Report from the Commission - Convergence Report 2007 on Cyprus  (prepared in accordance with Article 122(2) of the Treaty at the request of Cyprus)
Date: 2007-05-16
Institutions: European Commission
Subjects: Cyprus, Economic and Monetary Union, European Commission, convergence criteria, economic convergence, euro, report

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 16.5.2007 
COM(2007) 255 final 

REPORT FROM THE COMMISSION 

CONVERGENCE REPORT 2007 ON CYPRUS 

(prepared in accordance with Article 122(2) of the Treaty at the request of Cyprus) 

{SEC(2007) 623} 

EN 

   EN 

 
 
 
  
 
 
1. 

PURPOSE OF THE REPORT 

Article 122(2) of the Treaty requires the Commission  and the ECB to report to the 
Council  at  least  once  every  two  years,  or  at  the  request  of  a  Member  State  with  a 
derogation, on the progress made by the Member States in fulfilling their obligations 
regarding the achievement of economic and monetary union. 

This  report  has  been  prepared  in  response  to  the  request  of  Cyprus,  submitted  on 
13 February 2007. A more detailed assessment of the state of convergence in Cyprus 
is provided in a technical annex to this report (SEC(2007) 623). 

The content of the reports prepared by the Commission and the ECB is governed by 
Article  121(1)  of  the  Treaty.  This  Article  requires  the  reports  to  include  an 
examination of the compatibility of national legislation, including the statutes of its 
national central bank, and Articles 108 and 109 of the Treaty and the Statute of the 
ESCB  and  of  the  ECB  (ESCB  Statute).  The  reports  must  also  examine  whether  a 
high  degree  of  sustainable  convergence  has  been  achieved  in  the  Member  State 
concerned by reference to the fulfilment of the convergence criteria (price stability, 
government budgetary position, exchange rate stability, long-term interest rates), and 
by  taking  account  of  several  other  factors  mentioned  in  the  final  sub-paragraph  of 
Article  121(1).  The  four  convergence  criteria  are  developed  further  in  a  Protocol 
annexed to the Treaty (Protocol No 21 on the convergence criteria).  

This  report  only  examines  the  areas  in  which  the  Government  of  the  Republic  of 
Cyprus exercises effective control, as defined in Protocol No 10, annexed to the 2003 
Act  of  Accession,  as  has  been  done  in  all  other  relevant  procedures  (e.g.  EDP, 
Lisbon, participation in ERM II). 

The  examination  of  the  compatibility  of  national  legislation,  including  the  statutes 
of the national central banks, with Articles 108 and 109 of the Treaty and the ESCB 
Statute  requires  an  assessment  of  compliance  with  the  prohibition  of  monetary 
financing (Article 101 EC) and the prohibition of privileged access (Article 102 EC); 
consistency with ESCB's objectives (Article 105(1) EC); central bank independence 
(Article  108  EC);  and  integration  of  national  central  banks  into  the  ESCB  (several 
EC Treaty and ESCB Statute articles). 

The  price  stability  criterion  is  defined  in  the  first  indent  of  Article  121(1)  of  the 
Treaty:  “the  achievement  of  a  high  degree  of  price  stability  […]  will  be  apparent 
from a rate of inflation which is close to that of, at most, the three best performing 
Member States in terms of price stability”. 

Article  1  of  the  Protocol  on  the  convergence  criteria  further  stipulates  that  “the 
criterion  on  price  stability  […]  shall  mean  that  a  Member  State  has  a  price 
performance  that  is  sustainable  and  an  average  rate  of  inflation,  observed  over  a 
period  of  one  year  before  the  examination,  that  does  not  exceed  by  more  than  1.5 
percentage points that of, at most, the three best-performing Member States in terms 
of price stability. Inflation shall be measured by means of the consumer price index 
on a comparable basis, taking into account differences in national definitions”. The 
requirement of sustainability implies that the satisfactory inflation performance must 
essentially  be  attributable  to  the  behaviour  of  input  costs  and  other  factors 

EN 

2 

   EN 

 
influencing  price  developments  in  a  structural  manner,  rather  than  the  influence  of 
temporary  factors.  Therefore,  the  convergence  examination  includes  an  assessment 
of  the  factors  underlying  inflation  and  of  medium-term  prospects.  It  also  assesses 
whether the country is likely to meet the reference value in the months ahead1. 

The  inflation  reference  value  was  calculated  to  be  3.0%  in  March  20072  with 
Finland, Poland and Sweden as the three best-performing Member States. 

The Treaty refers to the exchange rate criterion in the third indent of Article 121 as 
“the observance of the normal fluctuation margins provided for by the exchange-rate 
mechanism  of  the  European  Monetary  System,  for  at  least  two  years,  without 
devaluing against the currency of any other Member State”. 

