s adverse demographic outlook by reforming the pension system, mainly focussing on slightly higher contributions and stricter eligibility conditions.

Three decades of division have left Cyprus with an economic development gap. A successful settlement of the country’s political problems would have positive effects on A successful the island’s economy: an increase of GDP by 20-40%, as well as a direct increase of settlement of the financial activities and economic growth. In particular, according to an independent island’s division report from the local branch of the International Peace Research Institute of Oslo, the would be positive impact of a political settlement on tourism, transport, higher education and financial and for the economy business services would raise real GDP growth by 3 percentage points in the first five years, creating more than 33,000 jobs, especially in the tourism and the real estate sectors. In addition, there would be some indirect positive repercussions such as the opening of the vast market of Turkey to Cyprus, the elimination of defence expenses and an increased level of confidence in the Cypriot economy.

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Commercial Environment

Overview

Cyprus offers a favourable commercial environment. A number of factors contribute to make it a suitable base for business activities and at the same time a gateway for The commercial expansion in other regions and countries: its EU membership; its geographical location environment is at the crossroads of three continents; a modern infrastructure; a sound legal system; low generally tax rates; improving corruption rates; a liberal investment regime; low set-up and favourable operating costs; and simplified administrative procedures for acquiring necessary permits. The absence of a political settlement and the ongoing division of the island pose only a very low risk for businesses. In the World Economic Forum’s latest Global Competitiveness Index, Cyprus is ranked in 34th position (out of 132 states surveyed). Over the past two years, Cyprus has improved its ranking significantly; in the 2008/09 edition Cyprus was ranked 44th, up from 50th in the 2007/08 edition.

Relative Competitiveness, 2009/10

Greece 4.04

Turkey 4.16

Malta 4.30

Italy 4.31

Portugal 4.40

Slovenia 4.55

Cyprus 4.57

US 5.59

0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 0.00=least competitive 7.00=most competitive

Source: World Economic Forum, Global Competitiveness Index

Physical Environment

Natural Environment

Cyprus is situated in the eastern Mediterranean Sea, at the crossroads of three continents linking Europe with the Middle East, Africa and Asia. It has an area of 9,251 square kilometres (km) and is the third largest island in the Mediterranean, after Sicily and Sardinia. The physical setting for life on the island is dominated by the two mountain masses and the central plain they encompass. Its pleasant Mediterranean climate, coupled with a relatively extensive coastline of 648km, make Cyprus an attractive tourist destination.

Cyprus has Cyprus is relatively well-endowed with mineral resources: it is among the five richest abundant mineral areas in the world with respect to copper-pyrites and also has rich chromite deposits. As resources a result, there is extensive quarrying of rocks and industrial minerals. There are around 220 quarries producing various materials for local use (havara, sand and gravel, aggregates from diabase and limestone, building stone, limestone, clay, gypsum) and for export (building stone, gypsum, bentonite, umber and ochre). There is also local production and export of quick and hydrated lime, portland and other types of cement and gypsum plasters. Asbestos was also once exploited, but its deposits are now closed for environmental and health reasons.

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Oil has recently been discovered in the seabed between Cyprus and Egypt, while the Rich offshore seabed separating Lebanon and Cyprus is believed to hold significant quantities of deposits of oil and crude oil and natural gas: talks are underway between Cyprus, Lebanon and Egypt to natural gas have reach an agreement regarding the exploration of these resources. In January 2009, rich been discovered natural gas reserves were also located between the exclusive economic zones of Cyprus and Israel, which are said to be in the region of 3.3trn cubic metres, enough to satisfy the country’s energy needs for the next 20 years.

Cyprus faces little risk of natural disasters: occasionally, it experiences earth tremors, but these are invariably very mild. In addition, the country suffers chronic water shortages, as it is heavily reliant on rainfall for water supplies, and regularly imports water. In 2008, the island suffered one of the worst droughts of the past 100 years, which sapped water reserves to critically low levels and triggered emergency rationing to households. In order to address the problem, the government cut the supply of water to water boards by 30% in 2009, while it has expedited plans for new desalination units. However, all water cuts were suspended in March 2010 following the country’s wettest winter in six years.

Infrastructure

Cyprus is well served by sea, air and telecommunications connections. Its role as a regional commercial and business centre, coupled with increasing tourist traffic, has led Cyprus’ to the development of a wide network of air routes offering excellent connections with infrastructure is the rest of Europe, Africa and Asia. The island has two international airports, situated adequate for near Larnaca and Paphos, and another 16 national ones. Cyprus’ seaborne cargo and business needs passenger traffic is served by a fully renewed port system comprising the multi-purpose ports of Limassol and Larnaca, the industrial port of Vassiliko and the three specialised oil terminals of Larnaca, Dhekelia and Moni. The Cyprus registry ranks tenth among international fleets. A significant number of ship management companies have been established in Cyprus and manage a sizable proportion of the Cyprus merchant fleet, as well as a large number of vessels under foreign flags. The total fleet managed from Cyprus represents 20% of the world third-party ship management market, making it one of the top five countries in this field.

Cyprus has developed one of the most modern road networks in Europe, which is continuously improved and upgraded. However, it has no working railway system, following the dismantling of the last railway in 1952.

