Council opinion of 4 March 2008 on the stability programme of Cyprus, 2007-2011
Date: 2008-03-04
Institutions: Council of the European Union
Subjects: Cyprus, budget estimate, economic forecasting, public finance, stability programme

C 73/10

EN

Official Journal of the European Union

19.3.2008

COUNCIL OPINION

of 4 March 2008

on the stability programme of Cyprus, 2007-2011

(2008/C 73/03)

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 particular
Article 5(2) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1)

(2)

On 4 March 2008, the Council examined the first stability programme of Cyprus, which covers the
period 2007 to 2011 (2).

Over the last ten years, Cyprus has been characterised by solid economic growth, albeit with fluctua-
tions in some years, which reflect exposure of the small open economy to external shocks.

Fiscal policy has not always taken advantage of favourable cyclical conditions to achieve budgetary
targets close-to-balance or in surplus, which would provide a safety margin to normal fluctuations,
and allow automatic stabilizers to operate fully in economic downturns. This highlights the need for
avoidance of pro-cyclical stance in good times. In the last four years the Cypriot authorities embarked
on a successful, mainly, revenue-based fiscal consolidation, which brought the general government
deficit from 6,5 % of GDP in 2003 to 1,2 % in 2006. On the back of a likely transitory tax-rich
composition of growth, which brought about exceptionally high government receipts, the budget
balance is currently estimated at a surplus of 1,5 % of GDP in 2007. Furthermore, debt declined
from a 69 % of GDP in 2003 down to about 60 % in 2007. The limited primary current expenditure
restraint and the likely transitory character of composition effects in the recent increase in tax
revenues, highlight the need for further improvements in expenditure control. This would help to
stabilise the economy in the new context of euro area membership. The reform of the pension
system and a timely implementation of the adopted reforms in health care would also contribute to
the control of primary spending, while underpinning the sustainability of public finances in the long
run.

(3)

The macroeconomic scenario underlying the programme envisages that real GDP growth will
moderate slightly from 4,2 % in 2007 to some 4 % on average over the rest of the programme
period. Assessed against currently available information (3), this scenario appears to be based on plau-
sible growth assumptions until 2009, while they appear to be slightly on the high side thereafter. The
programme's projections for inflation appear realistic but on the backdrop of the latest developments
in oil and food prices at international level, the balance of risks is somewhat tilted on the upside.

(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://ec.europa.eu/economy_finance/about/activities/sgp/main_en.htm

(2) The update was submitted 1 week beyond the 1 December deadline set in the code of conduct.
(3) The assessment takes into account notably the Commission services' autumn 2007 forecast and the Commission assess-

ment of the October implementation report of the national reform programme.

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C 73/11

(4)

(5)

(6)

(7)

For 2007, the stability programme estimates the general government surplus at 1,5 % of GDP, more
than 3 percentage points of GDP better than the target of a deficit of 1,6 % of GDP set in the last
update of the convergence programme. The marked turnaround in 2007 is attributed to exceptional
rise in total revenues, due to especially high tax receipts brought by the strong profitability of the
financial sector and the booming investment in real estate. Part of the increase in tax bases and in the
associated revenues does not appear to be permanent. The 2007 estimated outturn respects the invi-
tation in the Council opinion of 27 February 2007 on the last update of
the convergence
programme (1) to ‘implement the fiscal consolidation path as foreseen in the programme’.

In view of the better-than-expected 2007 outturn, the budgetary targets presented in the stability
programme are much improved compared to those in the last update of the convergence programme
against a broadly unchanged macroeconomic background. The stability programme puts forward a
more ambitious medium-term objective (MTO) of a balanced position in structural terms (i.e. in cycli-
cally-adjusted terms net of one-off and other temporary measures), compared to a structural deficit of
0,5 % of GDP previously. The budgetary strategy in the stability programme aims at maintaining this
new MTO, which has already been over-achieved in 2007, over the programme period. The general
government surplus is planned to decline to 0,7 % of GDP by 2011, from 1,5 % in 2007; in primary
terms, the drop is more pronounced, to 2,8 % of GDP in 2011 from 4,7 %. The narrowing of the
surplus mainly reflects a fall in the share of total revenues in GDP by 1,25 percentage points as total
expenditure is planned to decline by just 0,25 of a percentage point of GDP.

