COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the budgetary situation in Cyprus following the adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to bringing an end to the situation of an excessive government deficit Accompanying the document 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  
SWD(2013) 176 final 

COMMISSION STAFF WORKING DOCUMENT 

Analysis by the Commission services of the budgetary situation in Cyprus following the 
adoption of the Council Recommendation to Cyprus of 13 July 2010 with a view to 
bringing an end to the situation of an excessive government deficit 

Accompanying the document 

Recommendation for a  

COUNCIL RECOMMENDATION 

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

{COM(2013) 284 final} 

 
 
 
 
  
 
1. 

INTRODUCTION  

On 13 July 2010, the Council decided in accordance with Article 126(6) of the Treaty of the 
Functioning  of  the  European  Union  (TFEU)  that  an  excessive  deficit  existed  in  Cyprus  and 
issued  a  recommendation  to  Cyprus  in  accordance  with  Article  126(7)  of  the  TFEU  with  a 
view to bringing an end to the situation of an excessive government deficit by 20121. In its 
recommendations,  the  Council  established  in  line  with  Article  3(4)  of  Regulation  (EC) 
1467/97 a deadline of 13 January 2011 for effective action to be taken. 

Specifically,  the  Council  recommended  that  Cyprus  brings  the  general  government  deficit 
below  3%  of  GDP  by  2012  in  a  credible  and  sustainable  manner  by  taking  action  in  a 
medium-term  framework.  To  this  end,  Cyprus  was  recommended  to:  "(a)  take  necessary 
measures to reduce the 2010 deficit to at most 6% of GDP and define an expenditure-driven 
consolidation  strategy  in  order  to  bring  the  deficit  below  the  reference  value  by  2012;  (b) 
ensure  an  average  annual  fiscal  effort  of  at  least  1½%  of  GDP  in  2011-12,  also  in  order  to 
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; and (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 
expected at the time"2.  

On 27 January 2011, the Commission (following an assessment of action taken by Cyprus, in 
line  with  Art.  9(3)  of  Regulation  (EC)  No  1467/97)  concluded  that,  on  the  basis  of 
information  available  at  the  time,  Cyprus  had  taken  action  representing  adequate  progress 
towards the correction of the excessive deficit within the time limits set by the Council3. On 
11  January  2012,  the  Commission  confirmed  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 step in the excessive 
deficit procedure was therefore necessary. 

This  document  provides  an  assessment  of  whether  Cyprus  has  undertaken  effective  action 
towards the correction of its excessive general government deficit and considers the case for 
an  extension  of  the  time  necessary  for  a  sustainable  correction  of  the  excessive  deficit.  In 
particular,  the  document  examines  the  budgetary  developments  since  the  Commission 
Communications  to  the  Council  on  action  taken  as  of  27  January  2011  and  of  11  January 
2012.  

On  25  June  2012,  Cyprus  formally  presented  to  euro-area  Member  States  a  request  for 
external financial assistance from the EFSF/ESM to contain the risks to the Cypriot economy, 
notably  those  arising  from  the  banking  sector.  On  27  June  2012,  the  Eurogroup  invited  the 

1  OJ 115, 9.5.2008,  p. 99–102. All  EDP-related  documents  for  Cyprus  can be found  at  the following  website: 
http://ec.europa.eu/economy_finance/sgp/deficit/countries/cyprus_en.htm. 
2  Council  Recommendation  to  Cyprus  with  a  view  of  bringing  an  end  to  the  situation  of  an  excessive  deficit 
procedure, 11296/10, Council of the European Union.  
3 Communication from the Commission to the Council - Current state of the excessive deficit procedure in the 
Member  States  and  assessment  taken  by  Cyprus,  Finland,  Bulgaria  and  Denmark  in  response  to  the  Council 
Recommendation of 13 July 2010 with a view to bringing an end to the situation of excessive government deficit 
-  COM(2011) 22 final.  

2 

 
 
                                                 
European  Commission  (EC),  in  liaison  with  the  European  Central  Bank  (ECB),  the  Cypriot 
authorities  and  the  International  Monetary  Fund  (IMF)  to  agree  on  an  economic  adjustment 
programme,  including  the  financing  needs,  and  to  take  appropriate  action  to  safeguard 
financial stability, in light of the very challenging external environment and spill-over effects 
from sovereign market turbulence. On 23 November 2012, a provisional staff level agreement 
was  reached  with  Cyprus  on  the  policy  adjustments  and  conditionality  underpinning  an 
economic  adjustment  programme,  which  were  laid  down  in  a  draft  Memorandum  of 
Understanding  on  Specific  Economic  Policy  Conditionality  (MoU).  On  16  March  and  25 
March 2013, the Eurogroup reached a political agreement with Cyprus on the key elements of 
a  programme,  which  included  the  restructuring  and  substantial  downsizing  of  the  banking 
sector  and  the  reinforcement  of  efforts  on  fiscal  consolidation,  structural  reforms  and 
privatisation.  On  2  April  2013,  staff  level  agreement  on  the  updated  MoU  was  reached 
between  Cyprus  and  the  EC/ECB/IMF.  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. 

2. 

RECENT MACRO-ECONOMIC AND BUDGETARY DEVELOPMENTS 

More than a decade of sustained and strong economic expansion in Cyprus came to an end in 
2009. Economic activity in Cyprus 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%.  

The Cypriot  economy  grew by a  modest 0.5% in 2011,  0.8  p.p.  lower than  projected in the 
Commission  services'  2010  Spring  Forecast  underlying  the  Council  recommendation  of  13 
July  2010.  After  a  relatively  strong  first  half  year,  when  GDP  increased  by  1.5%  (yoy), 
economic  activity  was  seriously  affected  by  an  accident  in  July  2011,  which  destroyed  the 
Vasilico  power  station.  Significant  reductions  in  investment  and  private  consumption  were 
observed following the explosion.  