Article  3  of  the  Protocol  on  the  convergence  criteria  stipulates:  “The  criterion  on 
participation in the exchange rate mechanism of the European Monetary System (…) 
shall  mean  that  a  Member  State  has  respected  the  normal  fluctuation  margins 
provided  for  by  the  exchange-rate  mechanism  of  the  European  Monetary  System 
without  severe  tensions  for  at  least  the  last  two  years  before  the  examination.  In 
particular, the Member State shall not have devalued its currency’s bilateral central 
rate  against  any  other  Member  State’s  currency  on  its  own  initiative  for  the  same 
period”. 

The relevant two-year period for assessing exchange rate stability in this report is 27 
April 2005 to 26 April 2007. 

The  convergence  criterion  dealing  with  the  government  budgetary  position  is 
defined in the second indent of Article 121(1) of the Treaty as “the sustainability of 
the  government  financial  position:  this  will  be  apparent  from  having  achieved  a 
government  budgetary  position  without  a  deficit  that  is  excessive  as  determined  in 
accordance  with  Article  104(6)”.  Furthermore,  Article  2  of  the  Protocol  on  the 
convergence  criteria  states  that  this  criterion  means  that  “at  the  time  of  the 
examination the Member State is not the subject of a Council decision under Article 
104(6) of this Treaty that an excessive deficit exists”. 

The  fourth  indent  of  Article  121(1)  of  the  Treaty  requires  “the  durability  of 
convergence achieved by the Member State and of its participation in the exchange 
rate mechanism of the European Monetary System being reflected in the long-term 
interest  rate  levels”.  Article  4  of  the  Protocol  on  the  convergence  criteria  further 
stipulates that “the criterion on the convergence of interest rates (…) shall mean that, 
observed over a period of one year before the examination, a Member State has had 
an  average  nominal  long-term  interest  rate  that  does  not  exceed  by  more  than  2 
percentage points that of, at most, the three best-performing Member States in terms 
of  price  stability.  Interest  rates  shall  be  measured  on  the  basis  of  long-term 
government  bonds  or  comparable  securities,  taking  into  account  differences  in 
national definitions”. 

1 

2 

The forecast of the reference value is subject to significant uncertainties given that it is calculated on the 
basis of the inflation forecasts for the three Member States projected to have the lowest inflation in the 
forecast period, thereby increasing the possible margin of error.  
The cut-off date for the data used in this report is 26 April 2007. 

EN 

3 

   EN 

 
                                                 
The interest rate reference value was calculated to be 6.4% in March 2007. 

Article 121  of  the  Treaty  also  requires  an  examination  of  other  factors  relevant  to 
economic integration and convergence. These additional factors include financial and 
product  market integration, the development of the balance of payments on current 
account and the development of unit labour costs and other price indices. The latter 
are covered within the assessment of price stability. 

In  the  December  2006  Convergence  Report,  the  Commission  assessment  was  that 
Cyprus  fulfilled  three  of  the  convergence  criteria  (on  price  stability,  government 
budgetary  situation  and  long-term  interest  rates).  Pending  the  adoption  of  the  draft 
Law  amending  the  Central  Bank  of  Cyprus  Law  of  2002  and  2003,  legislation  in 
Cyprus,  in  particular  the  Central  Bank  of  Cyprus  law,  was  considered  not  fully 
compatible  with  Article  109  of  the  Treaty  and  the  ESCB  Statute  as  regards  central 
bank integration into the ESCB at the time of the adoption of the euro.  

2. 

LEGAL COMPATIBILITY 

All outstanding incompatibilities have been addressed in a Law amending the Central 
Bank of Cyprus Laws of 2002 and 2003 adopted by Parliament on 15 March 2007. 
The Law entered into force on the day of its adoption, though certain provisions will 
take  effect  on  the  date  of  the  introduction  of  the  euro  in  Cyprus.  In  particular,  the 
Law  has  repealed  or  amended  a  series  of  articles  so  as  to  take  account  of  the 
respective roles and competences assigned by the EC Treaty to the ECB, ESCB and 
EC  Council.  This  concerns  notably  provisions  on  monetary  policy,  on  monetary 
operations  and  instruments  of  the  ESCB,  on  the  conduct  of  foreign  exchange 
operations and on the issue of banknotes and coins. 

Legislation in Cyprus, in particular the Central Bank of Cyprus Law, is compatible 
with the requirements of the EC Treaty and the ESCB Statute. 

3. 

