Council Opinion of  14 March 2006  on the updated convergence programme of Cyprus, 2005-2009
Date: 2006-03-14
Institutions: Council of the European Union
Subjects: Cyprus, budget estimate, economic forecasting, public finance, stability programme

C 82/36

EN

Official Journal of the European Union

5.4.2006

COUNCIL OPINION

of 14 March 2006

on the updated convergence programme of Cyprus, 2005-2009

(2006/C 82/09)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveil-
lance of budgetary positions and the surveillance and coordination of economic policies (1), and in particu-
lar Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

(3)

(4)

(5)

On 14 March 2006, the Council examined the updated convergence programme of Cyprus, which
covers the period 2005 to 2009.

Supported by robust productivity and employment growth, Cyprus' real GDP growth (3,5 %) was
among the highest in the EU over the last decade. Net borrowing vis-à-vis the rest of the world (the
external deficit) has expanded (4,8 % of GDP in 2004) due to a number of factors, including robust
domestic demand, competitiveness losses related to increased competition in some of Cyprus' main
export sectors, the appreciation of the Cyprus pound, as well as higher reinvested earnings. This was
largely matched by the borrowing needs of the public sector, which posted a deficit of 4,1 % of
GDP in 2004. HICP inflation remained below 3 % for most of the decade.

On 5 July 2004, the Council decided that Cyprus was in excessive deficit. According to the Council
recommendation under Article 104(7) of the same date, the excessive deficit had to be corrected by
2005. In its opinion of 8 March 2005 on the previous update of the convergence programme,
covering the period 2004-2008, the Council invited Cyprus to implement with vigour the measures
envisaged to bring the deficit below 3 % of GDP by 2005, ensure that the debt ratio started to
decline by then, and pursue pension and health reforms.

The current update estimates the 2005 deficit outcome at 2,5 % of GDP, compared with 2,75 % of
GDP in the Commission services' autumn 2005 forecast and just below 3 % in the previous update.
The difference with the update mainly reflects a 0,5 % of GDP better than expected interest expendi-
ture.

The new programme broadly follows the model structure and data provision requirements for stabi-
lity and convergence programmes specified in the new code of conduct (2). The update was
submitted 2 weeks beyond the 1 December deadline set in the code of conduct reflecting the autho-
rities' wish to incorporate the budgetary measures announced in the second week of December.

(1) OJ L 209, 2.8.1997, p. 1. Regulation as amended by Regulation (EC) No 1055/2005 (OJ L 174, 7.7.2005, p. 1). The

documents referred to in this text can be found at the following website:
http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

(2) The programme provides all compulsory and most of the optional data prescribed by the code of conduct. Optional
data on labour market developments (in particular, employment (hours worked) and labour productivity (hours
worked)) and on the contributions to potential GDP growth are missing.

5.4.2006

EN

Official Journal of the European Union

C 82/37

(6)

(7)

(8)

(9)

(10)

The macroeconomic scenario underlying the programme envisages real GDP growth just above 4 %
over the period 2005-2009. Assessed against currently available information, this scenario appears
to be based on plausible growth assumptions until 2007 and slightly favourable ones in 2008 and
2009. As a result, cyclical conditions, as measured by the output gap, might be more favourable
than implied by the programme's projections. The programme's projections for inflation appear
realistic.

Building on the deficit reduction to below 3 % of GDP in 2005, the update aims at further consoli-
dating public finances until 2009, when the deficit would approach 0,5 % of GDP. After reaching
0,75 % of GDP in 2005, the primary surplus is projected to rise gradually to 1,75 % of GDP in
2009. The narrowing of the deficit reflects a cut in the expenditure ratio by around 4 % of GDP that
is less than fully compensated by a decline in the revenue ratio (by 2 %). The adjustment is based on
structural cuts in current primary expenditure, savings on interest expenditure and a combination of
structural and one-off measures on the revenue side. The more gradual adjustment over 2006-2008
compared to the previous programme reflects slightly lower GDP growth.