The telecommunications infrastructure is one of the most modern in the region, enhanced by an extensive submarine fibre optic cable network and access to major satellite systems. Coverage of fixed-line telecommunications is almost universal, while mobile phone penetration was at 126% in 2009, which means that people have more than one mobile phone on average. The rates of internet usage and broadband penetration have grown, but are still well below the EU average.

Water shortages and Although almost all households and businesses are connected to a water supply, Cyprus supply cuts are a suffers from water shortages. There are some desalination plants operating; however, problem the authorities occasionally introduce controlled supply cuts. Practically all households are connected to the sewage system and electrification is near universal.

Legal and Regulatory Environment

In recent years a series of legal and regulatory reforms have been implemented, owing to the country’s EU membership. As a result, existing procedures and regulations affecting businesses (including foreign investment regulations) are generally transparent and enforced effectively by an independent judiciary. While foreigners enjoy equal treatment as nationals, in some cases foreign businesses have expressed concerns about the appearance of bias and lack of transparency in decisions made by the technical committees responsible for preparing specifications and reviewing government tenders.

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Judicial Environment

Procedures and Cyprus has a well-functioning legal system, which is a mixture of legislative statutes regulations and case law and is based on English Common Law. The Cypriot company law and affecting businesses other laws regulating business originate in the UK Companies Act of 1948, recently are generally updated and harmonised with EU directives. Companies can seek redress through the transparent and legal system and can expect to obtain a fair hearing. They will also be able to enforce effectively enforced orders made by Cypriot courts and those obtained in foreign courts. Cyprus is a signatory to the 1979 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards. However, legal proceedings are usually a last resort and a system of arbitration is effective in settling disputes. The system is regulated by the Arbitration Law, under which either an independent ‘umpire’ is appointed or both sides in a dispute appoint arbitrators.

Rule of Law, 2009

Romania -0.05

Turkey 0.09

Italy 0.43

Greece 0.75

Portugal 1.02

Cyprus 1.03

US 1.65

-2.50 -2.00 -1.50 -1.00 -0.50 0.00 0.50 1.00 1.50 2.00 2.50 -2.50=lowest quality +2.50=highest quality

Note: The World Bank’s Worldwide Governance Indicators are derived from annual surveys of businesses, citizens and experts in nearly 200 countries on six governance indicators: voice and accountability; political stability; government effectiveness; regulatory quality; rule of law; and control of corruption. Source: World Bank, Worldwide Governance Indicators

The political While property rights are enforced effectively, the legal requirements and procedures situation creates for acquiring and disposing of property are complex. More importantly, the absence of a risks for investors political settlement poses an inherent risk for the foreign investor interested in buying or interested in buying leasing property in the Greek-Cypriot South, in the Turkish-Cypriot North and across or leasing property the buffer zone, as property issues are closely linked to the political situation (see Other Commercial Risks, p22).

Several high-profile cases have already been brought before the European Court on Human Rights and other international bodies, while other cases are still pending. In addition, in October 2006 a criminal code amendment relating to property came into effect. Under the amendment, buying, selling, renting, promoting or mortgaging a property without the permission of the owner (the person whose ownership is registered with the Republic of Cyprus Land Registry, including Greek-Cypriots displaced from Northern Cyprus in 1974) is a criminal offence. This also applies to agreeing to sell, buy or rent a property without the owner’s permission. Moreover, on May 2010, the European Court of Justice (ECJ), in a landmark case concerning the right of a Greek- Cypriot refugee to reclaim land in Northern Cyprus, ruled that although the Republic of Cyprus, the internationally recognised state, does not exercise effective control in Northern Cyprus, judicial decisions made in its courts that uphold the property rights of Greek-Cypriots are applicable through EU law. The case sets a precedent for Greek- Cypriot refugees to bring similar actions to court (see Other Commercial Risks, p22).

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Cyprus has a modern and comprehensive set of laws protecting intellectual property Laws protecting rights, which continues to be upgraded. As part of its accession to the EU in 2004, intellectual property legislation relating to various types of intellectual property was harmonised to meet the rights have been demands of EU law and Cyprus officially became a member of the Office of harmonised with Harmonisation for the Internal Market. It is also a member of the World Intellectual EU legislation and Property Organisation (WIPO) and of numerous related conventions. The Department continue to be of Registrar of Companies and Official Receiver is the organisation responsible for the upgraded protection of brands and patents in Cyprus. Enforcement of intellectual property regulation is typically quite diligent, although it can be improved further. According to industry sources, although software piracy, largely fuelled by small personal computer assembly and sale operations, has declined, it is still significantly above the European average. Internet piracy is also a growing concern.

Competition Law

The principal legislation on competition in Cyprus is the Law for the Protection of Competition, enacted in April 2008, which replaced the previous Competition Law of 1989. The new law entrusts the Competition Commission (CC), initially established in 1990, with the obligation for the fulfilment of the objective of maintenance of effective competition within the Cypriot market and specifically appoints the CC as the authority responsible for the application of the relevant EU regulations. With the enactment of the new legislation the competencies and powers of the CC have been enhanced and extended: among other things, the CC has the exclusive competence to investigate and take decisions on infringement cases and concerted practice, as well as to impose administrative fines and other sanctions.