Table 1: Macroeconomic developments and outlook  

2011 

2012 

Outturn 

SF10 

0.5 

Real GDP (% change) 
Contributions  to  real  GDP 
growth (pps): 
Final domestic demand 
Changes in inventories 
Net exports 
Employment (% change) 
GDP deflator (% change) 
Output gap  
        (% of potential GDP) 
Potential output growth             0.3 

-2.2 
0.5 
2.2 
0.5 
2.7 

1.2 

1.3 

-2.4 

1.1 
0 
0.3 
-0.2 
1.1 

-6.1 
-0.8 
4.4 
-4.1 
2.0 

-1.6 

0.0 

0.7 

-1.3 

3 

2013 

2014 
2015 
Programme Forecast 
(forecasted data) 
1.1 

-3.9 

-8.7 

-13.7 
0 
5.0 
-6.5 
0.6 

-6.2 

-2.6 

-5.5 
0 
1.6 
-3.1 
1.1 

-7.6 

-2.5 

0.9 
0 
0.2 
1.1 
1.5 

-4.3 

-2.3 

2016 

1.9 

2.0 
0 
0 
1.3 
1.8 

-0.9 

-1.6 

 
 
 
 
  
  
  
 
  
  
  
  
  
                        (% change) 

Source:  Commission  services,  SF10:  Spring  Forecast  2010;  Programme  Forecast:  Commission 
services' most recent forecast underpinning the economic adjustment programme agreed in April 2013 

At the same time, over the course of 2011 developments in the financial sector and growing 
uncertainty  regarding  the  public  finances  position,  including  the  impact  of  financial  sector 
related  contingent  liabilities  started  having  a  negative  impact  on  consumer  and  corporate 
sector confidence and economic activity. These adverse developments relate to the unwinding 
of  very  serious  private  and  public  sector  imbalances  in  the  Cypriot  economy  as  well  as  the 
negative  spill-over  from  financial  and  economic  turmoil  in  neighbouring  economies.  The 
onset of the  deleveraging process was marked by tightening  financial conditions and  much-
needed  fiscal  consolidation  measures,  which  compounded  the  negative  effect  on  economic 
activity.  This,  together  with  a  high  degree  of  economic  uncertainty  and  the  deterioration  in 
labour  market  conditions,  took  its  toll  on  the  growth  of  domestic  demand  in  2011,  which 
registered -2.2% compared to the 1.1% projected in the Commission's 2010 Spring Forecast. 
Private consumption grew slightly (0.5%) and investment activity suffered a sharp decline (-
13.0%),  both  of  which  were  significantly  below  the  Commission's  2010  Spring  Forecast 
(1.9% for private consumption growth and -3.8% for GFCF). The continued weakness of the 
international  environment  prevented  external  demand  from  fully  offsetting  the  subdued 
domestic  demand  even  if  a  positive  contribution  to  growth  was  observed  as  a  result  of  two 
good consecutive tourist seasons and a reduction in imports in line with the fall of domestic 
demand.   

The  Commission  services'  forecast  which  underpins  the  agreed  economic  adjustment 
programme and thus incorporates the agreed MoU measures, and being also the most recent 
Commission  services'  forecast,  (hereafter  the  Programme  Forecast)  projects  a  worsening  of 
economic  activity  in  2012,  with  real  GDP  declining  by  2.4%.  Private  consumption  is 
forecasted to recede by 3.0%, while investment activity is expected to suffer a further sharp 
drop (-23.0%). Although 2012 was beyond the forecast horizon at the time of the Commission 
services' 2010 Spring Forecast underlying the Council recommendation, higher growth than in 
2011  was  expected  for  2012  at  that  time,  under  the  hypothesis  of  a  gradual  closure  of  the 
negative output gap. This was apparent in the Commission's services 2010 Autumn Forecast 
which projected GDP growth for 2012 at 2.2%, with positive private consumption growth of 
2.2% and only a small fall (-1.5%) in gross fixed capital formation. The main reasons for the 
significantly  worse  2012  outcome  than  earlier  expected  are  found  in  a  series  of  events  that 
affected the Cypriot economy adversely from the second half of 2011 onwards. These relate 
notably  to  the  unwinding  of  Cyprus'  unsustainable  economic  imbalances,  which  led  to  a 
widespread  loss  of  confidence  among  economic  agents  and  a  loss  of  access  to  long-term 
market  financing  for  both  the  sovereign  and  major  financial  institutions,  to  the  Cypriot 
economy's  exposure  to  Greece,  the  explosion  of  the  major  electricity  plant,  and  the 
implementation of much-needed fiscal consolidation measures.  

The Programme Forecast projects that the economy would suffer an important output loss in 
2013 and continue to contract in 2014 due to  a significant drop in private consumption and 
investments,  as  well  as  weak  export  volumes.  Developments  are  driven  by  the  immediate 
restructuring of the banking sector, temporary capital controls, the worsening labour market 
outlook  with  rising  unemployment  and  negative  real  wage  growth,  the  impact  of  fiscal 
consolidation and anaemic consumer and business confidence.  

Public debt developments  

4 

 
 
Public debt rose by almost 10 p.p. to 71.1% of GDP in 2011. Debt developments were mostly 
driven by higher stock-flow adjustments due to a bilateral loan granted from Russia in 2011 
and  the  government's  participation  in  the  recapitalisation  of  one  commercial  bank  in  June 
2012.  In  addition,  higher-than-expected  deficit  outcomes,  partly  arising  from  higher 
borrowing  costs  due  to  Cyprus'  difficulty  in  accessing  international  markets,  as  well  as  the 
slowdown in the nominal GDP (through the denominator effect) also increased the debt level. 
It is projected to reach 85.8% of GDP in 2012 based on the Programme Forecast. 

