STABILITY PROGRAMME OF THE REPUBLIC OF CYPRUS 2009-2013 Ministry of Finance March, 2010 Republic of Cyprus: Stability Programme 2009-2013 STABILITY PROGRAMME OF THE REPUBLIC OF CYPRUS CONTENTS INTRODUCTION ..................................................................................................................... 3 1. OVERALL POLICY FRAMEWORK AND OBJECTIVES ................................................. 7 Fiscal Policy............................................................................................................................... 7 Monetary and Exchange Rate Policy ......................................................................................... 8 Structural Reforms ..................................................................................................................... 9 2. ECONOMIC OUTLOOK .................................................................................................... 11 World Economy in 2009 and prospects for 2010 ..................................................................... 11 Cyclical Developments and Current Prospects in Cyprus ....................................................... 13 Medium-term Scenario 2010-2013 ........................................................................................... 16 3. KEY ISSUES RELEVANT FOR POLICY ......................................................................... 22 Construction sector: evolution and outlook for the private residences segment of the market .22 Potential GDP Growth: How has it been affected by crisis? ................................................... 25 Potential GDP methodology and estimates for Cyprus ............................................................ 26 Competitiveness Challenges in the Medium Term ................................................................... 29 Structural Reform Challenges .................................................................................................. 34 4. GENERAL GOVERNMENT BALANCE AND DEBT 2009-2013 ................................... 38 Policy Strategy ......................................................................................................................... 38 Medium-Term Objective ........................................................................................................... 40 i Republic of Cyprus: Stability Programme 2009-2013 Nominal Fiscal Balance in 2009 .............................................................................................. 41 Features of the 2010 Budget .................................................................................................... 45 Fiscal Consolidation Plan ........................................................................................................ 48 Structural Balance and Fiscal Stance ...................................................................................... 52 Debt Management .................................................................................................................... 55 Balance by Sub-Sector of General Government ....................................................................... 59 Budgetary implications of “major structural reforms” ........................................................... 60 5. SENSITIVITY ANALYSIS OF THE GENERAL GOVERNMENT BALANCE AND DEBT ....................................................................................................................................... 61 Alternative Scenarios and Risks ............................................................................................... 61 Sensitivity of Budgetary Projections to Different Scenarios and Assumptions ........................ 62 Comparison with Previous Update .......................................................................................... 63 6. QUALITY OF PUBLIC FINANCES.................................................................................. 65 Policy Strategy ......................................................................................................................... 65 Policy Framework and Structural Reforms .............................................................................. 65 High priority areas ................................................................................................................... 67 Revenue Side ............................................................................................................................ 67 7. LONG-TERM SUSTAINABILITY OF PUBLIC FINANCES .......................................... 69 Ageing Working Group Report (Pre-reform scenario) ............................................................ 69 Adopted Reform Package – 1st April 2009 ............................................................................... 70 APPENDIX .............................................................................................................................. 74 ii Republic of Cyprus: Stability Programme 2009-2013 INTRODUCTION Two years after the adoption of the euro by Cyprus, and in the midst of the worse recession to hit the world economy since the 1930s, in accordance with the Council’s Regulation (EC) 1055/2005, Cyprus submits its Stability Programme (SP) for the period 2009-13. The SP has been prepared in line with the updated guidelines set out in the “Guidelines on the format and content of the Stability and Convergence Programmes (2005 Code of Conduct)”. The Stability Programme is the product of consultations with political parties and social partners. From these consultations it emerges that there is broad consensus to take measures to reduce the deficit in a sustainable manner. The Government of the Republic of Cyprus (“the Government”) will remain engaged in a continuous dialogue with political parties and social partners with the view to agree additional measures which are required, in order to safeguard the achievement of the targets set in the SP. With the adoption of the euro, the policy framework in Cyprus has changed fundamentally. Decision making on monetary policy has been transferred from the Central Bank of Cyprus to the European Central Bank (ECB). Monetary policy decisions made by the ECB are based on considerations about the euro area economy as a whole. At the same time, fiscal policy is guided by the Stability and Growth Pact, and by the national fiscal framework, which aims at safeguarding fiscal discipline, the quality of public finances and long-term fiscal sustainability. Undoubtedly, the biggest challenge facing policy makers at the current juncture is to address the economic slowdown, which has affected Cyprus considerably through falling external demand. The Government, in line with the European Economic Recovery Plan, has implemented several policy measures during the past 18 months, aimed at aiding the worst-affected segments of the economy. These measures have helped to partly offset the weak demand conditions and to minimise the negative repercussions of the downturn, particularly those in the labour market. Going forward, a key policy aim of the Government, especially against the background of the ensuing deep economic crisis, which is affecting the world economy, is to promote growth and to maintain and strengthen further social cohesion. In the first instance, policies aim at addressing the unemployment problem, which has particularly affected the tourism and construction sectors. Additionally, the Government aims at re-directing available resources in favour of growth-enhancing expenditure categories, improving physical infrastructure in various segments of the economy and social expenditures while, at the same time, safeguarding macroeconomic stability, reducing the fiscal deficit and stabilizing the debt level. 3 Republic of Cyprus: Stability Programme 2009-2013 Growth has decelerated in 2009, from very high levels the previous year. It is estimated that GDP has contracted in 2009 by about 1.7 % compared to the previous year, mainly owning to poor export performance, falling investment, particularly in construction and a significant negative stock adjustment. The SP envisages stabilisation in 2010 with a modest growth of some 0.5% compared with 2009. The slowdown, combined with a composition of growth which has been unfavourable to tax revenue, has resulted in a widening of the general government deficit to around 6% of GDP in 2009. It is clear now that the turnaround in revenues will not materialise in the short term, and consequently without any corrective measures the deficit would widen further in 2010. The aim is to prevent this unwarranted deterioration in public finances, and to bring about a timely consolidation, as required by the Treaty. The deterioration of the fiscal position is, mainly, attributed both to cyclical and structural factors, specifically falling revenues and to a lesser extent to higher expenditures related to the emergency support measures, and social transfers. Notwithstanding the challenging economic environment, which Cyprus is facing, the overriding aim of fiscal policy, as set out in this SP, is to stabilise the deficit in nominal terms as a percentage to GDP and reduce it by about ½ percentage point in structural terms in 2010 and to continue with the correction thereafter, bringing the fiscal deficit below 3% of GDP by 2013. At this juncture, all Member States, including Cyprus, face a difficult balancing act between continuing with the fiscal support measures which are needed to support the recovery,