Corporate Governance

Starting a business in Cyprus is relatively easy. Regulations have been streamlined, administrative procedures have been simplified, and business regulations are transparent Starting a business and consistently applied. The registration procedure is basically the same for all is relatively easy categories of business, with straightforward and speedy mechanisms. As of October 2004, foreign investors can register a company directly with the Registrar of Companies, and obtain any licence, if needed, from the appropriate authority according to the nature of investment.

The registration of companies and other legal entities, as well as their mode of operation, is governed by the Companies Act 1968-1995, Chapter 113, as amended by the House of Representatives as part of the harmonisation with the corresponding EU directives on company law. Within this legal framework, interested investors may set up the following legal entities:

Private Company Limited by Shares: Has at least one founding member, and is limited to 50 shareholders. The responsibility of the associate member is limited to the amount contributed to the total capital. The offer of shares for public subscription is not allowed and the transfer of shares is restricted. No minimum capital is required.

Public Company Limited by Shares: Minimum capital requirements apply; there is no maximum. On formation, there must be at least seven founders (shareholders). No maximum number is specified. The main feature is the power to extend an invitation to the public to subscribe to its shares. Subject to fulfilling the requirements of the relevant legislation a public company may be listed on the Stock Exchange.

General Partnership: Minimum two and maximum 20 associate members. Each member is personally and indefinitely responsible for the debts and obligations of the company. No minimum capital is required.

Limited Partnership: Minimum two and maximum 20 associate members. At least one of the members is personally and indefinitely responsible for the debts and obligations of the company, the other members’ responsibility being limited in nature. No minimum capital is required.

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In addition to these legal forms, section 347 of the Companies Act Chapter 113 provides for the registration in Cyprus of foreign companies under the form of a branch. Other corporate entities that a foreign investor can establish in Cyprus include the European Public Limited Liability Company (SE): this kind of company can be registered either by merger between two public companies, which are registered at least in two different EU countries, or by formation as a new company, under certain circumstances or by transformation of an existing public company into a European Company.

Financial Sector Oversight

Supervision and There are effectively four authorities responsible for the regulation and supervision of regulation of the the financial system as a whole: the Central Bank of Cyprus (CBC), which is financial system is responsible for the supervision of domestic banks and international banking units; the exercised by four Authority for the Supervision and Development of Co-operative Societies (ASDCS), authorities supervising the co-operative credit institutions; the Insurance Company Control Service (ICCS); and the Cyprus Securities and Exchange Commission (CySEC). In 2003, the four supervisory authorities concluded a Memorandum of Understanding to promote cross-sectoral co-operation and to enhance the exchange of information among them.

Since then, the central bank has made substantial progress in its supervisory practices to strengthen Cyprus’ supervisory framework for commercial banks. Its supervisory role The supervisory has been guided by the recommendations of the Basle Committee on Banking framework has Supervision and the relevant EU banking directives and has been effective. During 2008 improved… the central bank fully transposed the EU’s capital requirements directive into legislation, while it issued a number of circulars and directives aimed at improving supervisory rules and aligning them with international practice and standards. These included guidelines on the management of credit, market and operational risks. In addition, a comprehensive bottom-up stress-testing exercise is carried out by the bank’s Financial Stability Section randomly; the latest stress test (with support from European authorities) took place in July 2010.

Moreover, the ASDCS has made impressive progress both organisationally and to its practices to strengthen Cyprus’ supervisory framework for co-operative credit institutions. The legislative and regulatory framework has been harmonised with EU directives, while regulatory decisions addressing a number of prudential areas such as corporate governance, internal controls, supervisory reporting, application of minimum reserves and anti-money laundering have been issued. In addition, a comprehensive legislative framework, largely based on EU law, is in place for the supervision of the securities sector in Cyprus. The regulatory responsibilities of CySEC are set down clearly in legislation and CySEC appears to be carrying out its function in a consistent and effective manner.

Despite the considerable progress made so far, further improvements are needed. The ICCS has introduced significant supervisory and regulatory reforms in the insurance …but further area: the regulatory approach is in principle reflective of and appropriate for the low enhancements are complexity and sophistication of the insurance market in Cyprus. Although supervision needed has been updated and international co-operation with other supervisors has been fostered, the IMF still calls for closer co-operation with foreign supervisors, given the potential spill-over effects from neighbouring countries. Consideration should also be given to enlarging the deposit insurance facility. In its latest report on Cyprus from September 2010, the IMF also highlighted the urgency of strengthening the supervision and transparency of co-operative credit societies which are not yet properly regulated.

Corruption

Cyprus co-operates closely with the EU and other international authorities on fighting corruption and providing mutual assistance in criminal investigations. It has signed and ratified the European Convention on Mutual Assistance in Criminal Matters, while it uses the foreign Tribunal Evidence Law, Chapter 12, to execute requests from other countries for obtaining evidence in Cyprus in criminal matters.

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Cyprus is also an active participant in the Council of Europe’s Multidisciplinary Group on Corruption. As such, it has already signed and ratified the Criminal Law Convention on Corruption and has joined the Group of States Against Corruption (GRECO).

Corruption is not a As a result, corruption is not a significant impediment to conducting business in Cyprus. significant Indeed, Cyprus is ranked joint-31st out of 180 countries in Transparency International’s impediment to doing 2009 Corruption Perceptions Index, scoring 6.6 (where 10.0 is the lowest level of business perceived corruption and 0.0 is the highest). This marks a small improvement in corruption perceptions in Cyprus from the previous year, when the score was 6.4. The score compares favourably with regional neighbours (Greece ranked 71st, with a score of 3.8, and Turkey was in 61st position, scoring 4.4), as well as with many EU27 countries.