PRICE STABILITY 

Respect of the reference value 

inflation 

inflation 

in 
12-month  average 
the 
Cyprus  has  been  below 
reference value since August 2005. 
The  average 
in 
Cyprus  during  the  12  months  to 
March  2007  was  2.0%,  below  the 
reference  value  of  3.0%,  and  it  is 
likely 
the 
to 
the  months 
reference  value 
ahead3. 

remain  below 

rate 

in 

6

5

4

3

2

1

0

2004

Chart 1.  Cyprus: Inflation criterion since May 2004
 (percent, 12-month moving average)

Cyprus

Reference value

2005

2006
Sources:  Eurostat, Commission services' Spring 2007 Forecast

2007

3 

According  to  the  Commission  Spring  2007  Forecast,  12-month  average  inflation  in  Cyprus  will 
decrease to 1.3% in December 2007, while the reference value is forecast to stand at 2.8%. 

EN 

4 

   EN 

 
                                                 
Underlying factors and sustainability 

Cyprus has traditionally enjoyed relatively low, although at times volatile, inflation, 
reflecting  the  sensitivity  of  its  small  and  open  economy  to  external  price  shocks. 
HICP inflation was 2.6% on average in 1999-2006. However, inflation reached highs 
of around 6% in the spring of 2000 and again in the winter of 2003, in the first case 
largely owing to higher energy and food prices and in the latter case primarily due to 
accession-related increases in VAT rates and excise duties. Inflation increased in the 
first  half  of  2006,  but  declined  thereafter  to  1.4%  in  March  2007,  largely  as  a 
reflection of swings in energy and food prices.  

HICP  inflation  excluding  energy  and  unprocessed  food  has  been  contained, 
averaging  below  1%  since  2004.  Moderate  core  inflation  suggests  that  underlying 
inflationary  pressures  have  remained  limited,  against  the  background  of  a  negative 
output gap and moderate increases in unit labour costs (between 1 and 2% annually 
since  2004).  Wage  pressures  in  recent  years,  in  the  context  of  tightening  labour 
market, were mitigated by an increasing share of foreign workers in the labour force 
and  exemplary  wage  discipline  in  the  public  and  private  sectors.  The  effective 
exchange rate of the Cypriot pound was stable in 2005-2006, thus remaining neutral 
with respect to import prices. 

Inflation is expected to remain low in the coming months largely due to a favourable 
oil  price  base  effect,  lower  prices  of  clothing  and  footwear  and  the  reduction  of 
excises on cars. Inflation performance over the medium term will, to a large extent, 
depend on the development of energy and other import prices and on the containment 
of possible wage and demand pressures in a context of strong cyclical conditions and 
interest  rate  and  reserve  requirement  convergence.  Increases  in  VAT  rates  on 
foodstuff,  pharmaceuticals  and  restaurants  that  are  related  to  fulfilling  EU 
requirements,  as  the  current  derogations  expire  at  the  end  of  2007,  are  expected  to 
have a significant  (around one percentage point) impact on inflation. Although this 
impact is expected to be temporary, some second-round effects cannot be excluded, 
in particular via the inclusion of VAT increases in the cost of living index. 

Cyprus fulfils the criterion on price stability.  

4. 

GOVERNMENT BUDGETARY POSITION 

Cyprus  is  not  at  present  the  subject  of  a  Council  Decision  on  the  existence  of  an 
excessive deficit, the Decision on the existence of such deficit in Cyprus adopted by 
the  Council  on  5  July  20044  having  been  abrogated  by  the  Council  Decision  of  11 
July 20065.  

The  general  government  deficit  peaked  at  6.3%  of  GDP  in  2003,  but  was  reduced 
markedly  in  the  following  years,  to  1.5%  of  GDP  in  2006,  following  the 
implementation  of  a  strong  fiscal  adjustment  in  2004  and  2005.  For  2007,  the 
Commission  services'  Spring  2007  Forecast  projects  an  almost  unchanged  deficit 
(1.4% of GDP).  

4 
5 

Decision 2005/184/EC (OJ L 62, 9.3.2005, p. 19). 
Decision 2006/627/EC (OJ L 256, 20.9.2006, p. 13). 

EN 

5 

   EN 

 
                                                 
-2

-3

-4

-5

-6

80

70

60

Inverted s cale
-7

Chart 2 . Cyprus: Government budget balance and debt
(in percent of GDP)

In 
the 
its  Opinion  on 
December  2006  update  of 
the 
Convergence 
Programme of Cyprus, the 
that 
Council  considered 
after  the  correction  of  the 
excessive  deficit  in  2005, 
Cyprus  was  making  good 
the 
progress 
objective 
medium-term 
(MTO) 
the 
that 
and 
budgetary  strategy  in  the 
seemed 
programme 
sufficient to ensure that the MTO is achieved by 2008. At the same time, the Council 
invited Cyprus to 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 and to implement the fiscal consolidation path as 
foreseen in the programme. 

