Recommendation for a COUNCIL RECOMMENDATION with a view to bringing an end to the situation of an excessive government deficit in Cyprus
Date: 2013-05-07
Institutions: European Commission
Subjects: Cyprus, budget deficit, budgetary equilibrium, public debt, tax reform

EUROPEAN 
COMMISSION 

Brussels, 7.5.2013  
COM(2013) 284 final 

Recommendation for a 

COUNCIL RECOMMENDATION 

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

{SWD(2013) 176 final} 

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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  on  the  Functioning  of  the  European  Union 
(TFEU) 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. 

On 13 July 2010, the Council decided, in accordance with Article 126(6) TFEU that an 
excessive  deficit  existed  in  Cyprus1  and  issued  a  Recommendation  to  correct  the 
excessive  deficit  by  2012  at  the  latest,  in  accordance  with  Article  126(7)  TFEU  and 
Article 3 of Council Regulation (EC) No 1467/97 of 7 July 1997 on speeding up and 
clarifying the implementation of the excessive deficit procedure.  

On 27 January 2011, the Commission concluded in a Communication to the Council 
the  Council 
that  Cyprus  had 
recommendation of 13 July 2010 to bring its government deficit below the 3% of GDP 
reference  value  and  considered  that  no  additional  steps  under  the  excessive  deficit 
procedure were necessary. 

taken  effective  action 

in  compliance  with 

On  11  January  2012,  the  Commission  confirmed  in  a  second  Communication  to  the 
Council  that  Cyprus  had  taken  effective  action  in  compliance  with  the  Council 
recommendation of 13 July 2010 to bring its government deficit below the 3% of GDP 
reference  value  and  considered  that  no  additional  steps  under  the  excessive  deficit 
procedure were necessary. 

1 

OJ L 186, 20.07. 2012, p. 30. 

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(6) 

(7) 

(8) 

(9) 

According to Article 3(5) of Regulation (EC) No 1467/97, the Council may decide, on 
a  recommendation  from  the  Commission,  to  adopt  a  revised  recommendation  under 
Article  126(7)  TFEU,  if  effective  action  has  been  taken  and  unexpected  adverse 
economic  events  with  major  unfavourable  consequences  for  government  finances 
occured  after  the  adoption  of  the  initial  recommendation.  The  occurrence  of 
unexpected adverse economic events with major unfavourable budgetary effects shall 
be assessed against the economic forecast underlying the Council recommendation. 

In  accordance  with  Article  126(7)  of  the  TFEU  and  Article  3  of  Council  Regulation 
(EC)  No  1467/97,  the  Council  is  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 maximum deadline of 
six months for effective action to be taken by the Member State concerned to correct 
the excessive deficit. Furthermore, in a recommendation to correct an excessive deficit 
the Council should request the achievement of annual budgetary targets which, on the 
basis of the forecast underpinning the recommendation, are consistent with a minimum 
annual  improvement  in  the  structural  balance,  i.e.  the  cyclically-adjusted  balance 
excluding  one-off  and  other  temporary  measures,  of  at  least  0.5%  of  GDP  as  a 
benchmark. 

On  the  basis  of  an  in-depth  review  of  the  nature,  origin,  and  severity  of 
macroeconomic  developments  in  Cyprus,  the  Commission  concluded  in  May  2012 
that  Cyprus  was  experiencing  very  serious  imbalances,  in  particular  as  regards  the 
external  position,  public  finances,  and  the  financial  sector,  which  needed  to  be 
urgently  addressed.  The  situation  in  the  Cypriot  banking  sector  was  seen  to  threaten 
the  sustainability  of  the  country's  position.  On  the  external  side,  the  current  account 
balance  exhibited  sizeable  and  persistent  decifits,  linked  to  a  gradual  erosion  of 
price/cost competitiveness, while the international investment position was found to be 
a cause for concern. Moreover, the situation in the Cypriot banking sector was seen to 
threaten  the  sustainability  of  the  country's  position.  On  the  internal  side,  the  highly 
leveraged private sector, with the outstanding debt level of non-financial corporations 
and  very  high  household  indebtedness  were  a  source  of  concern.  In  addition, 
government finances have swung to annual deficits and widened even as the economy 
recovered from recession, with recent efforts to correct the excessive deficit found to 
possibly  not  be  sufficient.  The  public  debt  has  progressively  been  above  the  Treaty-
based threshold and was expected to increase sharply.  