The latter mainly reflects important savings on interest expenditure as primary expenditure is set to
increase by 0,25 of a percentage point, as a containment of expenditure on compensation of
employees, subsidies and public investment is more than offset by increases in social payments and
other expenditure. The fall in total revenues is concentrated in 2008 (1,5 percentage points of GDP),
as half of the extraordinary increase of revenues in 2007, amounting to 1,5 % of GDP, is not expected
to continue in 2008. Government gross debt, estimated at 60 % of GDP in 2007, is projected to
decline by 11,5 percentage points of GDP in 2008 to 48,5 % of GDP. This is mainly due to a high
primary surplus and a large debt-decreasing stock-flow adjustment, resulting from a large decumula-
tion of financial assets associated with the sinking funds. Thereafter, debt-to-GDP ratio is projected to
decline further by 8 percentage points of GDP over the programme period to 40,5 % by 2011.

The budgetary outcomes in 2008 and 2009 could be better than projected in the programme but
worse thereafter. The programme assumes that only part of the better-than-expected revenues in
2007 is carried over to subsequent years. Although uncertain in the absence of more detailed data,
there seems to be scope for a higher degree of carryover, especially in 2008 and 2009. A negative
risk to revenues stems from the fact that the macroeconomic scenario embodies favourable projec-
tions for private consumption growth in the outer programme years. The reliance on expenditure ceil-
ings, which were introduced as recently as 2006, constitutes a further risk as their coverage is not
complete and in particular enforcement mechanisms are not fully specified.

In view of this risk assessment, the budgetary stance in the programme seems sufficient to maintain
the new MTO throughout the programme period, as envisaged in the programme. The 1,5 % of GDP
in revenues considered by the programme as temporary, although likely transitory in nature, does not
qualify as a one-off and it is not considered as such by the Commission services. Given the good
times, the structural surplus reduction by more than 1 percentage points of GDP in 2008, from
1,75 % of GDP the previous year, may imply a pro-cyclical fiscal stance, which would not be in line
with the Stability and Growth Pact. However, the consideration by the Government that the rise in
revenues in 2007 may be only partially permanent reflects a prudent budgetary approach, according
to which revenues from a particularly tax-intensive composition of growth should not trigger addi-
tional permanent expenditure. Although the planned deterioration of
the budgetary position
compared to 2007 reflects to a large extent an expected normalisation of tax revenues, there is a risk
that the stance in 2008 may turn out to be pro-cyclical, given the risks associated to the enforcement
of the expenditure ceilings.

(1) OJ C 71, 28.3.2007, p. 16.

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Official Journal of the European Union

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(8)

(9)

Cyprus appears to be at high risk with regard to the sustainability of public finances. The long-term
budgetary impact of ageing is among the highest in the EU,
influenced notably by a very large
increase in pension expenditure as a share of GDP. The budgetary position in 2007 as estimated in
the programme contributes to offsetting part of the projected considerable long-term budgetary
impact of an ageing population but it is not sufficient to cover it. Maintaining high primary surpluses
and adopting pension reform measures aimed at containing the significant increase in age-related
expenditures, as currently envisaged, would contribute to reducing risks to the sustainability of public
finances.

The stability programme is fully consistent with the October 2007 implementation report of the
national reform programme. In particular, the budgetary projections incorporate the budgetary cost
of the various projects and measures included in the national reform programme, for example to
foster a knowledge-based economy, to promote R&D, to enhance human capital development.

(10)

The budgetary strategy in the programme is broadly consistent with the country-specific broad
economic policy guidelines included in the integrated guidelines and the guidelines for euro area
Member States in the area of budgetary policies issued in the context of the Lisbon strategy.

(11) As regards the data requirements specified in the code of conduct for stability and convergence

programmes, the programme provides all required and most of the optional data (1).

The overall conclusion is that the budgetary strategy in the programme should be sufficient to maintain a
sound budgetary position and macroeconomic stability throughout
the period. The programme puts
forward a more ambitious MTO of a balanced position in structural terms (compared to a deficit of 0,5 %
of GDP previously), which has already been over-achieved in 2007. This is the result of an unexpected
increase in total revenues by over 3 percentage points of GDP, largely explained by composition effects asso-
ciated to the strong profitability of the financial sector and the buoyant investment in real estate, which are
projected by the programme to return to historical trends in the coming years. The budgetary targets, which
are significantly better than in the previous programme, could be overachieved in 2008 and 2009 given the
better 2007 base.

Thereafter, they could be worse given the favourable growth assumptions. Although the planned reduction
of the budgetary surplus compared to 2007 reflects to a large extent an expected normalisation of tax
revenues, there is a risk that the stance in 2008 may turn out to be pro-cyclical. The level of debt is
projected to decline significantly, especially in 2008. Given the projected increase in age-related spending,
the reform of the pension system and a timely implementation of adopted reforms in health care, would
have a positive effect on the long-term sustainability of public finances, which appears to be at high risk.

