Recommendation for a Council Recommendation with a view to bringing an end to the situation of an excessive government deficit in Cyprus
Date: 2010-06-15
Institutions: European Commission
Subjects: Cyprus, budget deficit, economic recession, public debt, public finance, stability pact

EN 

EN 

   EN 

 
EUROPEAN COMMISSION 

Brussels, 15.6.2010 
SEC(2010) 741 final 

Recommendation for a 

COUNCIL RECOMMENDATION  

with a view to bringing an end to the situation of an excessive government deficit in 
Cyprus 

EN 

   EN 

 
 
  
Recommendation for a 

COUNCIL RECOMMENDATION  

with a view to bringing an end to the situation of an excessive government deficit in 
Cyprus 

THE COUNCIL OF THE EUROPEAN UNION, 

Having  regard  to  the  Treaty  on  the  Functioning  of  the  European  Union,  and  in  particular 
Article 126(7) thereof; 

Having regard to the recommendation from the European Commission; 

Whereas: 

(1) 

(2) 

(3) 

(4) 

(5) 

According  to  Article  126  of  the  Treaty  Member  States  shall  avoid  excessive 
government deficits. 

The Stability and Growth Pact is based on the objective of sound government finances 
as a means of strengthening the conditions for price stability and for strong sustainable 
growth conducive to employment creation. 

The  2005  reform  of  the  Stability  and  Growth  Pact  sought  to  strengthen  its 
effectiveness and economic underpinnings as well as to safeguard the sustainability of 
the public finances in the long run. It aimed at ensuring that in particular the economic 
and budgetary background was taken into account fully in all steps in the EDP. In this 
way,  the  Stability  and  Growth  Pact  provides  the  framework  supporting  government 
policies  for  a  prompt  return  to  sound  budgetary  positions  taking  account  of  the 
economic situation. 

The Council has decided on [13 July 2010], in accordance with Article 126(6) of the 
Treaty, that an excessive deficit exists in Cyprus. 

In accordance  with Article  126(7)  of  the Treaty and Article 3 of Council  Regulation 
(EC) No 1467/97 on speeding up and clarifying the implementation of the excessive 
deficit procedure1 (which is part of the Stability and Growth Pact), the Council is also 
required  to  make  recommendations  to  the  Member  State  concerned  with  a  view  to 
bringing  the  situation  of  excessive  deficit  to  an  end  within  a  given  period.  The 
recommendation  has  to  establish  a  deadline  of  six  months  at  the  most  for  effective 
action to be taken by the Member State concerned to correct the excessive deficit as 
well  as  a  deadline  for  the  correction  of  the  excessive  deficit,  which  should  be 
there  are  special 
completed 
circumstances.  In  deciding  whether  special  circumstances  exist,  “relevant  factors”  as 
clarified in Article 2(3) of Regulation (EC) No 1467/97 should be taken into account. 

identification  unless 

the  year  following 

its 

in 

1 

OJ L 209, 2.8.1997, p. 6.  

EN 

2 

   EN 

                                                 
(6) 

(7) 

(8) 

Furthermore, in a recommendation to correct an excessive deficit the Council should 
request the achievement of a minimum annual improvement in the structural balance, 
i.e. the cyclically-adjusted balance excluding one-off and other temporary measures, of 
0.5% of GDP as a benchmark. 

Special circumstances, which are relevant for the greater flexibility in the application 
of  the  EDP  introduced  with  the  2005  reform  of  the  Stability  and  Growth  Pact,  are 
deemed to exist in the case of Cyprus. In 2009, for the first time in 35 years, economic 
activity contracted. The recession reflected a significant fall in domestic demand and 
an adverse external environment. In particular, high household indebtedness together 
with  tighter  lending  conditions,  a  worsening  labour  market  outlook  and  negative 
confidence  effects  led  to  a  decline  in  private  consumption.  In  parallel,  investment 
recorded a strong correction, amidst a fall in foreign demand for housing, low capacity 
utilisation  and  restructuring  of  corporate  balance  sheets.  Moreover,  exports  of  goods 
and  services,  especially  tourism,  plummeted  as  a  consequence  of  the  financial  crisis 
and the global slowdown, in particular the much lower growth prospects of the main 
trading  partners  (United  Kingdom,  Euro  Area,  Russia).  The  deficit  in  2009  is  a 
consequence of both the economic downturn and the stimulus measures taken in line 
with  the  EERP  by  the  Cypriot  authorities.  The  existence  of  special  circumstances 
authorises  the  Council  to  allow  the  correction  of  the  excessive  deficit  in  a  medium-
term framework. 