Over the programme period, the structural balance (i.e. the cyclically-adjusted balance net of one-off
and other temporary measures) calculated according to the commonly agreed methodology is
planned to improve on average by more than 0,5 % of GDP per year, from a deficit of around 3 %
of GDP in 2005 to about 0,5 % in 2009. The lack of improvement in the structural balance in 2007
reflects the anticipated deterioration of Cyprus' net position vis-à-vis the EU budget, as temporary
compensating grants associated with accession to the EU are terminated in 2006. The programme
sets the medium-term objective (MTO) for the budgetary position at a structural deficit of 0,5 % of
GDP and aims to achieve this position by 2009. As this MTO is more demanding than the
minimum benchmark (estimated at a deficit of close to 2 % of GDP), its achievement should fulfil
the aim of providing a safety margin against the occurrence of an excessive deficit. The programme's
MTO is at an appropriate level as it lies within the range indicated for euro area and ERM II
Member States in the Stability and Growth Pact and the code of conduct and adequately reflects the
debt ratio and average potential output growth in the long term.

The risks to the budgetary projections in the programme appear broadly balanced. Given Cyprus'
strong specialisation in tourism, the risks for the macroeconomic scenario are mainly associated
with geopolitical developments in the region. Moreover, the macro outlook in 2008 and 2009 is
slightly optimistic and tax projections seem somewhat favourable. However, the Cypriot government
has so far over-achieved the budgetary targets and the update reiterates its commitment to adopt
additional measures if needed to achieve the projected adjustment.

Based on the estimated outturn for 2005 and taking account of the balance of risks to the budgetary
targets, the budgetary stance in the programme seems consistent with a correction of the excessive
deficit by 2005 as recommended by the Council. In addition, it seems to provide a sufficient safety
margin against breaching the 3 % of GDP deficit threshold with normal macroeconomic fluctuations
from 2008. Furthermore, it seems sufficient to ensure that the programme's MTO is almost reached
by 2009, as envisaged in the programme. In the years following the correction of the excessive
deficit, the pace of adjustment towards the programme's MTO implied by the programme is broadly
in line with the Stability and Growth Pact, which specifies that, for euro area and ERM II Member
States, the annual improvement in the structural balance should be 0,5 % of GDP as a benchmark
and that the adjustment should be higher in good economic times and could be lower in bad times.

(11)

The debt ratio is estimated to have reached 70,5 % of GDP in 2005, above the 60 % of GDP Treaty
reference value. The programme projects the debt ratio to decline to 53,5 % in 2009. The risks to
the projected evolution of the debt ratio appear to be broadly balanced. In view of this risk assess-
ment, the debt ratio seems to be sufficiently diminishing towards the reference value.

C 82/38

EN

Official Journal of the European Union

5.4.2006

(12) With regard to the sustainability of public finances, Cyprus appears to be at high risk on grounds of
the projected budgetary costs of ageing populations. Implementing rigorously the planned consolida-
tion of public finances over the medium term will alleviate the risks to long-term sustainability and,
as recognized in the programme, substantial pension and health care reform measures will also be
necessary to contain the projected high increase in age-related expenditure in the period up to 2050
and to reduce the risk to long-term sustainability.

(13)

(14)

The envisaged measures in the area of public finances are broadly consistent with the broad
economic policy guidelines included in the integrated guidelines for the period 2005-2008. In par-
ticular, Cyprus is on track to correct its excessive deficit by the deadline set by the Council and does
the necessary to achieve its MTO, while the debt ratio is on a declining path from 2005 onwards.

The National Reform Programme of Cyprus, submitted on 11 November 2005 in the context of the
renewed Lisbon strategy for growth and jobs, identifies the following challenges with significant
implications for public finances: (i) promoting R&D and innovation and facilitation of ICT diffusion;
(ii) upgrading of basic infrastructures; (iii) enhancing human capital development and (iv) social
cohesion. The budgetary implications of the actions outlined in the National Reform Programme are
reflected in the budgetary projections in the update of the convergence programme. The envisaged
measures in the area of public finances are consistent with the priorities foreseen in the National
Reform Programme. In particular, the update outlines measures to monitor and better control public
spending.