On 10 July 2012, the Council addressed country-specific recommendations to Cyprus 
based,  inter  alia,  on  the  assessment  of  Cyprus's  national  reform  programme  and 
Cyprus's stability programme covering the period 2012-15. The first recommendation 
calls for the rigorous implementation of the budgetary strategy in 2013 and beyond. It 
also  calls  for  an  acceleration  of  the  phase-in  of  an  enforcable  multianuual  budgetary 
framework with a binding staturory basis and corrective mechanism. This framework 
should  be  reinforced  also  by  the  implementation  of  programme  and  performance 
budgeting.  Given  the  inefficiencies  in  the  tax  administration  and  the  tax  collection, 
measures improving tax compliance and combating tax evasion need to be adopted. 

(10) 

In  view  of  increasingly  severe  economic  and  financial  conditions,  the  Cypriot 
authorities  officially  requested  financial  assistance  under  the  terms  of  a  loan  by  the 
European  Financial  Stability  Facility  /  European  Stability  Mechanism  (ESM)  on  25 
June  2012,  as  well  as  from  the  International  Monetary  Fund  (IMF),  with  a  view  to 

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supporting  the  return  of  the  economy  to  sustainable  growth,  ensuring  a  properly-
functioning banking system and safeguarding financial stability in the European Union 
and  in  the  euro  area.  On  27  June  2012,  the  Eurogroup  invited  the  Commission,  in 
liaison  with  the  ECB,  the  Cypriot  authorities,  and  the  IMF  to  agree  on  a 
macroeconomic  adjustment  programme,  including  the  financing  needs,  and  to  take 
appropriate action to safeguard financial stability in the very challenging environment 
with a risk of spill-over effects from sovereign market turbulence. On 16 March and 
25  March  2013,  the  Eurogroup  reached  a  political  agreement  with  Cyprus  on  a 
financial  assistance  and  the  key  elements  of  a  programme.  On  12  April  2013,  the 
Eurogroup  considered  that  the  necessary  elements  of  the  macroeconomic  adjustment 
programme  were  in  place  to  launch  the  relevant  national  procedures  for  the  formal 
approval  of  the  ESM  financial  assistance  facility.  On  25  April  2013,  the  Council 
adopted  a  decision  under  Article  136  TFEU  containing  the  main  elements  of  the 
macroeconomic  adjustment  programme  to  be  implemented  by  Cyprus.  On  26  April 
2013, a Memorandum of Understanding consistent with the said decision was signed 
by the Cypriot authorities and the Commission, acting on behalf of the ESM. 

(11)  More than a decade of sustained and strong economic expansion in Cyprus came to an 
end  in  2009.  Economic  activity  fell  by  1¾%,  with  weak  domestic  demand  and  an 
adverse  external  environment  weighing  strongly  on  growth.  Economic  activity 
recovered in 2010 with real GDP growth of 1.1% and a growth of 1.5% was recorded 
in the first half of 2011. According to the Commission services’ 2010 Spring Forecast, 
which was underlying the Council recommendation under Article 126(7) TFEU of 13 
July  2010,  the  Cypriot  economy  was  expected  to  grow  by  1.3%  in  2011.  Despite  a 
very  good  tourist  season  in  2011,  the  recovery  suffered  a  setback  from  the  grave 
accident  in  July  2011  that  destroyed  the  Vasilico  electricity  producing  plant, 
accounting  for  half  of  total  generating  capacity.  Moreover,  the  unwinding  of  very 
serious  private  and  public  sector  imbalances  in  the  Cypriot  economy  resulted  in 
tightening  financial  and  fiscal  conditions,  which  compounded  the  negative  effect  on 
economic activity, caused a high degree of economic uncertainty and exacerbated the 
deterioration in labour market conditions. The continued weakness of the international 
environment  prevented  external  demand  from  offsetting  the  impact  on  domestic 
demand. As a result, 2011 annual economic growth turned out at 0.5%, close to one 
percentage  point  below  the  Commission  forecast  at  the  time  of  the  Council 
Recommendation. 2012 was beyond the forecast horizon at the time of the Commision 
forecast underlying the Council recommendation. However, under the hypothesis of a 
gradual closure of the negative output gap, higher growth than in 2011 was expected 
for  2012.  According  the  latest  Commission  services'  forecast,  real  GDP  growth  is 
expected to be -2.4% in 2012.  

(12)  The general government deficit reached 6.3% of GDP in 2011, increasing from 5.3% 
in  2010.  The  worsening  of  the  budget  balance  took  place  in  spite  of  the  fiscal 
consolidation  measures  in  the  2011  Budget  Law  and  three  sets  of  further  deficit-
reducing measures adopted over the course of 2011, which were insufficient to stem 
the  deterioration  of  public  finances.  The  abovementioned  series  of  economic  events, 
notably  the  unwinding  of  very  serious  private  and  public  sector  imbalances  in  the 
Cypriot  economy,  form  the  background  of  the  developments  in  public  finances, 
including  non-negligible  growth  composition  effects  and  higher  debt  financing  cost 
implied by loss of access to longer-term market financing. 