Table 2: Public debt developments 2009-2012   

2009 

2010 

2011 

2012 

58.5 
9.6 

3.6 
3.4 
2.6 
0.9 
0.0 
2.6 

61.3 
2.8 

3.0 
0.4 
2.3 
-0.8 
-1.1 
-0.6 

71.1 
9.7 

3.9 
0.4 
2.4 
-0.3 
-1.7 
5.4 

85.8 
14.7 

3.1 
3.6 
3.2 
1.8 
-1.4 
8.1 

Gross debt ratio (% of GDP) 
Changes in the ratio (pps) 
of which 

(1) Primary balance (pps) 
(2) Snowball effect (pps) 

Interest expenditure (pps) 
Growth effect (pps) 
Inflation effect (pps) 

(3) Stock flow adjustment (pps) 
 Source: Commission services 

3. 

EFFECTIVE ACTION  

3.1. Background information 

In 2010, the year of the Council recommendation, the general government deficit was reduced 
to  5.3%  of  GDP  from  6.1%  in  2009  due  to  discretionary  revenue  measures  (in  particular  a 
deemed  dividend  distribution  fee  of  15%  on  undistributed  corporate  profits,  a  rise  in  the 
excise  duties  imposed  on  petroleum  products  and  increased  contribution  rates  as  part  of  a 
pension reform) and one-off revenues (the transfer of higher-than-usual central bank profits). 
The  increase  in  revenues  was  partially  offset  by  higher  expenditures,  in  particular  rising 
expenditure on social benefits due to an increase in the unemployment rate and the enactment 
of discretionary social policy measures.  

With a view to ensuring a fiscal effort in line with the Council's recommendation, the Cypriot 
authorities  put  forward  in  autumn  2010  -  in  preparation  of  the  2011  Budget  Law  -  a  fiscal 
consolidation package aimed at containing the fiscal deficit at 4.5% of GDP in 2011. On the 
expenditure  side,  measures  included  cuts  in  the  government's  operating  expenditure  (i.e., 
reduction  in  intermediate  consumption)  and  restraint  in  public  investment  and  employment. 
On  the  revenue  side,  measures  included  a  phase-out  of  the  tax  relief  on  excise  duties  and 
VAT,  which  was  part  of  an  earlier  stimulus  package  of  2010.  The  2011  budget  also 
incorporated higher excise duties on petroleum products, foodstuff and pharmaceuticals.  

In the second half of 2011, the government adopted three further sets of fiscal measures. The 
first  set  of  measures  adopted  in  August  2011  included  additional  contributions  from  public 
sector employees to the Government Employees Pension Scheme, the inclusion of new public 
sector employees in the general pension scheme under the social security fund instead of the 
more  generous  public  sector  pension  scheme,  and  the  increase  of  the  withholding  tax  on 
interest accrued on deposits of credit institutions operating in Cyprus, excluding subsidiaries 
and branches operating outside of Cyprus, and branches in Cyprus of credit institutions and 

5 

 
 
  
 
 
 
 
Member  States  of  the  European  Union  and  of  branches  of  credit  institutions  from  third 
countries.  In  context  of  preparing  the  2012  Budget  Law,  an  additional  set  of  measures 
contained, inter alia, better targeting of social transfers, a hike in the VAT rate from 15% to 
17%,  a  temporary  reduction  in  the  public  sector  wage  bill  by  freezing  emoluments,  and  an 
increase of the tax rate on deemed dividend distribution from 17% to 20% for a period of two 
years.  On  the  day  of  adoption  of  the  2012  Budget  Law,  the  Parliament  voted  last-minute 
amendments comprising a cut of about 8% in selected government expenditure categories. 

In  November  2012,  in  context  of  the  provisional  staff-level  agreement  on  an  economic  and 
financial adjustment programme, Cyprus took steps to implement additional measures for the 
remainder  of  2012.  In  particular,  a  scaled  reduction  in  emoluments  of  public  and  broader 
public sector employees and pensioners was implemented for the remaining salary payments 
in  2012  (salary  payments  of  December  and  the  13th  salary),  while  general  government 
received a one-off additional dividend income collected from a semi-public organisation. 

3.2.  Earlier assessments of effective action  

On the basis of the 2011 draft budget available at that time, the Commission services' 2010 
Autumn  Forecast4  projected  a  deficit  of  5.7%  of  GDP  for  2011.  This  forecast  did  not 
incorporate the additional consolidation measures agreed by the Government and presented in 
context  of  the  2011  Budget  Law  since  the  measures  had  not  been  yet  adopted  by  the 
Parliament. The adoption of the consolidation package was taken into account subsequently. 
As a result, the Commission concluded on 27 January 2011 that Cyprus would ensure a fiscal 
effort of at least 1½% of GDP in 2011 and had taken effective action with a view to bringing 
an end to the situation of excessive deficit by 2012.  

The 2011 update of the Stability Programme (SP) presented a headline deficit target of 4.0% 
of  GDP  for  2011  on  the  basis  of  a  lower-than-expected  deficit  outturn  of  5.3%  of  GDP  in 
2010.  In  contrast  to  the  target  of  the  SP,  the  Commission  services'  2011  Autumn  Forecast 
estimated  the  budget  deficit  at  6.7%  of  GDP.  The  deviation  from  the  national  forecast  was 
mainly due to expected lower revenues (2¼% of GDP) and slightly higher expenditures (½% 
of  GDP).  Based  on  its  assessment  of  the  adopted  consolidation  measures,  and  taking  into 
account cyclical conditions, the Commission concluded on 11 January 2012 that Cyprus had 
taken  effective  action  to  correct  the  excessive  budget  deficit  in  a  timely  and  sustainable 
manner.  

