INTERNATIONAL rating agency Fitch yesterday assigned Cyprus’ upcoming 500 million-euro 10-year bond issue an expected long-term foreign currency ‘A+’ rating with a Positive Outlook.
Cyprus’ economic performance is expected to improve this year. GDP growth slowed to only two per cent in 2002-3 after tourist arrivals fell a cumulative 15 per cent following September 11 attacks and then the Iraq war.
Tourism, however, has picked up this year, with over 10 per cent arrivals growth in the first five months.
Although arrivals remain almost a fifth down on their 2001 peak, this year’s pick-up, combined with stronger EU growth, makes the official 3.5 per cent GDP growth forecast attainable.
This is despite a one per cent increase in short-term interest rates on the eve of EU accession on May 1. That seems to have successfully reversed short-term capital outflows in April that were prompted by heightened uncertainties in the run-up to the referendum on the Annan Plan for re-unifying the island and the abolition of remaining exchange controls on joining the EU.
Conditions in the foreign exchange market have now returned to normal, with the Cyprus pound trading on the strong side of its central rate against the euro. However, the last two years have witnessed a major fiscal blow-out – partly the result of the economic slowdown and attempts to improve it, but also due to an overly generous tax reform package and increased spending in the context of the 2003 elections.
Fiscal indiscipline is highlighted by the excessive number of supplementary budgets last year. The budget deficit rose to 6.3 per cent of GDP and public debt exceeds 70 per cent of GDP. As both exceed their Maastricht reference values, Cyprus risks having to delay its official objective of joining the euro area in 2007. The next few months are crucial if this objective is to be achieved.
Without corrective measures, the budget deficit would likely exceed seven per cent of GDP, notwithstanding the economic recovery. And although Cyprus’ Convergence Programme shows the deficit falling to 5.2 per cent of GDP this year, delayed enactment of this year’s slated measures threatens another overshoot, which would further dent Cyprus’s fiscal credibility.
Reducing the deficit below three per cent of GDP next year will be even more challenging. It remains to be seen whether the tough political decisions required to fulfil the Convergence Programme targets will be taken. If they are not, Cyprus could find itself faced having to choose between unpalatable tax increases, or delaying its accession to the euro area to 2008 or beyond. Such a delay would also run the risk of the euro entry timetable being complicated by any revived effort to reunify the island.
Cyprus’ long term foreign currency rating was placed on Positive Outlook last November, alongside that of seven other new EU members. This action recognised that all new EU members have undertaken to join the euro area, which should improve external creditworthiness.
Cyprus is an obvious candidate for early euro entry since its exchange rate has long been tied to the euro in an arrangement that shadows ERM II. In Cyprus’ case this should be a powerful incentive to restore the fiscal discipline needed to meet the Maastricht fiscal criteria. The decision to eschew supplementary budgets this year is encouraging. Fitch also understands that the authorities will soon start publishing monthly fiscal data, lack of which has hampered monitoring of fiscal outturns and compares unfavourably with Cyprus’ rating peer group.
In coming months, Fitch will monitor the progress of fiscal consolidation, including the political decisions needed to implement the Convergence Plan, and the implications for Cyprus’ euro entry timetable. A delay of a year would not necessarily have negative rating implications, provided public finances were moving in the right direction. However, serious fiscal overshooting would be a major cause for concern.