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(13)  According to the Commission services' most recent forecast, the general government 
deficit  is  projected  to  reach  6.3%  of  GDP  in  2012.  This  projected  deficit  outturn  is 
significantly worse than previous Commission services' forecasts, in particular due to a 
significant  shortfall  of  both  indirect  and  direct  tax  revenues  (mostly  due  to  VAT, 
corporate taxation and social contributions) and higher expenditures due to increasing 
the 
unemployment  and  higher-than-expected  early  retirement.  Compared 
Commission services' 2013 Winter Forecast, the 2012 deficit was adjusted upwards by 
around ½% of GDP due to an one-off expenditure relating to insurance costs from the 
explostion at the Vasilico electricity producting plant in July 2011, payable in a period 
of four years but booked fully in 2012, as well as the recording of a capital transfer for 
the capitalised interest payment on the recapitalisation bond for Cyprus Popular Bank. 

to 

(14)  According to the Commission services' most recent economic forecast, the structural 
deficit  was  5.7%  and  6.6%  of  GDP  in  2010  and  2011  respectively.  It  is  expected  to 
reach  6.6%  of  GDP  in  2012.  The  Commission  services'  forecast  underlying  the 
Council  Recommendation  in  July  2010  pointed  to  an  expected  average  potential 
growth  of  around  1%  over  the  adjustment  period.  Under  the  Commission  services' 
most recent economic forecast, the average potential output for the years 2011-2012 is 
now  considered  to  be  negative  (around  -0.5%)  and  is  estimated  to  remain  negative 
over  2013-2016.  Correcting  for  the  downward  revision  of  the  potential  output  since 
the  Council  Recommendation,  the  average  fiscal  effort  over  2011-2012  would  be 
around  0.5%.  However,  the  estimated  change  in  the  structural  balance  was  also 
severely affected  by  unexpected revenue shortfalls, due to lower-than-projected final 
domestic demand and lower imports, as well as the stronger deterioration in the labour 
market.  This  led  to  major  revenue  shortfalls,  notably  in  indirect  taxes.  Taking  these 
effects  into  account,  the  overall  adjusted  fiscal  effort  is  estimated  at  around  2.4%  of 
GDP on average, well above the required average annual fiscal effort over 2011-2012 
of  at  least  1½%  of  GDP  recommended  by  the  Council.  Cyprus  can  therefore  be 
considered to have taken effective action in line with the Council Recommendation. 

(15)  The  2012  Budget  Law  adopted  on  16  December  2011  incorporated  an  expenditure-
driven consolidation strategy consisting of mainly (i) contributions from public sector 
employees  to  their  pensions  combined  with  a  freeze  of  emoluments  in  the  broader 
public sector for two years (ii) inclusion of new public sector employees in the general 
pension scheme under the social security fund instead of in the more generous public 
sector  pension  scheme,  (iii)  a  better  targeting  of  social  transfers,  iv)  cuts  in  selected 
government expenditure categories, (v) a hike of the VAT rate from 15% to 17%, (vi) 
a temporary contribution on gross earnings of private sector employees and pensioners 
and  (vii)  an  increase  in  the  tax  rate  on  deemed  dividend  distribution.  The 
aforementioned  fiscal  projections  include  also  consolidation  measures  taken  by  the 
Cypriot authorities for the remaining part of 2012 after a provisional agreement with 
programme  partners  on  fiscal  policies  in  November  2012,  in  particular  a  scale 
reduction  in  emoluments  of  public  and  broader  public  sector  pensioners  and 
employees sector. In sum, Cyprus adopted consolidation measures in 2011-2012 with 
an estimated direct deficit-reducing impact of more than 5½% of GDP. This bottom-
up  assessment  of  the  fiscal  consolidation  measures  taken  in  the  years  2011-2012 
confirms the conclusion that effective action has been taken by Cyprus.  

(16)  Gross  public  debt  rose  to  71.1%  of  GDP  in  2011,  compared  to  67.6%  of  GDP 
projected  in  the  Commission  services'  2010  Spring  Forecast  underlying  the  Council 
recommendation  under  Article  126(7)  TFEU  of  13  July  2010.  Debt  developments 

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were mostly driven by the higher-than-expected deficit outcomes, lower-than-expected 
growth,  and  Cyprus's  difficulties  in  accessing  international  markets  to  cover  its 
financing  needs,  which  resulted  in  increases  in  the  borrowing  costs.  These  factors, 
together with the government's participation in the recapitalisation of one commercial 
bank in June 2012, led to an increase in the general government debt to about 85.8% 
of  GDP  in  2012.  In  the  next  years,  the  government  debt  will  inevitably  increase 
further, reflecting the weak growth and substantial fiscal financing needs. In 2013-14, 
the government debt will increase further upon receipt of the financial assistance. The 
debt-to-GDP ratio is forecast to peak at around 128% of GDP in 2015 before declining 
thereafter on the back of sustainable primary surpluses and the return to positive real 
GDP growth rates. 

