Four More Years Of Negative Growth


BMI View: The break-up of Cyprus' second-biggest bank, the ensuing collapse of the country's large offshore financial services sector and fiscal austerity imposed on the government as a result of the EUR10bn bailout deal reached in late March , will prolong the island economy's economic contraction for another four years. We have aggressively lowered our economic growth forecasts for Cyprus, anticipating an increase in unemployment and a freezing up of fixed investment levels.

Macro Strategy

While the approval of a EUR10bn bailout package for Cyprus in late March means that a disorderly exit from the eurozone has been averted, the accompanying break-up of the country's second-largest lender Laiki Bank and the decimation of the offshore financial service sector will be game changing for the island economy's outlook. Moreover, the size of the aid deal means that Cyprus will likely require additional funds in the future, subjecting the economy to a prolonged period of tight fiscal policy and a continued retrenchment in overall domestic demand for several years to come. The long-term economic costs of the banking crisis and the bailout will be a lot more severe than has previously been factored into our baseline scenario, prompting major downward revisions to our forecasts of the individual expenditure components of GDP. Although we had already expected a second consecutive year of negative real GDP growth in 2013, we have revised our growth forecast from -1.4% to -9.0% and project another three years of economic contraction beyond 2013.

Troika Bailout A Game Changer
Cyprus - Real GDP by Expenditure Growth, Forecast Changes, %

Having previously suggested that Cyprus' economy would return to pre-crisis levels by 2016 in real terms ( see our online service, February 5, 'Meaningful Recovery Remains A Long Way Off' ) , we now no longer see the economy returning to its previous 2008 size (in constant prices) over the course of our 10-year forecast period . A lengthy structural adjustment process will see the unemployment rate head sharply higher this year and remain at elevated levels for years to come. Reaching 13.9 % in Q113 , we see seasonally adjusted unemployment heading to 14. 7 % by end-2013, but note that risks are firmly to the upside. This means that household spending will continue to decline in 2013 and beyond, while the likely sharper rise in youth unemployment will result in a steady outflow of a key cross- section of Cyprus' economically active population over the coming years, limiting the economy's ability to return to stronger growth over the course of this decade.

Heading Higher Still
Cyprus - Registered Unemployment Rate (Seasonally Adjusted), %

The one silver lining for the Cypriot economy over the coming decade will be developing and commercialising its vast offshore natural gas potential . Indeed, discovery of offshore gas reserves has even featured in government attempts to negotiate for more favourable bailout terms in March , despite failing to achieve the desired result ( see 'Banking (And Risking It All) On Gas' , March 21 ). Nevertheless, this could very well end up tying Cyprus' fiscal and banking sector fortunes closer to Russian interests in South Mediterranean hydrocarbon reserves over the coming decade, as state-run gas giant Gazprom has been keen to gain a foothold in the region's resources. This could potentially reduce the need to accept stringent conditionalities imposed by the Troika of the EU, ECB and the IMF , in the event that future financing deals will be arranged with Russia .

From Bad...
Cyprus - Expenditure Contribution To Real GDP Growth In 2012, pp

That said, Cyprus is still a very long way from commercialising its offshore gas reserves and finding the financing for a proposed liquefied natural gas (LNG) terminal. Moreover, the region's offshore reserves are becoming increasingly contested among key stakeholders, linking future monetisation of natural gas resources in the South Mediterranean closely to rising geopolitical tensions. We therefore do not believe that a prompt recovery beyond 2013 is likely. Indeed, we are now forecasting three additional years of negative real GDP growth from next year, with a return to positive growth not likely before 2017.

...To Worse
Cyprus - Expenditure Contribution To Real GDP Growth In 2013 (BMI Forecast), pp

Expenditure Breakdown

Private Consumption: In year-on-year (y-o-y) terms, final household expenditure has been contracting for the seventh consecutive quarter in Q412, according to data from Eurostat, suggesting that the Cypriot consumer has been in perpetual decline well before bailout negotiations started late last year. Contracting by 3.0% in real terms in 2012, we have aggressively revised down our 2013 growth forecast from -1.5% to -15.0%, implying a -10 percentage points (pp) contribution to headline growth this year ( see chart above).

Key Areas Of Employment To Suffer Layoffs
Cyprus - Employment by Sector, '000s

A breakdown of employment by economic activity reveals that while the construction sector has been suffering a sharp decline in employment numbers since 2008, other sectors have so far escaped unscathed based on the latest available data from Cyprus' statistical service for 2011. The largest employing sector is wholesale and retail trade, which stands to suffer in light of already falling household consumption levels, layoffs in other areas of the economy and likely wage cuts across the board. However, we also believe that the bailout terms - and the widely-expect ed need for additional financial rescues - will see public sector employment levels decline over the coming years.

Higher Education No Longer Offers Job Security
Cyprus - Unemployment By Level Of Education, % of Total

What is more, construction will continue to suffer in the current financial conditions, manufacturing will be subjected to a continued internal devaluation, while financial and insurance activities are set to be particularly hit hard by the country's banking sector crisis. The number of self-employed has been steadily on the rise in recent years, measuring 26,200 in 2011, but we do not expect this trend to continue. We further caution that the true number of people without work may not be accurately reflected in official unemployment data over the coming years, since an increasing number of people may stop looking for work or simply leave Cyprus to seek job opportunities elsewhere. Either way, we see sharply lower household consumption levels over the coming years, with real growth forecast to average -3.9% through to 2017.