3.3.   Current assessment of effective action  

The  assessment  of  effective  action  should  be  seen  as  the  result  of  the  comparison  of  the 
recommended  fiscal  effort  in  the  Council  recommendation,  the  apparent  fiscal  effort, 
measured  by  the  change  in  structural  balance,  and  the  adjusted  structural  effort.  The 
adjustment takes into account: (i) the impact of revisions in potential output growth compared 
to  that  underlying  the  growth  scenario  in  the  Council  recommendation  (alpha),  and  (ii)  the 
impact  on  revenue  of  revisions  of  the  tax  content  of  economic  activity  (composition  of 
economic  growth)  relative  to  what  was  assumed  at  the  time  of  the  recommendation  (beta). 
This  top-down  approach  is  complemented  by  a  careful  analysis,  including  a  bottom-up 
assessment of consolidation measures undertaken by Cyprus.  

4 The Commission services’ 2010 Autumn Forecast was published on 29 November 2010. The data cut-off date 
was 15 November 2010. 

6 

 
 
 
                                                 
According to the Programme Forecast, which incorporates the policy measures agreed in the 
MoU, the structural deficit was 5.7% of GDP in 2010, 6.6% of GDP in 2011 and is projected 
at 6.7% of GDP in 2012.  

At  the  time  of  the  Council  Recommendation,  a  steady  economic  recovery  was  expected  to 
materialise  over  the  adjustment  period.  After  a  projected  fall  in  GDP  in  2010,  real  GDP 
growth in 2011 was projected at 1.3% and was seen to strengthen thereafter (see section 2). In 
terms  of  actual  outturn,  real  GDP  growth  however  weakened  year-by-year  over  2010-2012 
and fell significantly short of projected in both 2011 and 2012 (Table 4). This was mainly due 
to  less  resilient  domestic  demand  than  expected,  in  particular  weaker  private  consumption 
growth and a larger contraction of investment activity. For 2011, the shortfall in growth was 
marked  by  the  loss  in  output  after  the  destruction  of  the  Vasilico  power  plant.  The 
Commission services' 2011 Spring Forecast projected growth of 1.5% for 2011 compared to 
the  Commission  services'  2011  Autumn  Forecast  of  0.3%,  which  took  into  account  the 
disruption of economic activity. For 2012, the more pronounced and protracted recession than 
expected  in  the  Commissions'  services  successive  forecasts  was  caused  in  particular  by  an 
abrupt  drop  in  domestic  demand  and  investment  activity,  and  a  deterioration  in  the  labour 
market, which had a negative impact on disposable income and private consumption.  

The  fall  in  investment  and  worse  labour  market  developments,  depicted  in  successive 
Commission services' forecasts from the time of the Council Recommendation in July 2010, 
also find evidence in the considerable downward revisions in the estimate of Cyprus' potential 
growth (Table 3). At the time of the Council Recommendation, 2011 potential output growth 
was  estimated  at  around  0.7%  compared  to  the  current  estimate  of  0.3%  in  the  Programme 
Forecast. Actual growth for 2011 turned out well below what was originally projected in the 
forecast underpinning the EDP recommendation. Together with revisions to potential growth 
in preceding years this has resulted in the estimated output gap to now be considered positive, 
while  it  was  estimated  to  be  largely  negative  at  the  time  of  the  Council  Recommendation. 
However, despite the significant revisions in the level of output gap, the year-on-year change 
in the output gap in 2011 has only been slightly revised.  

For 2012, the Commission services' Autumn 2010 forecast estimated potential output growth 
to  be  in  the  order  of  1%  compared  to  the  current  estimate  of  -1.3%  in  the  Programme 
Forecast. The significant revisions of the estimates of the potential growth underlie also the 
large changes in the estimates of the output gap in 2012, which from being largely negative 
have progressively being projected as more positive. This is the case also for recent forecasts, 
where the projection of actual growth has been stable, while the estimate of potential growth 
has changed. The year-on-year change in the output gap has also been significantly revised in 
the direction of depicting worsening cyclical conditions. 

Table 3: Comparison of potential growth estimates for 2011 and 2012 

7 

 
 
SF 2010

AF 2010

SF 2011

AF 2011

SF 2012

AF 2012 WF 2013

SF 2013

Potential Growth 
(annual %  change)

Actual Growth
 (annual %  change)

Output gap
(%  of potential output)

2011

2012

2011

2012

2011

2012

0.7

1.5

1.3

n.a.

-1.6

n.a.

1.1

1.1

1.5

2.2

-1.8

-0.7

1.3

1.4

1.5

2.4

-1.5

-0.5

0.9

1.1

0.3

0.0

-1.0

-2.1

0.3

0.4

0.5

-0.8

-0.6

-1.9

0.8

-0.7

0.5

-2.3

-0.4

-2.0

0.8

-0.7

0.5

-2.3

0.4

-1.3

0.3

-1.3

0.5

-2.4

1.2

0.0

Swings  in  potential  growth  estimates  are  quite  strong  in  the  case  of  Cyprus,  related  to  the 
revisions  to  actual  growth  and  real  economy  variables.  This  is  seen  by  variation  over 
successive  forecasts  in  the  contributions  to  potential  growth  stemming  from  total  labour, 
capital  accumulation,  and  productivity  (TFP).  Revisions  to  the  contributions  concern  both 
their  share  in  potential  growth  and  in  some  cases  the  sign  of  the  contribution  to  potential 
growth  (i.e.  positive  or  negative)  for  2011-2012.  Correcting  the  apparent  change  in  the 
structural balance for the impact of revisions in potential output growth ('alpha') compared to 
that underlying the growth scenario in the Council recommendation of July 2010, the average 
annual change in the structural balance over the period 2011-2012 would be around 0.5% of 
GDP.  