In Cyprus, corruption in its various forms (active and passive, public and private) constitutes a criminal offence, punishable by up to seven years of imprisonment and a pecuniary penalty. Although cases usually move at a slow pace, the government generally implements the law effectively. To this end, a Co-Coordinating Body Against Corruption, chaired by the Attorney General, has been created to advise on anti- corruption policy and is composed of representatives from the public and the private sectors. The Office of the Ombudsman, which is responsible for overseeing the actions of the administration, has also operated since 1999.

Corruption Perceptions, 2009

Greece 3.8

Italy 4.3

Turkey 4.4

Malta 5.2

Portugal 5.8

Slovenia 6.6

Cyprus 6.6

US 7.5

012345678910 0.0=most corrupt 10.0=least corrupt

Source: Transparency International, Corruption Perceptions Index

In addition, a 2004 anti-corruption law instituted compulsory asset declarations by state officials, although evidence has shown that many do not comply with the law. In its annual reports, the office of the auditor-general, who under the constitution controls all disbursements and receipts and has the right to inspect all accounts on behalf of Cyprus’s government, has reported serious financial mismanagement in government departments. In 2007, the government investigated alleged deals between officials and developers, who made suspicious gains from zoning changes, while an official of the road transport department was arrested and charged with soliciting a bribe. Furthermore, in December 2008 the escape of a convict serving a life sentence from a Nicosia private hospital (where he had been staying for seven months) prompted a series of investigations into possible corruption of police and other government officials.

Taxation

Tax legislation is in Following a tax reform that came into effect in January 2003, legislation in the field of line with EU taxation fully complies with EU law and with the Code of Conduct for Business standards Taxation. Under the new tax regime the definition of ‘resident in Cyprus’ was introduced: a company is ‘tax-resident’ in Cyprus when its management and control is exercised in the country; taxable income includes both incomes earned in Cyprus and abroad. A non-Cyprus tax resident is taxed only on income earned in Cyprus.

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All companies tax-resident in Cyprus are subject to a uniform tax rate of 10% (the lowest corporate tax rate in the EU) except for semi-government organisations, which are taxed at 25%. Dividends received from companies located in Cyprus or abroad are exempt from corporation tax. Dividends received by a Cyprus-resident company from another Cyprus-resident company also are exempt from the special defence contribution under the Special Contribution for Defence Law, which taxes special types of income. Dividends received from non-resident companies are exempt from the special defence contribution provided that: a minimum 1% holding in the company paying the dividend is maintained and either the paying company engages directly or indirectly in more than 50% of activities that give rise to non-investment income or the non-Cypriot tax burden on the dividend paying company’s income is not lower than 5%.

Special tax Special tax treatments apply to shipping companies, international trusts and to Cyprus treatments apply to holding companies. In addition, Cyprus has a wide and beneficial Double-Tax Treaty some companies, Network. There are currently 44 double-taxation treaties with other jurisdictions, while while a wide Cyprus is one of the few countries in the world that has concluded tax treaties with all network of double Eastern European countries. In particular, in 2009 Cyprus signed a double-taxation taxation treaties is avoidance agreement with the Czech Republic, which provides several incentives to in place Czech businesspeople to invest in Cyprus, while it initialled an agreement with Russia to avoid double-taxation between the two countries, thus removing Cyprus from the Russian tax blacklist. Under the agreement, the profit made on the shares of Russian subsidiaries of Cyprus holding companies that will have more than 50% of their assets in property in Russia will be taxed in Russia (thus addressing Russia’s concerns over the possibility of Russian nationals laundering ill-gotten gains through the island by taking advantage of the local lack of income tax controls for non-residents). The agreement will also reinforce Cyprus’ advantages as an investment portal between the EU and Russia by eliminating double-taxation on assets and business activities for both individuals and companies.

Headline Corporate Tax Rates, 2009

Cyprus 10.00

Turkey 20.00

Slovenia 21.00

Greece 25.00

Portugal 25.00

Italy 31.40

Malta 35.00

US 40.00

% 0 5 10 15 20 25 30 35 40 45

Source: KPMG, Corporate and Indirect Tax Rate Survey

VAT is imposed on domestic goods and services, as well as on imports to Cyprus. Since January 2003 VAT has been set to 15%; the lowest rate permitted in the EU. Cyprus also applies a reduced VAT rate of 5% on the hospitality sector, newspapers and magazines. A zero-rate VAT is imposed on specific supplies of goods and services, such as exports, foodstuffs, medicines, commissions received for arranging exports of goods, international air and sea transport, and others. In April 2010 (with effect from 1 January 2011), the parliament decided to rise VAT on some previously zero-rated goods (e.g. pharmaceuticals and food) to finance the increased government deficit (see Policy Agenda, p7).

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Cyprus has a progressive personal income tax system with effectively four tiers, including a tax-free threshold up to EUR19,500. Annual income between EUR19,501 and EUR28,000 is taxed at 20%; income from EUR28,001 to EUR36,300 is taxed at 25%; and 30% is levied on income exceeding EUR36,300. Resident individuals (i.e. individuals who stay in the Cyprus for 183 days in the year of assessment) are subject to income tax on their worldwide income, while non-residents are taxed only on their Cyprus-sourced income.