In the years prior to the crisis and in a context of good economic times, supported by 
an  asset  boom  and  buoyant  tax  receipts,  Cyprus  was  able  to  build  up  budgetary 
surpluses  and  reduced  its  gross  debt  ratio  to  48.4%  of  GDP  in  2008  (from  70.2%  in 
2004). In 2009, however, the economic crisis weighed heavily on public finances. As a 
result, the budget balance plunged from a surplus of 0.9% of GDP in 2008 to a deficit 
of  6.1%  of  GDP  in  2009.  This  was  also  the  result  of  a  number  of  discretionary 
measures in response to the economic downturn (in line with the EERP) and of rather 
large composition effects on account of a much less tax-rich GDP growth pattern. The 
deficit is projected to widen further to 6.2% of GDP in 2010 according to the March 
2010 EDP notification presented by the Ministry of Finance. However, the budgetary 
projections  of  the  Commission  services’  spring  2010  forecasts  indicate  that  the 
budgetary  deficit  would  reach  about  7%  of  GDP  in  2010.  Potential  extra-budgetary 
measures  still  under  discussion  with  uncertain  or  no  information  on  their  modalities 
and timing of implementation, were not incorporated.  

Considering  the  special  circumstances  and  the  EERP  framework,  an  average  annual 
fiscal  effort  is  recommended.  The  fiscal  effort  should  take  into  account  all  factors 
relevant for achieving the fiscal policy objectives, starting with the level of the general 
government  deficit  and  gross  debt  as  well  as  other  indicators,  such  as  the  current 
account  position,  the  level  of  contingent  liabilities  of  the  financial  sector,  interest 
payments,  risk  premia  and  the  expected  change  in  age-related  expenditure  in  the 
medium  term.  In  calculating  the  average  annual  fiscal  effort,  the  2011  deficit  in  the 
Commission  services'  spring  2010  forecast  is  taken  as  the  starting  point.  The  total 
fiscal effort needed to reach the nominal deficit target of 3% by the deadline is then 
calculated by assuming a gradual closure of the output gap by 2015. 

(9) 

Against  this background, it is  appropriate to consider  the correction of the excessive 
deficit  in  a  medium-term  framework  with  a  deadline  for  the  correction  of  2012.  In 
particular,  in  view  of  the  high  external  and  domestic  imbalances,  a  credible  and 

EN 

3 

   EN 

sustainable adjustment path would require Cypriot authorities to strengthen the fiscal 
strategy in 2010 with measures to control current expenditure, to reduce the deficit to 
below  6%  of  GDP  in  2010,  and  take  timely  action  to  define  an  expenditure-driven 
consolidation strategy. To this effect, the Cypriot authorities should ensure an average 
annual fiscal effort of 1¾% of GDP over the period 2010-2012; specify the measures 
that are necessary to achieve the correction of the excessive deficit by 2012, cyclical 
conditions  permitting,  and  accelerate  the  reduction  of  the  deficit  if  economic  or 
budgetary conditions turn out better than currently expected. In its stability programme 
submitted to the Commission and the Council on 1 April 2010, Cyprus committed to 
reduce its deficit to 4.5% of GDP in 2011 and 3.4% of GDP in 2012. Therefore, the 
additional  effort  requested  to  Cyprus  in  this  recommendation  compared  to  the  initial 
plan of the Cypriot authorities is considered to be doable and necessary. The budgetary 
consolidation should also contribute to bringing the government gross debt ratio back 
on  a  declining  path  that  approaches  the  reference  value  at  a  satisfactory  pace  by 
restoring an adequate level of the primary surplus. 