In view of the above assessment, the Council welcomes the structural adjustment planned over the
programme period after bringing the deficit below 3 % of GDP in 2005. In the light of the recommenda-
tions under Article 104(7), the Council invites Cyprus to:

(i) In line with the updated convergence programme, ensure through measures of a permanent nature
that budgetary consolidation towards the programme's medium-term objective is sustained after the
excessive deficit has been corrected;

(ii) Control public pension expenditure and implement further reforms in the areas of pensions and health

care in order to improve the long-term sustainability of the public finances.

Comparison of key macroeconomic and budgetary projections

Real GDP
(% change)

HICP inflation
(%)

2004

2005

2006

2007

2008

2009

CP December 2005

3,8

4,1

4,2

4,2

4,2

4,3

COM Nov 2005

3,8

3,9

4,0

4,2

n.a.

n.a.

CP December 2004

3,6

4,0

4,4

4,5

4,5

n.a.

CP December 2005

1,9

2,1

2,0

2,0

2,0

2,0

COM Nov 2005

1,9

2,3

2,1

2,1

n.a.

n.a.

CP December 2004

2,1

2,6

2,2

2,1

2,0

n.a.

Output gap
(% of potential GDP)

CP December 2005 (1)

– 1,3

– 0,8

– 0,3

0,1

0,0

0,1

COM Nov 2005 (5)

– 1,1

– 0,7

– 0,2

0,4

n.a.

n.a.

CP December 2004 (1)

– 1,5

– 1,1

– 0,6

0,0

+ 0,5

n.a.

5.4.2006

EN

Official Journal of the European Union

C 82/39

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance
(% of GDP)

Structural balance (2)
(% of GDP)

Government gross debt
(% of GDP)

2004

2005

2006

2007

2008

2009

CP December 2005

– 4,1

– 2,5

– 1,9

– 1,8

– 1,2

– 0,6

COM Nov 2005

– 4,1

– 2,8

– 2,8 (6)

– 2,4 (6)

n.a.

CP December 2004

– 4,8

– 2,9

– 1,7

– 1,5

– 0,9

CP December 2005

COM Nov 2005

CP December 2004

– 0,9

– 0,9

– 1,3

0,7

0,5

0,7

1,2

0,3

1,8

1,2

0,7

2,0

1,4

n.a.

2,5

n.a.

n.a.

1,7

n.a.

n.a.

CP December 2005 (1)

– 3,6

– 2,2

– 1,8

– 1,8

– 1,2

– 0,6

COM Nov 2005

– 3,9

– 2,5

– 2,7

– 2,6

n.a.

CP December 2004

– 4,3

– 2,7

– 1,7

– 1,5

– 0,9

n.a.

n.a.

CP December 2005 (3)

– 4,6

– 3,1

– 2,1

– 2,1

– 1,5

– 0,6

COM Nov 2005 (4)

– 4,9

– 3,1

– 2,7

– 2,6

CP December 2004

CP December 2005

COM Nov 2005

CP December 2004

n.a.

71,3

72,0

74,9

n.a.

70,5

70,4

71,9

n.a.

67,0

69,1

69,2

n.a.

64,0

67,4

65,7

n.a.

n.a.

56,9

n.a.

58,1

n.a.

n.a.

53,5

n.a.

n.a.

Notes:
(1) Commission services calculations on the basis of the information in the programme
(2) Cyclically-adjusted balance (as in the previous rows) excluding one-off and other temporary measures
(3) One-off and other temporary measures taken from the programme (one-off revenues of 1.0% of GDP in 2004, 0.9% of GDP in 2005,

and 0.3% of GDP in 2006-2008)

(4) One-off and other temporary measures taken from the Commission services' autumn 2005 forecast (1.0% of GDP in 2004 and 0.6%

of GDP in 2005)

(5) Based on estimated potential growth of 4.0%, 3.5%, 3.5% and 3.5% respectively in the period 2004-2007.
(6) The 2006 deficit projection was made under a no-policy change scenario, since the 2006 draft budget was not available at the cut-off

date of the Commission services autumn 2005 forecast, which also partially explains a higher deficit projection for 2007.

Source:
Convergence programme (CP); Commission services' autumn 2005 economic forecasts (COM); Commission services' calculations