Table 4: Comparison of budgetary adjustment  

2010 

2011 

2012 

outturn 

COM 
2010 SF 

outturn 

% of 
GDP 
40.9 

% of 
GDP 
41.2 

% of 
GDP 
39.7 

COM 
2010 
SF 
% of 
GDP 
41.3 

15.4 

15.0 

14.5 

15.2 

11.1 
8.9 
5.5 
46.2 

11.2 
9.6 
5.4 
48.3 

11.7 
8.7 
4.8 
46.0 

11.2 
9.6 
5.3 
49.0 

Programme 
Forecast     

% of GDP 

40.0 

14.8 

11.1 
9.1 
5.0 
46.3 

COM 
2010 
AF 
% of 
GDP 
40.5 

15.8 

10.8 
8.8 
5.0 
46.2 

43.9 

45.6 

43.6 

46.1 

43.1 

43.7 

15.8 
5.6 
14.4 
0.4 
3.8 
3.9 
2.2 

15.9 
5.8 
15.2 
0.4 
4.1 
4.2 
2.7 

16.0 
5.3 
14.6 
0.5 
3.5 
3.7 
2.4 

16.0 
5.8 
15.7 
0.4 
4.1 
4.1 
2.9 

15.8 
5.1 
15.1 
0.5 
2.7 
3.9 
3.2 

16.1 
5.0 
15 
0.4 
3.7 
3.6 
2.4 

Revenue 
of which: 
- Taxes on production and 
imports 
- Current taxes on income, 
wealth, etc. 
- Social contributions 
- Other (residual) 
Expenditure 
of which: 
- Primary expenditure 
      of which: 
     - Compensation of employees 
     - Intermediate consumption 
     - Social payments 
     - Subsidies 
     - Gross fixed capital formation 
     - Other (residual) 
- Interest expenditure 

General government balance 

-5.3 

-7.1 

-6.3 

-7.7 

-6.3 

-5.7 

8 

 
 
 
 
  
 
 
 
  
  
 
  
  
  
  
  
  
  
  
  
  
  
 
  
  
 
  
 
  
 
(GGB) 

Primary balance 
One-off and other temporary 
measures 
Cyclically-adjusted balance 
Structural balance 
Change in structural balance 
Corrected change in structural 
balance due to revision of 
potential output growth 
('alpha') 

Real GDP growth 

GDP deflator 

Nominal GDP 

-3.0 

0.0 
-5.7 
-5.7 
0.8 

1.3 

1.9 

3.3 

-4.4 

0.0 
-6.3 
-6.3 
0.0 

-0.4 

2.1 

1.5 

-3.9 

-4.8 

-0.2 
-6.8 
-6.6 
-0.9 

0.1 

0.5 

2.7 

3.3 

0.0 
-7.1 
-7.1 
-0.8 

1.3 

2.4 

3.6 

-3.1 

0.4 
-6.3 
-6.7 

-0.1 

0.5 

-2.4 

2.0 

-0.5 

-3.3 

0 
-5.4 
-5.4 
-0.4 

2.2 

2.5 

4.8 

Source: COM 2010 SF: Commission Services' 2010 Spring Forecast; Programme Forecast; COM 
2010 AF: Commission Services' 2010 Autumn Forecast, which was the first forecast to include 
projections for 2012. 

9 

 
 
 
 
 
 
 
Table 5: Change in the structural balance corrected for revisions in potential output gap 
and revenue windfalls/shortfalls  

Uncorrected fiscal 
effort (ΔS) 

Fiscal effort corrected for 
α and β (ΔS*) 

Required fiscal effort in the 
latest 2010 Council 
recommendation (R) 

Deadline 
for 
correction 

2011 

2012 

2011 

-0.9 

-0.1 

 2.2 

2012 

2.4 

2011 – 2012 

1½ 

2012 

Source: Commission services 

The less tax-rich growth composition in 2011 and 2012, marked by lower-than-projected final 
domestic demand and lower imports, and the stronger deterioration in the labour market also 
led to major revenue shortfalls, notably in indirect taxes. For 2011, the difference between the 
projected revenue ratio underpinning the Council Recommendation and the actual outcome is 
around  1.5  p.p.  of  GDP.  This  was  in  particular  due  to:  (i)  the  loss  in  output  after  the 
destruction  of  the  Vasilico  power  plant;  (ii)  growth  composition  effects  leading  to  lower 
revenue collection, e.g. due to lower activity in the construction sector and lower collection of 
revenues from income taxation and social contributions due to the reduction of compensation 
of employees in the public sector; (iv) reduced corporate profitability as a consequence of the 
economic  slowdown.  For  2012,  the  total  revenue  ratio  turned  out  closer  to  projected,  but 
indirect tax collection was particularly weak, showing a shortfall of 1 p.p. compared to what 
was projected in autumn 2011. In addition to the factors that impacted on 2011, this was in 
particular due to: (i) tightening bank lending conditions and weakening confidence weighing 
on  private  consumption,  (ii)  subdued  foreign  demand  for  housing,  (iii)  restructuring  of 
corporate balance sheets which kept investment on a strong downwards correction path  and 
(iv) less tax rich growth, e.g. exports of tourism gaining relative weight while final domestic 
demand posted a negative drag to GDP of around 6% of GDP. Moreover, a further worsening 
of  the  labour  market  caused  a  certain  shortfall  in  social  contributions  compared  to  the 
projected.  As  a  result,  despite  the  adoption  and  implementation  of  discretionary  revenue 
measures, overall revenue collection turned out weaker than expected. 

The  deterioration  of  the  expectations  about  economic  developments,  and  therefore  revenue 
collection,  is  also  reflected  in  the  downward  trend  in  successive  Commission  services' 
forecasts since spring 2011.  