In the recent past, Cyprus' budgetary framework has been improved with the adoption 
of  the  Financial  Management  Accounting  System  (FIMAS).  As  from  2006,  Cyprus 
also enacted the gradual adoption of a three-year medium term budgetary framework 
(MTBF)  and  as  from  2007  it  introduced  a  Programme  and  Performance  Budgeting 
(PPB). Nevertheless, the new framework is still phasing in and is only foreseen to be 
fully  in  place  in  2012.  Therefore,  its  impact  could  become  effective  only  in  the 
medium-term.  The  new  framework's  timely  implementation  would  be  critical  for  a 
successful  and  lasting  consolidation  of  public  finances.  The  existing  practice  of 
adopting supplementary budgets during the course of the year has implied an increase 
in  current  expenditure  beyond  the  intended  reallocation  of  funds.  Once  the  new 
budgeting framework is fully implemented, it is expected to end this practise and lead 
to  a  more  effective  and  efficient  budgeting  process  and  contribute  to  containing 
expenditure  by  ministry  according  to  the  ceilings  set.  At  the  same  time,  the  new 
budgeting  process  would  set  a  sound  basis  for  reallocating  expenditure  in  favour  of 
growth enhancing activities. 

(10) 

(11)  The  long-term  budgetary  impact  of  ageing  is  significantly  above  the  EU  average, 
mainly  as  a  result  of  a  relatively  high  increase  in  pension  expenditure  as  a  share  of 
GDP over the coming decades partly due to the fact that the pension scheme is still in 
a  maturing  phase.  A  pension  reform  introduced  in  April  2009  would  slightly  reduce 
the  increase  in  pension  expenditure  and,  more  significantly,  raise  the  social  security 
contribution  rates.  The  reform  should  improve  the  long-term  balance  of  the  pension 
system  and  reduce  risks  to  sustainability,  however  without  having  an  effect  on  the 
overall assessment. The budgetary position in 2009 compounds the budgetary impact 
of population ageing on the sustainability gap. Improving the primary balance over the 
medium  term  and  implementing  further  measures  aimed  at  curbing  the  substantial 
increase  in  age-related  expenditure,  especially  pension  and  healthcare  expenditure, 
would  contribute to reducing the  risks to the sustainability  of public finances,  which 
were assessed in the Commission 2009 Sustainability Report2 as high. 

2 

In the Council conclusions from 10 November 2009 on sustainability of public finances "the Council 
calls on Member States to focus attention to sustainability-oriented strategies in their upcoming stability 
and convergence programmes" and further "invites the Commission, together with the Economic Policy 
Committee and the Economic and Financial Committee, to further develop methodologies for assessing 

EN 

4 

   EN 

                                                 
(12)  According  to  data  notified  by  the  Cypriot  authorities  in  April  2010,  general 
government  gross  debt  was  56.2%  of  GDP  in  2009.  This  increase  was  mainly  the 
result  of  the  significant  deterioration  in  the  primary  balance  and  debt-increasing 
"snowball" effects on the back of falling nominal GDP. Stock-flow adjustments also 
had a negative contribution to the debt level equivalent to about 1 percentage point of 
GDP, due to accumulation of government assets at the end of the year in order to meet 
debt  maturity  obligations  arising  early  in  January  of  2010,  as  well  as,  differences 
between cash and accruals. For 2010, Cyprus notified a planned debt of 62% of GDP, 
thus  exceeding  the  60%  of  GDP  Treaty  reference  value  (the  April  2010  stability 
programme  plans  a  slightly  lower  figure  (61%)  and  foresees  a  further  increase  to 
63.2%  of  GDP  in  2011).  In  view  of  the  downward  risks  to  the  macroeconomic 
scenario  and  the  budgetary  targets,  the  evolution  of  the  debt  ratio  may  be  less 
favourable than planned. The Commission services spring 2010 forecast projects debt 
to  rise  further  to  62.3%  of  GDP  in  2010  and  67.6%  in  2011,  on  the  back  of  a 
deteriorated primary balance. 