Trade Environment

Current Account Exchange Regulations

Cyprus has accepted the obligations of Article VIII, Sections 2, 3 and 4 of the IMF’s Articles of Association to refrain from imposing restrictions on payments and transfers for current international transactions and from engaging in discriminatory currency arrangements or multiple currency practices without IMF approval.

Trade Regulations

As a member of the EU, Cyprus applies the EU’s integrated tariff (TARIC) regime on imports from non-EU countries. The TARIC database, updated daily by the EU’s Directorate General for Taxation and Customs Union, contains information on the tariff rates and quantitative restrictions in place for any good and from any source country.

Tariffs

Tariff rates on The EU’s Common Customs Tariff (CCT) rates, which differ by product and origin, manufactured goods depend on the economic sensitivity of products and are a means of protecting the EU’s tend to be low producers. Raw materials, as well as semi-manufactured goods not produced within the EU and needed for manufacturing, usually benefit from duty-free entry or low tariff rates. Duty suspensions may be made for imports needed to produce EU exports.

Over half of all products from non-EU countries can enter the EU tariff-free. For example, under the WTO Information Technology Accord, the EU has eliminated tariffs on a range of IT products in six categories: computers; telecommunications equipment; semiconductors; semiconductor manufacturing equipment; software; and scientific instruments.

EU agriculture While the (weighted) average EU tariff level for non-agricultural goods is relatively low remains heavily at 1.64%, some goods attract a higher rate of up to 25.0%. The majority of agricultural protected by high imports are subject to variable (and sometimes high) levies under the Common tariff barriers Agricultural Policy (CAP). These bound duties are designed to equalise the prices of imported commodities with those of EU produce. Hence, the (weighted) average EU tariff level for agricultural goods stands at a comparatively high 10.06%.

Regarding the origin of goods imported to the EU, it is important to note that the EU has entered various regional trade pacts:

• The European Economic Area (EEA) integrates Iceland, Liechtenstein and Norway (with Switzerland as an observer member) into the single market for most goods. • In the context of the Euro-Mediterranean Partnership (EMP), EU Association Agreements are in force with Algeria, Egypt, Israel, Jordan, Lebanon, Morocco, the Palestinian Authority, Tunisia and Turkey. Negotiations with Syria on an Association Agreement have also been concluded and the agreement might enter into force by end-2010. Libya has the status of observer in the EMP. The Association Agreements encompass gradual, reciprocal dismantling of trade barriers between the EU and the other contractual party, with manufactured goods usually an initial priority. The EU intends to create a fully fledged Euro-Mediterranean regional free-trade area in the course of 2010.

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• In addition to its Association Agreement (which dates from as early as 1963), Turkey has also been in a customs union (a two-way free-trade agreement, FTA, with common external tariffs) with the EU since 1995, although this excludes crucial areas such as agriculture, services and public procurement. • The EU operates a separate Customs Union Agreement with Andorra covering manufactured goods (but not agricultural products). • Free-trade areas (with varying degrees of product coverage and transition periods, but all without common external tariffs) are in operation with Chile, Mexico and South Africa. In October 2009 the EU concluded an FTA with South Korea (which could take effect by end-2010) in a deal worth around EUR19bn for EU exporters. • Under the Everything But Arms initiative, the EU has eliminated quotas and duties on all products except arms for the world’s 50 least-developed countries since 2001. • A total of 79 former European colonies in the African, Caribbean and Pacific regions (the so-called ACP countries) have long enjoyed preferential access to the EU market on the basis of a series of ACP-EU Partnership Agreements, the latest of which was signed in Cotonou in 2000. However, as these agreements only stipulated EU tariff exemptions for ACP products (and not vice versa), they have become incompatible with WTO provisions on reciprocity and are therefore being replaced with new, reciprocal Economic Partnership Agreements (EPAs). As of early 2010, a full EPA had been signed with the Caribbean countries (CARIFORUM). A number of interim agreements have been concluded with other ACP countries. • An FTA has been signed with six Central American countries (Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama) but are awaiting ratification in the parliaments of each of these respective countries. • FTAs have been signed with Colombia and Peru but are awaiting ratification in the Peruvian and Colombian parliaments (expected in 2011).

Moreover, negotiations for inter-regional FTAs are ongoing with:

• the South American trade bloc Mercosur (comprising Argentina, Brazil, Paraguay, Uruguay and Venezuela; although Venezuela has not yet implemented most of the practical trade arrangements, such as Mercosur’s common external tariff); • the Gulf Co-operation Council (GCC, consisting of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates); • the Association of South East Asian Nations (ASEAN, encompassing Brunei Darussalam, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam);

The EU has also launched bilateral negotiations with major trade partners such as India (with an FTA to be concluded by end-2010) and Canada (with which negotiations started in 2009).

Quotas and Licences

The EU import In accordance with its EU membership, Cyprus is subject to the EU import regime. regime applies to Import licences are issued with due consideration for the provisions of relevant EU Cyprus trade agreements and the fulfilment of quotas, established in accordance with such agreements. There are some restrictions, especially on agricultural products, following the implementation of the CAP, while special import licences are required for a small number of goods, including iron and steel products from some low-cost countries.