(17)  Considering  all  these  factors  and  in  particular  the  substantial  deterioration  in  the 
budgetary  position  resulting  from  the  worse-than-expected  economic  downturn  and 
the weaker overall position of the economy than envisaged at the time of the original 
Council recommendation under Article 126(7) TFEU implies that a new deadline for 
correction  of  the  excessive  deficit  by  Cyprus  is  warranted.  Granting  four  additional 
years for the correction of the excessive deficit is necessary in view of the projected 
distance  to  the  3%  of  GDP  reference  value  at  end-2012  and  the  adverse  macro-
economic circumstances. 

(18)  Under  the  Commission  services'  most  recent  economic  forecast  for  nominal  GDP 
growth, the primary general government balance is projected to attain a deficit of 2.4 
% of GDP in 2013, a deficit of 4.3 % of GDP in 2014, a deficit of 2.1 % of GDP in 
2015 and a surplus of 1.2% of GDP in 2016, while the headline general government 
deficit is projected to reach 6.5% of GDP for 2013, 8.4% of GDP for 2014, 6.3% of 
GDP for 2015 and 2.9% of GDP in 2016. For monitoring purposes, and in view of the 
limited control of the Cypriot authorities over interest payments, the macroeconomic 
adjustment  programme  to  be  implemented  by  Cyprus  sets  primary  balance  fiscal 
targets. 

(19) 

In  order  to  ensure  a  sustainable  correction  of  the  excessive  deficit,  the  appropriate 
adjustment  path  shall  be  established  and  evaluated  on  the  basis  of  an  overall 
assessment  with  the  structural  balance  as  the  reference  and  with  a  minimum  annual 
improvement in the structural balance of at least 0.5 % of GDP as a benchmark. Fully-
specified consolidation measures of about 4¾% of GDP in 2013 are projected to result 
in an improvement in the structural fiscal balance of around 1.3% of GDP in 2013. For 
2014,  the  adopted  consolidation  measures  amount  to  around  1¾%  of  GDP  and  are 
estimated  to  improve  the  structural  balance  by  0.3%  of  GDP  in  2014while  the 
improvement of the structural balance is estimated at 0.7% of GDP in 2015 and 1.8% 
of GDP in 2016.  

(20)  The  adjustment  for  2013-16  contains  measures  to  reduce  the  growth  in  expenditure 
mainly on the public sector wage bill and social benefits, and to  increase revenue in 
partiuclar by increasing VAT rates, excise duties, tax rate on interest income, property 
and  corporate  taxation.  Fiscal  consolidation  should  be  maintained  over  the  medium 
term  by  containing  expenditure  growth,  improving  the  structure  of  taxation  and 
undertaking fiscal-structural measures. 

(21) 

In light of the substantial additional consolidation in 2013 and the adverse and highly 
uncertain  macroeconomic  conditions,  inter  alia  due  to  the  imposition  of  temporary 

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(22) 

capital  controls,  loss  of  confidence  and  financial  sector  instability,  an  ex-ante 
obligation  of  further  fiscal  consolidation  measures  for  2014  (additional  to  the 
measures  adopted  in  December  2012  with  effect  from  1  January  2014)  was  not 
considered  appropriate.  However,  an  obligation  of  the  Cypriot  authorities  to  stand 
ready to preserve the programme objectives by taking additonal measures in the event 
of  underperformance  of  revenues  or  higher  social  spending,  taking  into  account 
adverse macroeconomic effects, is laid down in the economic and financial adjustment 
programme.  