After  revising  upward  the  forecast  of  the  2011  nominal  GDP  between  the  2010  spring  and 
autumn  forecasts,  nominal  GDP  was  substantially  revised  downwards  in  three  successive 
forecasts  and  then  revised  upward  again  in  the  autumn  of  2012.  In  parallel,  the  forecast  of 
total  revenues  was  also  adjusted  downwards,  even  in  the  last  forecast  of  autumn  of  2012. 
Finally,  total  revenues  collected  in  2011  were  only  slightly  higher  than  in  2010  in  spite  the 
3.3% growth in GDP. Abstracting from one-offs, this was driven by developments in taxes on 
production  and  imports  and  in  social  contributions  rather  than  current  taxes  on  income  and 
wealth, which were higher in 2011 compared to 2010 and also higher than projected in 2010. 
Looking deeper into the reasons for this underperformance in taxes on production and imports 
results in a mixed picture. A comparison of 2010 with 2011 shows that the weak performance 
cannot  be  explained  by  developments  in  the  tax  bases.  However,  compared  to  the  forecast 
underpinning the Council Recommendation, the tax base for indirect taxes, which constitute 

10 

 
 
more than 80% of taxes in production and imports, indeed turned out much lower. In addition, 
excise  duties  on  motor  vehicles  also  performed  considerably  worse  than  in  2010.  The 
downward  revision  of  expected  social  contributions  is  partially  explained  by  a  downward 
revision of compensation of employees. 

For 2012, nominal GDP has been revised downward by close to 7% from EUR billion 19.2 
(and nominal GDP growth of 4.8%) in autumn 2010 to 17.9 (and nominal GDP growth of -
0.5%) in the spring forecast of 2013, with a parallel deterioration of the forecasted tax bases 
as  well.  Compared  to  2011,  the  overall  performance  of  revenues  was  slightly  better  than 
expected.  Despite  the  0.5%  decrease  of  nominal  GDP  from  the  previous  year,  revenues 
increased  by  0.2%.  However,  eliminating  the  effect  of  one-offs  and  discretionary  measures, 
revenues  would  have  gone  down  by  around  3%.  Contrary  to  2011,  the  source  of 
underperformance  does  not  lie  in  indirect  taxes.  Despite  a  decrease  in  total  consumption, 
collection  of  taxes  on  production  and  imports  went  up  compared  to  2011.  This  is  partially 
explained by discretionary measures, also considering that some of the 2011 measures came 
into full effect only in 2012, but is also linked to the weak performance in 2011. For taxes on 
income  and  wealth,  the  picture  is  different.  They  deteriorated  more  than  what  standard 
elasticities  would  suggest.  Looking  into  a  breakdown  of  revenues  gives  a  mixed  picture. 
While  personal  income  tax  performed  roughly  as  expected,  corporate  income  tax 
underperformed  substantially  compared  to  developments  in  its  tax  base  (gross  operating 
surplus).  Increased  capital  write-offs  could  have  contributed  to  this  underperformance.  The 
parallel  deterioration  of  collection  from  the  special  defence  contribution  by  roughly  10%, 
despite a tax rate increase on dividend and interest income, is likely due to substantially lower 
pay-outs  of  dividends.  Other  revenues  in  the  category  taxes  on  income  and  wealth  that 
deteriorated substantially are capital gains taxes, which are likely linked to the deteriorating 
real estate market, and penalties, which are probably due to the tax amnesty that was decided 
at the end of 2011. Social contributions in 2012 seem to have performed well since collection 
of  social  contributions  went  up  by  4.3%  despite  a  stronger  than  expected  contraction  of  the 
revenue  base.  The  additional  collection  is  partially  explained  by  the  introduction  of  a  3% 
contribution  on  public  sector  salaries,  but  the  increase  may  have  been  large  also  due  to  the 
weak performance of social contributions in 2011.   

Accounting for the impact of revisions to the composition of economic growth and shortfalls 
of  revenue,  the  adjusted  average  annual  improvement  of  the  structural  budget  balance  over 
2011-2012 would be around 2.4% of GDP. This is above the minimum average annual fiscal 
effort  of  at  least  1½%  of  GDP  over  2011-2012  required  by  the  Council  recommendation. 
Cyprus can therefore be considered to have taken effective action.  

This  analysis  is  confirmed  by  the  bottom-up  assessment  of  Cyprus  having  adopted  sizeable 
consolidation  measures  over  2011-12.  As  described  in  section  3.1,  the  Cypriot  authorities 
have  undertaken  in  all  five  sets  of  fiscal  consolidation  measures  impacting  on  2011-2012, 
which  have,  however,  been  ineffective  in  containing  the  continued  deterioration  in  public 
finances caused by shortfalls in indirect taxation and social contributions.  

A first set of measures accompanied the 2011 Budget Law (Table 6) which amounted to an 
estimated  impact  of  1%  of  GDP  on  the  2011  fiscal  outcome  (0.4%  GDP  deriving  from 
expenditure  measures  and  0.6%  of  GDP  from  revenue  measures).  The  measures  were 
implemented as of October 2011. The adoption of the package of consolidation measures in 
August 2011 is estimated to have had a deficit-reducing impact of 0.3% of GDP in 2011 and 

11 

 
 
an additional  impact in 2012 of 0.8%  of GDP (equally distributed between expenditure  and 
revenue).  

The  additional  set  of  measures  prepared  for  implementation  via  the  2012  Budget  Law  is 
estimated  to  have  had  a  fiscal  impact  of  2.9%  of  GDP  in  2012  (2.1%  expenditure  side  and 
0.8%  revenue  side).  The  last-minute  amendments  to  the  Budget  Law  2012  produced  an 
additional  fiscal  impact  of  0.3%  of  GDP  in  2012.  All  measures  were  implemented  as  of 
January 2012 with the exception of the increase of the standard VAT rate from 15% to 17% 
on 1 March 2012. 

Finally,  in  November  2012,  in  the  context  of  the  provisional  staff-level  agreement  reached, 
Cyprus took steps to implement additional measures with a fiscal impact of 0.3% of GDP for 
the remaining part of 2012.  