The licensing system is administered by the Department of Trade of the Ministry of Commerce, Industry and Tourism. Importers apply for import licences at the respective government department that controls the commodity. Licences are granted if all conditions have been fulfilled, and are valid for one year.

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Anti-dumping and Countervailing Duties

With scope for The EU adheres to WTO conventions covering anti-dumping duties, subsidies and conventional tariffs countervailing duties; these set the preconditions for the imposition of such duties and heavily restricted by their duration. The EU defines the ‘community interest’ (which must be threatened by WTO disciplines… imports before any anti-dumping duties can be levied) in a way that includes the interests of EU importers, retailers and consumers, rather than just those of domestic producers of import-competing goods.

…anti-dumping Nonetheless, the EU’s anti-dumping investigations are still liable to abuse by import- duties have become competing industries, as allegations that certain overseas competitors are ‘dumping’ an important their products onto the EU market (i.e. selling them at below-cost price) are notoriously instrument of difficult to verify or refute; much depends on the price accepted as the benchmark by protectionism the investigation. As in the case of other major trading blocs, anti-dumping duties can therefore be the easiest way to gain protection from outside competition for an EU industry, despite the European Commission’s procedural safeguards. One of the widely publicised examples of anti-dumping duties imposed by the EU is that on Chinese and Vietnamese leather shoes, in place since 2006.

Non-Tariff Barriers

Importers to Cyprus benefit from a liberal trading regime, in line with EU stipulations; non-tariff barriers are the exception, rather than the rule. However, it is advisable to examine Cypriot and EU phytosanitary, animal health and consumer protection rules.

EU rules on specific For example, the Conformite Europeenne (CE) marking has become a de facto products can result requirement for importing a wide range of goods into the EU. This is because the EU- in compliance costs based importer incurs legal liability for any damages caused by a product not labelled to producers with the CE marking, and few are prepared to take that risk. The symbol indicates that a product meets the essential health, safety and environmental requirements of any EU product safety directives applicable to the specific product. It can be self-awarded by the manufacturer. The CE mark is not a quality mark and only signifies to EU surveillance authorities that the product is in compliance with EU legislation.

CE marking directives apply to the following product categories: construction products, explosives for civil uses, gas appliances, active implantable medical devices, new hot water boilers, low voltage devices, machine safety, medical devices, non-automatic weighing machines, personal protection equipment, recreational craft, simple pressure vessels, telecommunications terminal equipment, toys and in vitro diagnostic devices.

Non-Tariff Trade Barriers Cyprus Region OECD Average Average Documents required for export (number) 5.0 4.0 4.3 Time required for export (days) 7.0 12.0 10.5 Cost to export (USD per container) 820 852 1,090

Documents required for import (number) 6.0 4.8 4.9 Time required for import (days) 5.0 12.2 11.0

Cost to import (USD per container) 1,030 958 1,146 Note: The region average refers to Mediterranean Countries (Cyprus itself, Greece, Italy, Malta, Portugal and Spain). Source: World Bank, Doing Business

According to the World Bank’s Doing Business 2010 report, Cyprus’ documentation requirements are more complex than in other Mediterranean countries because more documents are required in Cyprus than in neighbouring states. However, the processing of documents required for import and export transactions requires less time in Cyprus, taking only takes 5.0 days (import) and 7.0 days (export), while in neighbouring states the comparable figures are, on average, 12.2 days (import) and 12.0 (export).

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Trade Documentation

The ten-digit TARIC codes, used in all documentation for custom and statistical purposes, are based on the international Harmonised System (HS) code. All EU countries accept the Single Administrative Document (SAD), which facilitates intra-EU cross-border commerce, allowing firms to ship products to a variety of national markets from a single gateway port with a minimal amount of paperwork. The SAD is completed by the importer.

Where Cyprus is the first port of call within the EU, the following documentation guidelines apply:

Bill of Lading: There are no special requirements affecting the preparation of bills of lading, but they should show the marks of identification and indicate the name and address of the consignee. ‘To Order’ bills of lading are recognised and protected. Air cargo shipments require air way bills, while mail and parcel post shipments require postal documentation in place of bills of lading.

Delivery order: A delivery order, duly certified by a customs official, is required for the release of the specified goods.

Commercial Invoice: An invoice must be presented to Customs. Evidence of freight and insurance, if not given in the invoice, must be produced separately. There are no requirements regarding chamber of commerce certification and/or consular legalisation. Follow importer’s instructions in this regard.

Insurance Certificate: Normal commercial practices obtain. Follow importer’s and/or insurance company’s instructions.

Packing List: Required. A minimum of two copies should be issued and data should agree with the data in other documents.

Investment Environment

A number of factors make Cyprus an attractive country in which to invest: the island’s strategic location between Europe and the Middle East; its preferential tax regime (with the lowest corporation tax rate in the EU); an extensive network of double-taxation treaties; a legal and accounting framework based on UK law and practice; the availability of a well-qualified labour force particularly skilled in accounting and law; a reliable telecommunications system; the island’s status as an international shipping centre; and relatively liberal immigration and visa regulations.

FDI policy for EU Attracting foreign investment is among the primary objectives of Cyprus’ development and non-EU policy. For this reason, the government has liberalised FDI policy for both EU and non- nationals has been EU nationals: foreign companies can invest and establish business in Cyprus on equal liberalised terms with local investors. Administrative procedures have been simplified and no limitations apply in most sectors of the economy. Bureaucratic intervention has also been reduced.