2005
Government balance (lhs)
Cyclically-adjusted balance (lhs)
Gross debt (rhs)

(*) Commission services' Spring 2007 Forecast

Sources : Eurostat and Commission services

towards 

2007(*)

2002

2001

2003

2006

2004

10

20

30

40

50

-1

0

0

During  the  seven  years  to  2006,  both  total  revenue  and  total  expenditure  ratios 
followed, on average, an upward trend. Total revenue increased, mainly owing to a 
mix of structural and one-off measures. The former included the alignment of VAT 
tax rates with the acquis in May 2004 and measures to discourage tax evasion, while 
the  one-off  measures  took  the  form  of  an  exceptional  dividend  on  past  profits  of 
semi-governmental  organisations  and  a  tax  amnesty.  Current  primary  expenditures 
increased, mainly owing to increases of wages and salaries and social transfers. From 
2005  onwards,  expenditure  growth  was  restricted  by  the  imposition  of  a  ceiling  on 
the nominal growth rates of current primary and capital expenditure.  

Government debt followed an upward trend between 2000 and 2004 but has been on 
a declining path since 2005. It decreased to 65.3% of GDP in 2006, and according to 
the  Commission  services’  Spring  2007  Forecast,  will  continue  to  decline  in  2007, 
reaching some 61.5% of GDP. 

Cyprus fulfils the criterion on the government budgetary position.  

5. 

EXCHANGE RATE STABILITY 

The Cyprus pound has participated 
in  ERM  II  since  2  May  2005,  i.e. 
for  24  months  at  the  time  of 
adoption  of  this  report.  Before 
ERM II entry, the Central Bank of 
Cyprus  had  been  operating  a 
unilateral  peg  vis-à-vis  the  euro, 
containing 
fluctuations  within 
relatively  narrow  margins.  During 
the  period  of  the  assessment  not 
covered  by  ERM  II  participation 
(27  April  –  1  May  2005),  the 

2.4

2.2
2.0

1.8
1.6

1.4

1.2
1.0

0.8
0.6

0.4
0.2

0.0
May-05

Chart 3.  CYP: Spread vs central rate
 (as percent, daily values)

Sep-05

Jan-06 May-06

Sep-06

Jan-07

Sources:  ECB, Commission services

EN 

6 

   EN 

 
pound  stayed  close  to  the  future  central  rate.  Since  ERM  II  entry,  the  pound  has 
consistently traded in the upper half of the fluctuation band, close to the central rate, 
and  it  has  not  experienced  severe  tensions.  Additional  indicators,  such  as 
developments in short-term interest rates and foreign exchange reserves, do not point 
to pressures on the exchange rate. 

Cyprus fulfils the exchange rate criterion. 

6. 

LONG-TERM INTEREST RATES 

7

Chart 4.  Cyprus: Long-term interest rate criterion
 (percent, 12-month moving averages)

6

5

The average long-term interest rate 
in  Cyprus  in  the  year  to  March 
2007  was  4.2%,  below 
the 
reference  value  of  6.4%.  Average 
long-term  interest  rates  in  Cyprus 
have  been  below  the  reference 
value since November 2005. Long-
term  interest  rates  in  Cyprus  have 
decreased  substantially  in  the  past 
few  years  as  have  spreads  to  the 
euro area. Low yield spreads vis-à-
vis  the  euro  area  indicate  that  the  residual  country  risk  priced  in  by  markets  is 
limited.  

Sources:  ECB, Eurostat, Commission services

Reference value

Cyprus

2005

2004

2006

3

4

Cyprus fulfils the criterion on the convergence of long-term interest rates.  

7. 

ADDITIONAL FACTORS 

Additional  factors  have  been  examined,  including  product  and  financial  market 
integration and balance of payments developments. The Cypriot economy is highly 
integrated with the EU. In particular, trade and FDI are increasing, and the Cypriot 
financial system is substantially inter-linked with the financial systems of the EU and 
other  countries  in  terms  of  branches  and  subsidiaries  of  foreign  banks  operating  in 
Cyprus. The Cypriot current account deficit has widened in recent years, from 3.2% 
of  GDP  in 2003  to 5.9%  of  GDP in 2006.  The deficit in the combined current and 
capital  account  increased  from  1.9  to  5.9%  of  GDP  in  this  period.  The  current 
account  deficit  reflects  large  disparities  in  net  trade  in  goods  and  services. 
Traditionally, substantial surpluses on services trade have not fully offset very large 
deficits in goods trade and negative income balances. On the financing side, net FDI 
inflows have covered a substantial share of the current account balance.  

* * * 

In  the  light  of  its  assessment  on  the  fulfilment  of  the  convergence  criteria,  the 
Commission  considers  that  Cyprus  has  achieved  a  high  degree  of  sustainable 
convergence. 

EN 

7 

   EN