(13)  Enhanced  surveillance  under  the  EDP  will  require  regular  and  timely  monitoring  of 
the  progress  made  in  the  implementation  of  the  fiscal  consolidation  strategy.  In  this 
context,  a  separate  chapter  in  the  forthcoming  updates  of  the  Cypriot  stability 
programme could usefully be devoted to this issue. 

(14) 

In general, in the view of the Council, budgetary consolidation measures should secure 
a lasting improvement in the general government balance, while being geared towards 
enhancing the quality of the public finances and reinforcing the growth potential of the 
economy. 

HAS ADOPTED THIS RECOMMENDATION: 

(1) 

(2) 

Recognising  that  Cyprus’  budgetary  position  in  2009  resulted  from  measures 
amounting  to  about  1½%  of  GDP  in  2009,  which  is  an  adequate  response  to  the 
downturn  and  were  in  line  with  the  European  Economic  Recovery  Plan,  as  well  as 
from the free play of automatic stabilisers, Cyprus’ authorities should put an end to 
the present excessive deficit situation as rapidly as possible and at the latest by 2012. 

The  Cypriot  authorities  should  bring  the  general  government  deficit  below  3%  of 
GDP  in  a  credible  and  sustainable  manner  by  taking  action  in  a  medium-term 
framework. Specifically, to this end, the Cypriot authorities should:  

(a) 

(b) 

take  necessary  measures  to  reduce  the 2010 deficit to below 6% of  GDP and 
define  an  expenditure-driven  consolidation  strategy,  in  order  to  bring  the 
deficit below the reference value by 2012; 

to this end ensure an average annual fiscal effort of at least 1¾% of GDP over 
the period 2010-2012, which should also contribute to bringing the government 
gross debt ratio back on a declining path that approaches the reference value at 
a satisfactory pace by restoring an adequate level of the primary surplus;  

the  long-term  sustainability  of  public  finances  in  time  for  the  next  Sustainability  report",  which  is 
foreseen in 2012. 

EN 

5 

   EN 

                                                                                                                                                         
(c) 

specify  and  rigorously  implement  the  measures  that  are  necessary  to  achieve 
the correction of the excessive deficit by 2012, cyclical conditions permitting, 
and accelerate the reduction of the deficit if economic or budgetary conditions 
turn out better than currently expected.  

(3) 

(4) 

(5) 

(6) 

To limit risks to the adjustment, Cyprus should strengthen the binding nature of its 
medium-term budgetary framework as well as improve the monitoring of the budget 
execution throughout the year.  

Improve  the  long-term  sustainability  of  public  finances  by  implementing  reform 
measures  to  control  pension  and  health  care  expenditure  in  order  to  curb  the 
projected increase in age-related expenditure. 

In  addition,  the  Cypriot  authorities  should  seize  opportunities  beyond  the  fiscal 
effort, including from better economic conditions, to accelerate the reduction of the 
gross debt ratio back towards the reference value.  

The  Council  establishes  the  deadline  of  [13  January  2011]  for  the  Cypriot 
government to take effective action to specify the measures that will be necessary to 
progress towards the correction of the excessive deficit. The assessment of effective 
action  will  take  into  account  economic  developments  compared  to  the  economic 
outlook in the Commission services' spring 2010 forecast.  

The  Cypriot  authorities  should  report  on  progress  made  in  the  implementation  of  these 
recommendations  in  a  separate  chapter  in  the  forthcoming  updates  of  the  stability 
programmes until the abrogation of the excessive deficit procedure.  

In  addition,  the  Council  highlights  the  importance  of  achieving  the  medium-term  objective 
(MTO) for appropriate budgetary management of economic downturns. It therefore invites the 
Cypriot authorities to ensure that budgetary consolidation towards the medium-term objective 
for  the  budgetary  position  –  a  balanced  budget  in  structural  terms  –  is  sustained  after  the 
excessive  deficit  will  have  been  corrected.  The  adherence  to  the  budgetary  targets  and  the 
firm  containment  of  expenditure  over  the  medium-term  could  be  improved  by  the  full 
implementation, as envisaged, of an effective multi-annual budgetary framework.  

This recommendation is addressed to the Republic of Cyprus. 

Done at Brussels,  

For the Council 
The President 

EN 

6 

   EN