In 2014, the structural balance is estimated to improve by 0.3% of GDP on the basis of 
agreed fiscal consolidation measures that have remained unchanged compared to those 
that were laid down in the November 2012 draft MoU. The estimated structural effort 
in 2014 is therefore, based on the most recent Commission services' forecast, slightly 
below the minimum annual improvement in the structual balance of at least 0.5% of 
GDP  as  a  benchmark.  This  level  of  improvement  should  nevertheless  be  considered 
acceptable  in  the  current  exceptional  situation  of  highly  uncertain  macroeconomic 
conditions  with  significant  shifts  in  actual  and  estimated  potential  output,  structural 
balance estimates being more uncertain and subject to variation over time than under 
more  stable  macroeconomic  conditions.  The  Commission  services'  Winter  2013 
forecast  took  into  account  the  consolidation  measures  for  2014  and  indicated  an 
improvement in the structural balance from 2013 to 2014 of around 1.4% of GDP. The 
lower  improvement  of  the  structural  balance  in  2014  now  estimated  –  in  spite  of  an 
unchanged set of consolidation measures – can be explained by (i) the deterioration of 
the tax base of the 2013 revenue measures, which implies that some of these measures 
are projected to have a decreasing impact in 2014; (ii) the downward revision of the 
impact of some of the consolidation measures already taken for 2014 due to the worse 
macroeconomic  conditions  throughout  the  programme  period;  (iii)  a  projected 
reduction  of revenue collection  in  2014  of some tax measures, the revenue of which 
(e.g.  collection  of  income  taxation  and  VAT)  depends  on  economic  activity  of  2013 
and  (iv)  the  fact  that  the  standard  elasticity  used  to  determine  the  split  between  the 
cyclical  component  and  the  structural  balance  may  lead  to  underestimating  the  true 
underlying  fiscal  effort.  A  bottom-up  view  of  discretionary  consolidation  measures, 
item-by-item, is an important element of an assessment of the fiscal policy stance. It 
may,  in  particular  under  highly  uncertain  macroeconomic  conditions,  give  a  useful 
complementary  view  of  the  true  underlying  fiscal  effort.  The  amount  of  fiscal 
consolidation  measures  is  on  average  above  3%  of  GDP  for  the  years  2013-2014. 
Albeit  significant,  the  corresponding  improvement  in  the  structural  balance  is  only 
around ¾% of GDP on average.  

(23)  Monitoring  of  progress  on  implementation  of  Cyprus's  EDP  commitments  will  be 
carried out at regular intervals. In the event of underperformance of revenues or higher 
social  spending  needs,  Cyprus  should  stand  ready  to  take  additional  measures  to 
preserve the attainment of fiscal targets.  

(24)  Cyprus  fulfils  the  conditions  for  the  extension  of  the  deadline  for  correcting  the 
excessive general government deficit as laid out in Article 3(5) of Regulation (EC) No 
1467/97  on  speeding  up  and  clarifying  the  implementation  of  the  excessive  deficit 
procedure, 

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HAS ADOPTED THIS RECOMMENDATION: 

(1) 

(2) 

(3) 

(4) 

(5) 

Cyprus should put an end to the present excessive budget deficit situation by 2016. 

In  order  to  bring  the  headline  government  deficit  below  the  3%  of  GDP  reference 
value by 2016, Cyprus should achievethe headline general government deficit targets 
of 6.5% of GDP in 2013, 8.4% of GDP in 2014, 6.3% of GDP in 2015, and 2.9% of 
GDP in 2016. 

To  this  end,  Cyprus  should  rigorously  implement  the  2013  Budget  Law  and  the 
agreed additional consolidation measures, which should amount to at least EUR 351 
million  in  2013.  Cyprus  should  fully  implement  the  fiscal  measures  for  2014  that 
were  adopted  in  December  2012,  amounting  to  at  least  270  million  EUR  in  2014. 
Cyprus  should  monitor  the  budgetary  effect  of  consolidation  measures  taken  on  a 
monthly  basis  and  stand  ready  to  preserve  fiscal  targets  by  taking  additional 
measures  in  the  event  of  underperformance  of  revenues  or  higher  social  spending, 
taking into account macroeconomic circumstances. 

Cyprus  should  maintain  fiscal  consolidation  over  the  medium  term,  converging 
towards  its  medium-term  budgetary  objective  of  a  balanced  budget  in  structural 
terms,  by  containing  expenditure  growth,  improving  the  structure  of  taxation  and 
undertaking fiscal-structural measures.  

The Council establishes the deadline of 3 months for the Cypriot authorities to take 
effective action and, in accordance with Article 3(4a) of Council Regulation (EC) No 
1467/97, to report in detail the consolidation strategy that is envisaged to achieve the 
targets. 

Beyond  the  report  foreseen  in  recommendation  (5)  and  also  in  parallel  to  the  financial 
adjustment  programme,  Cyprus  should  report  on  progress  made  in  the  implementation  of 
these  recommendations  every  three  months  as  well  as  in  a  separate  chapter  in  the  stability 
programme, until full correction of the excessive deficit has taken place. 

This Recommendation is addressed to the Republic of Cyprus. 

Done at Brussels,  

For the Council 
The President 

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