Most restrictions on In particular, restrictions concerning the maximum allowable percentage of foreign capital and foreign participation, as well as minimum level of foreign investment in any enterprise in participation have Cyprus, were lifted as of January 2000 for EU-citizens and from October 2004 for non- been lifted EU citizens. Most capital restrictions and limits on foreign equity participation or ownership have been lifted, granting national treatment to foreign investors, while non- EU investors can invest freely in Cyprus in most sectors, either directly or indirectly (including all types of portfolio investment in the Cyprus Stock Exchange). The only exceptions primarily concern the acquisition of property (Other Commercial Risks, p22) and, to a lesser extent, ownership restrictions on investment in the sectors of tertiary education, mass media, banking and construction.

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As of October 2004, foreign investors can register a company directly at the Registrar of Companies through qualified accountants or lawyers, a procedure that is exactly the same for local residents. Similarly, foreign investors can acquire shares in an existing Cypriot company directly, without earlier authorisation by the central bank. They are expected, however, to inform the Registrar of Companies about any change in ownership status.

In order to foster the influx of foreign investments, the Foreign Investors Service Centre operates under the auspices of the Ministry of Commerce, Industry and Tourism. The Centre (which constitutes the central agency of information, support and foreign investors’ relations), assists foreign-based companies investigating investment opportunities in Cyprus. It plays a vital role in attracting FDI in targeted industries, focusing especially on the development of high-technology products, the enhancement of R&D and technology transfer.

The process of Moreover, in its effort to facilitate, accelerate and simplify the process of setting up a setting up a business and reduce the level of bureaucratic intervention, in 2007 the government set business has been up a ‘one-stop shop’ under the auspices of the Ministry of Commerce, Industry and simplified and Tourism, for both local and foreign-based companies. Investors and businesspeople now bureaucracy have a single point of contact to obtain almost all the required permits in one reduced streamlined, co-ordinated process, considerably reducing the average time for setting up a business. In the same year, the government also established the Cyprus Investment Promotion Agency (CIPA), tasked with providing extensive and professional assistance to foreign-based companies and individuals that wish to investigate the possibility of investing in Cyprus, as well as after-care services to already established foreign-based companies in Cyprus. The CIPA will work in tandem with the Foreign Investors Service Centre, under the same ministry.

Capital Account Exchange Regulations

Cyprus allows complete freedom of capital movements and payments, in accordance with EU law.

Investment Incentives

Investors can Cyprus-based enterprises can benefit from the favourable tax regime and enjoy the benefit from a lowest corporate tax rate in the EU (10%). Moreover, various tax exemptions apply for favourable tax both corporate and personal tax: exemptions in respect of dividends received from local regime, tax and foreign subsidiaries, profits of permanent establishments abroad, capital gains exemptions and derived from the disposal of securities, outward dividends, company reorganisations, grant schemes free repatriation of profits and capital, and others.

In addition, the government has introduced various Grant Schemes. Such schemes and incentives, among other things, aim at the encouragement, strengthening and reinforcement of entrepreneurship; the technological upgrading of Cypriot enterprises; the export promotion of industrial products; the development of technologically advanced products and services; and the attraction of capital-intensive foreign investments.

There are three Cyprus has three free-trade zones (FTZs). The first two, located in the main seaports of free-trade zones Limassol and Larnaca, are used only for transit trade, while the third, located near the international airport in Larnaca, can also be used for repacking and reprocessing. These areas are treated as being outside normal EU customs territory and as a result non-EU goods placed in FTZs are not subject to any import duties, VAT or excise tax. FTZs are governed under the provisions of relevant EU and Cypriot legislation. The Department of Customs has jurisdiction over all three areas and can impose restrictions or prohibitions on certain activities, depending on the nature of the goods.

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Additional Sources of Information

Central Bank of Cyprus Cyprus Chamber of Commerce and Tel: +357-22-71 41 00 Industry http://www.centralbank.gov.cy Tel: +357-22-889800 http://www.ccci.org.cy

Cyprus Stock Exchange Department of Customs and Excise Tel: +357-22-712300 Tel: + 357-22-601 713 http://www.cse.com.cy http://www.mof.gov.cy/customs

Ministry of Commerce, Industry and Ministry of Labour and Social Tourism Insurance Tel: +357-22-867100 Tel: +357-22401600 http://www.mcit.gov.cy http://www.mlsi.gov.cy

D&B provides information relating to more than 155m companies worldwide. Visit www.dnb.com for details. Additional information relevant to country risk can be found in the:

International Risk & Payment Review: Provides timely and concise economic, political and commercial information and analysis on 132 countries. Available as a subscription- based internet service (www.dnbcountryrisk.com) and monthly update journal, the IRPR carries essential information on payment terms and delays. It also includes the unique D&B Country Risk Indicator to help monitor changing market conditions.