In view of the above assessment, Cyprus is invited to:

(i) avoid pro-cyclical fiscal policies by further improving the control of current expenditures, while using

revenue windfalls to further reduce debt;

(ii) contain public expenditure, notably by reforming the pension system and timely implementing the
adopted reforms in health care in order to improve the long-term sustainability of the public finances.

Comparison of key macroeconomic and budgetary projections

2006

2007

2008

2009

2010

2011

Real GDP
(% change)

SP Dec 2007

3,8

4,2

4,1

4,0

4,0

4,0

COM Nov 2007

3,8

3,8

3,9

3,9

n.a.

n.a.

CP Dec 2006

3,7

3,9

4,1

4,1

4,1

n.a.

(1) In particular, the capital account data for the years 2007-2011 in the table of sectoral balances are not provided, which

have the effect of making the assessment more difficult.

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C 73/13

2006

2007

2008

2009

2010

2011

HICP inflation
(%)

SP Dec 2007

COM Nov 2007

CP Dec 2006

2,2

2,2

2,4

2,2

2,0

2,5

2,5

2,3

2,4

2,0

2,1

2,0

2,0

n.a.

2,0

Output gap (1)
(% of potential GDP)

SP Dec 2007

– 1,0

– 0,7

– 0,6

– 0,6

– 0,4

COM Nov 2007 (2)

– 1,4

– 1,1

– 0,8

– 0,6

n.a.

CP Dec 2006

– 1,0

– 1,1

– 1,1

– 1,1

– 1,1

2,0

n.a.

n.a.

0,0

n.a.

n.a.

Net lending/borrowing
vis-à-vis the rest of the
world
(% of GDP)

General government
balance
(% of GDP)

Primary balance
(% of GDP)

Cyclically-adjusted
balance (1)
(% of GDP)

Structural balance (3)
(% of GDP)

Government gross debt
(% of GDP)

SP Dec 2007

– 5,9

– 6,6

– 6,5

– 6,3

– 5,9

– 5,6

COM Nov 2007

– 5,7

– 5,8

– 5,7

– 5,5

n.a.

CP Dec 2006

– 6,4

– 5,8

– 5,4

– 4,8

– 4,2

SP Dec 2007

– 1,2

1,5

0,5

0,5

COM Nov 2007

– 1,2

– 1,0

– 0,8

– 0,6

0,7

n.a.

– 1,9

– 1,6

– 0,7

– 0,4

– 0,1

CP Dec 2006

SP Dec 2007

COM Nov 2007

CP Dec 2006

SP Dec 2007

2,1

2,1

1,4

– 0,8

4,7

2,2

1,4

1,8

3,4

2,2

2,1

0,7

2,9

2,2

2,1

0,7

COM Nov 2007

– 0,7

– 0,6

– 0,5

– 0,4

CP Dec 2006

– 1,5

– 1,2

– 0,3

SP Dec 2007

– 0,8

0,3

0,7

0,0

0,7

COM Nov 2007

– 0,7

– 0,6

– 0,5

– 0,4

CP Dec 2006

SP Dec 2007

COM Nov 2007

CP Dec 2006

– 1,9

– 1,2

– 0,3

65,2

65,2

64,7

60,0

60,5

60,5

48,5

53,3

52,5

0,0

45,3

49,6

49,0

2,9

n.a.

2,2

0,8

n.a.

0,3

0,8

n.a.

0,3

43,8

n.a.

46,1

n.a.

n.a.

0,7

n.a.

n.a.

2,8

n.a.

n.a.

0,7

n.a.

n.a.

0,7

n.a.

n.a.

40,5

n.a.

n.a.

Notes:
(1) Output gaps and cyclically-adjusted balances from the programmes as recalculated by Commission services on the basis of the informa-

tion in the programmes.

(2) Based on estimated potential growth of 3,5 %, 3,5 %, 3,6 % and 3,7 % respectively in the period 2006-2009.
(3) Cyclically-adjusted balance excluding one-off and other temporary measures. There are no one-off and other temporary measures
according to the Commission services' autumn forecast. The stability programme considers revenues in 2007 amounting to 1,5 % of
GDP as one-offs. Although transitory in nature, this amount of revenues does not qualify as a one-off according to the Commission
services.

Sources:
Convergence programme (CP); Stability programme (SP); Commission services' autumn 2007 economic forecasts (COM); Commission services' calcula-
tions.