In sum, the Cypriot authorities have adopted consolidation measures with an estimated direct 
deficit-reducing  impact  in  2011  of  around  1½%  of  GDP.  For  2012,  the  Cypriot  authorities 
have  adopted  consolidation  measures  with  an  estimated  direct  deficit-reducing  impact  of 
around 4¼% of GDP.  

Table 6: Main discretionary budgetary measures in 2011 and 2012  

2011 (% GDP) 

2012 (% GDP) 

2010 
(2011 
Budget  Law) 
measures 
(expenditure)  

2010 
(2011 
Budget  Law) 
measures 
(revenue) 

2011 
measures 
(expenditure) 

•  Termination 

the  mitigating 
of 
measures in view of the application of a 
reduced  VAT  on 
foodstuffs  and 
pharmaceutical products (-0.1%) 

• Reduction 

of 

expenditures 
transfers (-0.4%) 

and 

operational 
current 

• Containment  in  the  rate  of  growth 
of capital expenditure (-0.2%) 
• Temporary  mitigating  measures  in 
view  of  the  application  of  a 
reduced  VAT  on  foodstuffs  and 
pharmaceutical products (0.1%) 

•  Increased 

excise 

on 
petroleum  products  in  line  with 
the acquis (0.4%) 

duties 

• Application  of  a  reduced  VAT  on 
foodstuffs  and  pharmaceutical 
products (0.3%) 

• Termination  of  the  application  of 
reduced  VAT  on  hotels  and 
restaurants (0.2%) 

• Termination  of  the  reduced  excise 
duty  on  heating  oil  during  the 
winter season (0.1%) 
in 

the  government's 
social  security  contribution  on 
gross  earnings  of  broader  public 
sector employees (-0.1%) 

• Reduction 

•  Reduction in the government's social 
security  contribution  on  gross  earnings 
of  broader  public  sector  employees  (-
0.2%) 

• Public sector wage cut in  the form 
of  a  temporary  contribution  on 
gross  earnings  of  broader  public 

•  Public sector wage cut in the form of 
a 
temporary  contribution  on  gross 
earnings  of  broader  public  sector 

12 

 
 
 
 
sector  employees  and  pensioners 
(-0.1%) 

• Transfer  to  CY  Airways  due  to 
extra costs related to embargo of 
airspace use (0.1%) 

• Bank  levy  at  a  rate  of  0.095%  of 
bank’s  deposits  excluding  intra-
bank deposits (0.4%) 

2011 
measures 
(revenue) 

• Application  of 

duties 
(0.1%) 

on 

increased  excise 
products 

tobacco 

• Introduction of a levy on registered 

companies (0.1%) 

• Return  of  penalty  imposed  by  the 
national  competition  authority  on 
petroleum companies (-0.2%) 

• The 

reverse 

effect  of  2010 
extraordinary  dividends  from  the 
Central Bank of Cyprus (-0.5%) 

2012 
(2012 
Budget  Law) 
measures 
(expenditure)  

2012 
(2012 
Budget  Law) 
measures 
(revenue) 

employees and pensioners (-0.1%) 

•  The  reverse  effect  of  the  transfer  to 
CY  Airways  due  to  extra  costs  related 
to embargo of airspace use (-0.1%) 

• 

Introduction  of  a  levy  on  registered 

companies (0.1%)  

•  Effect  of  the  2011  reduced  revenue 
due to the return of penalty imposed by 
the  national  competition  authority  on 
petroleum companies (0.2%) 

•  Targeting of all social schemes based 
income  and  economic 

mainly  on 
criteria. (-0.8%) 

•  Freezing  of  emoluments  including 
pensions  in  the  public  sector  for  a 
period  of  two  years  (this  includes 
COLA effect) (-0.7%) 

of 

the 

•  Reduction 

number 

of 
personnel  in  the  broader  public  sector 
by  5,000  over  the  next  five  years  (one 
recruitment  for  every  four  retirees)  (-
0.1%) 

• 

Increase  of  the  standard  VAT  rate 
from  15%  to  17%.  The  inflationary 
impact  of 
the 
calculation  of  the  COLA  index  will  be 
excluded (0.6%) 

this  measure  on 

• 

Increase  of  the  tax  rate  on  deemed 
dividend distribution from 15% to 17% 
(0.3%) 

•  Application of the reduced VAT rate 
on purchases or construction of primary 
residences (0.3%) 

•  Revenue  from  rights  issue  of  one  of 

the banks (0.2%) 

•  Temporary  contribution  on  gross 
earnings  of  private  sector  employees 
and  pensioners:  0-€2500              0%;  
€2501 - €3500       2.5%     (0.1%) 

Note: A positive sign implies that revenue / expenditure increases. 

13 

 
 
 
 
 
 
Only measures yielding more than 0.1% of GDP are listed. 

Source: Commission services 

14 

 
 
Table 7: Consolidation measures for 2012 in the MoU 

2012  measures 
(expenditure) 

•  Scaled  reduction  in  emoluments  of  public  and  broader  public  sector 
pensioners and employees including employees of private organizations as 
follows: €0-1000: 0%, €1001-1500: 6.5%, €1501-2000: 8.5%, €2001-3000: 
9.5%, €3001-4000: 11.5%, €4001: 12.5%   (-0.2%) 
•  Dividend from a semi-government organization (0.2%) 

2012  measures 
(revenue) 
Note: A positive sign implies that revenue / expenditure increases. 
Source: Commission services 

4. 

PROPOSED NEW ADJUSTMENT PATH 

Despite the significant fiscal consolidation undertaken in 2011-2012, Cyprus did not correct 
its  excessive  deficit  by  the  deadline  established  in  the  Council  Recommendation  of  13  July 
2010  due  to  the  deterioration  in  the  budgetary  position  resulting  from  the  weaker  overall 
position of the economy.  