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Glossary

Balance of payments The sum of payments made to all other nations less the sum of external receipts. Basis point One one-hundredth of a percentage point. CAD Cash against documents: On payment, the buyer receives the documents that give access to the goods. CiA Cash in advance: The buyer pays the seller before shipment is effected. CIS Commonwealth of Independent States (Armenia, Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, Ukraine, Uzbekistan) CLC Confirmed letter of credit: A letter of credit in which payment is guaranteed by the opening bank in the buyer’s country and by another bank. CPI Consumer price index Current account balance Part of the balance of payments that records a nation’s exports and imports of goods and services, and income and transfer payments. CWP Claims waiting period: The time between when the covered risk materialises and the earliest time when indemnification of a claim can take place. DSR Debt service ratio: Annual interest and principal payments on a country’s external debts as a percentage of exports of goods and services. ECB European Central Bank ECGD Export Credits Guarantee Department (UK) EU European Union Eximbank Export Import Bank (US) FDI Foreign direct investment: Investment in productive assets by a foreign company. Fitch Fitch Ratings FX Foreign exchange G7 Group of Seven industrial nations (Canada, France, Germany, Italy, Japan, UK, US) G8 Group of Eight industrial nations (G7 plus Russia) GDP Gross domestic product: The value of goods and services produced in an economy. GNP Gross national product: GDP plus net income from abroad. Government balance The balance of government expenditure and receipts. HIPC Heavily Indebted Poor Countries initiative: A framework for creditors to provide debt relief to the poorest and most heavily indebted countries. IMF International Monetary Fund Import cover The amount of official FX reserves a country has in relation to the average monthly value of imported goods and services. Inflation The increase in prices over a given period. IT Information technology LC Letter of credit: A guarantee of payment to a seller from a buyer’s bank. Payment is conditional on named documents being presented by specific dates. Moody’s Moody’s Investors Service MP Member of parliament NATO North Atlantic Treaty Organisation NGO Non-governmental organisation Nominal effective exchange rate The weighted average exchange rate of the local currency vis-a-vis a basket of foreign currencies. OA Open account: credit extended that is not supported by formal written evidence of indebtedness. OECD Organisation for Economic Co-operation & Development OPEC Organisation of Petroleum Exporting Countries Q1; Q2; Q3; Q4 First, second, third and fourth quarter R&D Research and development Real effective exchange rate The nominal effective exchange rate adjusted for inflation differentials with a country’s trading partners. Real GDP GDP adjusted for inflation S&P Standard & Poor’s SD Sight draft: A draft or bill that is payable on demand or on presentation. STIPP Short-Term Insurance Pilot Program (US): Provides short-term cover to buy US goods in countries where Eximbank is otherwise not open for medium-term financing in the public or private sector. Terms of trade The ratio of the index of export prices to the index of import prices. UN United Nations VAT Value-added tax: A consumption tax levied at each stage of production. WTO World Trade Organisation

2010/11 49 © Dun & Bradstreet Limited D&B Country Report Cyprus DB3a (Slight Risk)

Country Risk Indicator Definition & Report Guide

D&B’s Country Risk Indicator provides a comparative, cross-border assessment of the risk of doing business in a country. The indicator seeks to encapsulate the risk that country-wide factors pose to the predictability of export payments and investment returns over a time horizon of two years. The risk indicator comprises a composite index of four over-arching country risk categories:

Political risk Internal and external security situation, policy competency and consistency, and other such factors that determine whether a country fosters an enabling business environment.

In this report, analysis on the current factors affecting the political risk outlook of the country can be found in the Political Risk chapter; this is complemented by contextual information on the country’s political structures in the Political Environment chapter.

Macroeconomic risk The inflation rate, government balance, money supply growth and all such macroeconomic factors that determine whether a country is able to deliver sustainable economic growth and a commensurate expansion in business opportunities.

External economic risk The current account balance, capital flows, foreign exchange reserves, size of external debt and all such factors that determine whether a country can generate enough foreign exchange to meet its trade and foreign investment liabilities.

In this report, analysis on the current factors affecting the domestic and external economic risk outlook of the country can be found in the Economic Risk chapter; this is complemented by contextual information on the country’s economic structures in the Economic Environment chapter.

Commercial risk Sanctity of contract, judicial competence, regulatory transparency, degree of systemic corruption and other such factors that determine whether the business environment facilitates the conduct of commercial transactions.

In this report, analysis on the current factors affecting the commercial risk outlook in the country can be found in the Commercial Risk chapter; this is complemented by contextual information on the country’s commercial structures in the Commercial Environment chapter.

The risk indicator is divided into seven bands, ranging from DB1 to DB7. Each band is subdivided into quartiles (a-d), with an a designation representing slightly less risk than a b designation and so on. Only the DB7 indicator is not divided into quartiles. The individual DB risk indicators denote the following degrees of risk:

DB1 Lowest risk Lowest degree of uncertainty associated with expected returns, such as export payments and foreign debt and equity servicing.

DB2 Low risk Low degree of uncertainty associated with expected returns. However, country-wide factors may result in higher volatility of returns at a future date.

DB3 Slight risk Enough uncertainty over expected returns to warrant close monitoring of country risk. Customers should actively manage their risk exposures.

DB4 Moderate risk Significant uncertainty over expected returns. Risk-averse customers are advised to protect against potential losses.

DB5 High risk Considerable uncertainty associated with expected returns. Businesses are advised to limit their exposure and/or select high-return transactions only.

DB6 Very high risk Expected returns subject to large degree of volatility. A very high expected return is required to compensate for the additional risk or the cost of hedging such risk.

DB7 Highest risk Returns are almost impossible to predict with any accuracy. Business infrastructure has, in effect, broken down.

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