Government Expenditure: We continue to see Cyprus posting a third straight year of negative government expenditure growth in 2013, but have lowered our full-year forecast from -4.0% previously to -8.7% in our latest forecast revision. This will see government expenditure shave 1.7pp off the headline GDP growth number this year. Despite indications that the emphasis on fiscal austerity may begin to ease up in the eurozone following Germany's general election in September ( see 'Much More External Rebalancing Still Needed', May 10), we do not believe that Cyprus' government will be given much leniency or additional funding to step up public consumption levels in the foreseeable future.

We forecast government expenditure to continue to decline in real terms over the next few years, expecting a 4.0% contraction in 2014 followed by a 0.2% real decline in public consumption levels. On average, therefore, the public sectors' annual contribution to headline growth over the five years to 2017 will be -0.5pp.

Fixed Investment: By far the biggest downgrade to our forecasts has occurred in the gross fixed capital formation category of GDP expenditure. We have revised our previous 2013 real fixed investment growth forecast from -8.0% to -30.0%. The rationale behind this substantial forecast downgrade is primarily based on the banking sector's state of distress and a depressed business sector, with sharply lower confidence levels likely to lead to business investment seizing up. What is more, the decimation of Cyprus' offshore financial sector means that overseas interest to register businesses on the island has stopped overnight, particularly with many non-resident depositors - mostly from Russia - still coming to terms with the enormous hair cut imposed on deposits above EUR100,000.

Banking Liabilities Eclipse Economic Output
Eurozone - Foreign Claims On Banks In 2012, % of GDP

The economic pain associated with the bailout and banking sector restructuring will be felt long after this year. We forecast real gross fixed capital formation growth to remain in negative territory until 2018, when we see the first year of positive growth since 2008 . Fixed investment started to contract in 2009 (-9.7%) and has continued to shrink in every year to 2012, when the full-year contraction came in just slightly bigger than we had estimated at -23.0% (we previously estimated a 22.0% contraction in 2012). Gross fixed investment will remain a sizeable drag on headline GDP growth over the forecast period, on average shaving 1.2pp off real GDP growth through to 2017.

The caveat to this view towards the longer term will be rising investment into Cyprus' offshore natural gas sector and the development of a floating LNG terminal. For the time being, however, we believe that the impact will be gradual at best and will take time to materialise since offshore hydrocarbon reserves in the South Mediterranean remain highly contested among neighbouring countries. What is more, financing to develop the gas reserves will need to be secured before the first investment occurs.

Net Exports: The only expenditure component of GDP that will continue to provide a positive contribution to real GDP growth over the next two years will be the balance of exports and imports of goods and services. This will primarily be the result of sharper contractions in imports than exports, reflecting the dire state of domestic demand in Cyprus. Having contracted 7.2% in 2012 (slightly less than the 9.0% contraction we had estimated), we now see imports of goods and services shrinking 17.0% in real terms this year. Although exports are also set to decline (by 3.0%) this year, the net export contribution to headline growth will be 6.7pp.

This positive contribution will be somewhat smaller in 2014, when the gap between the decline in imports and exports narrows. Imports will contract 7.0% next year, while exports will also continue to decline, but at a slightly slower pace of 1.8%. This means that net exports will add just 2.1pp to headline real GDP growth of -3.4% in 2014. Going forward, we see this trend reversing slightly, since somewhat higher domestic demand will generate stronger import flows, thus leading to a moderately negative net export contribution of 0.2pp and 0.3pp to headline growth in 2015 and 2016 respectively, before reaching 0.0pp in 2017.

CYPRUS - ECONOMIC ACTIVITY
2008 2009 2010 2011 2012 2013f 2014f 2015f 2016f 2017f
Notes: e BMI estimates. f BMI forecasts. Sources: 1 BMI/Eurostat; 2 World Bank/UN/BMI; 3 BMI/IMF; 4 UN Population Division.
Nominal GDP, EURbn 1 17.2 16.9 17.4 18.0 17.9 16.7 16.5 16.8 17.2 17.8
Nominal GDP, US$bn 1 25.2 23.6 23.1 25.0 22.7 22.2 21.0 20.6 20.6 21.3
Real GDP growth, % change y-o-y 1 3.6 -1.9 1.3 0.5 -2.4 -9.0 -3.4 -1.1 -0.1 1.1
GDP per capita, US$ 1 24,065 21,071 22,550 22,202 20,696 20,620 18,960 18,230 18,448 18,894
Population, mn 2 1.1 1.1 1.1 1.1 1.1e 1.1 1.2 1.2 1.2 1.2
Unemployment, % of labour force, eop 4 3.6 6.5 5.9 9.4 13.3 14.7 14.0 13.4 12.7 12.0

Risks To Outlook

Although the economic playing field in Cyprus has been levelled after the EUR10bn bailout in March, making accurate macroeconomic forecasting highly challenging, we believe that the risks are currently skewed to the upside, as we may be underestimating the near-term impact on real GDP growth from a collapse in imports of goods and services. In the near term, therefore, the contraction in real GDP growth may prove to be less severe than we are forecasting, since net exports could have a more positive contribution to growth, particularly if imports drop more than forecast, and exports benefit from stronger consumption levels in core eurozone economies such as Germany, as a result of economic rebalancing.

In the more medium-to-long term, we note that interest in Cyprus' offshore hydrocarbon reserves may rise faster than we are currently factoring into our forecasts, resulting in stronger fixed investment levels and higher output of natural gas. This could also bolster export volumes, while providing a welcome source of revenues for the government to step up expenditure levels.

This article is tagged to:
Sector: Country Risk
Geography: Cyprus, Cyprus