4.1 Macroeconomic outlook 

Looking  ahead,  the  Cypriot  economy  is  expected  to  face  strong  headwinds  in  the  coming 
years,  with  a  projected  return  to  growth  only  in  2015  (Table  8).  Under  the  Programme 
Scenario, the weakness of economic activity is expected to persist over the first years of the 
programme  period. It is projected that domestic demand will continue to contract up to and 
including 2014, due to a drag on economic activity from both falling household consumption 
and investment. The immediate restructuring of the banking sector, which will impact on net 
credit  growth,  the  rapid  deterioration  in  labour  market  conditions  and  the  high  degree  of 
economic  uncertainty  are  together  expected  to  weigh  heavily  on  domestic  demand. 
Furthermore,  there  is  a  continued  need  to  deleverage  corporate  and  private  sector  balance 
sheets.  In  addition,  the  temporary  restrictions  required  to  safeguard  financial  stability  are 
expected  to  hamper  international  capital  flows  and  to  reduce  business  volumes  in  both 
domestic and internationally oriented companies. The bail-in of uninsured depositors causes a 
loss  of  wealth  and  will  have  short-term  confidence  effects,  which  will  reduce  private 
consumption  and  business  investment.  This,  compounded  by  the  impact  of  fiscal 
consolidation  already  undertaken  and  new  measures  agreed,  is  expected  to  result  in  a 
considerable  fall  in  domestic  demand.  Little  reprieve  can  be  expected  from  exports  amid 
uncertain external conditions and a shrinking financial service sector.  

Growth is projected to rebound mildly in 2015 and stronger in 2016. The fiscal consolidation 
is  expected  to  restore  the  confidence  of  consumers  and  investors,  while  the  result  of 
deleveraging  of  both  household  and  corporate  balance  sheets  over  time  would  create  the 
conditions for more balanced growth. At the same time, the restoration of a sound and well-
capitalised  banking  system  is  expected  to  gradually  loosen  the  tight  credit  conditions  in  the 
economy. In 2015, first positive effects of the economic adjustment programme are expected 
to  be  supported  also  by  an  improved  external  environment  and  a  gradual  normalisation  of 
labour  market  conditions.  In  2016,  the  economy  is  expected  to  build  on  the  positive 
momentum  set  up  in  2015  with  private  consumption  again  driving  economic  activity,  as 
economic sentiment improves. Also, in the outer years 2015-2016, investment projects related 
to  the  exploitation  of  natural  gas  should  contribute  increasingly  to  economic  growth.  The 

15 

 
 
recent  reform  of  Cyprus'  wage-indexation  system  (COLA)  will  contribute  to  align  public 
wages  with  developments  in  economic  activity,  improve  competitiveness,  and  support  the 
economic recovery. This is expected to have a positive impact on the external balance, with 
the  current  account  deficit  contracting  over  the  programme  period  and  external  debt,  in 
particular related to external liabilities of financial institutions, projected to decline.  

Macroeconomic  risks  remain  important  and  tilted  to  the  downside.  On  the  domestic  front, 
downside  risks  are  associated  with  domestic  credit  conditions  and  further  deterioration  of 
confidence  in  the  banking  system.  Moreover,  there  is  a  non-negligible  risk  of  a  cycle  of 
household  and  corporate  defaults  propagating  through  the  economy,  leading  to  further 
banking sector losses, worsening of labour market conditions, stronger than expected fall in 
house  price  and  a  prolonged  loss  of  business  and  consumer  confidence.  Also,  the  deep 
restructuring  of  the  Cypriot  banking  sector  could  have  strong  spill-overs  on  related 
professional business services and financial services exports. More generally, the transition to 
a more diversified growth model will be challenging for the economy in the coming years and 
will imply a re-allocation of economic resources across sectors, which may take time and will 
require flexible factor and product markets. Upside risks for the Cypriot economy are limited, 
relating mainly to higher investment activity in the energy sector and possible improvements 
in the external outlook, should the euro area economic activity strengthen beyond expected. 

Table 8: Forecast of key macroeconomic and budgetary variables under the Programme 
Scenario  

% of GDP (unless indicated otherwise)
Revenues 
Current revenues
Discretionary measures with impact on current revenue (EUR million)
Expenditure
Nominal GDP (EUR million)
Nominal GDP growth
Real GDP growth
Potential GDP growth
Structural balance
Primary balance
General government balance
p.m CAB methodology revenue elasticity
p.m Apparent revenue elasticity
p.m Output gap (% of potential output)

Source: Commission services 
p:provisional data; f:forecasted data 

4.2 Government deficit and public debt trajectory 

2014f
39.1
39.0
167
47.5

2012p
40.0
39.9
362
46.3

2013f
40.6
40.6
631
47.1
 17,887    16,425    15,951 
-8.2
-8.7
-2.6
-5.4
-2.4
-6.5
1.0
1.9
-6.2

-0.5
-2.4
-1.3
-6.7
-3.1
-6.3
1.0
9.5
0.0

-2.9
-3.9
-2.5
-5.1
-4.3
-8.4
1.0
1.4
-7.6

2015f
39.4
39.4
-21
45.7

2016f
40.8
40.7
-27
43.7

  16,361    16,967 

2.6
1.1
-2.3
-4.4
-2.1
-6.3
1.0
1.3
-4.3

3.7
1.9
-1.6
-2.5
1.2
-2.9
1.0
2.0
-0.9

An ambitious but achievable fiscal adjustment path over the medium-term is essential to make 
Cyprus' public debt sustainable. For this reason, a key objective of the fiscal strategy and the 
agreed  consolidation  measures  in  the  MoU  is  to  achieve  a  strengthening  of  the  primary 
balance over the programme period, with primary balance targets of -2.4% of GDP in 2013, -
4.3% of GDP in 2014, -2.1% of GDP in 2015 and 1.2% of GDP in 2016. The attainment of 
these  targets  is  consistent  with  headline  deficit  targets  of  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 

16 

 
 
 
The  adoption  and  implementation  of  fiscal-structural  measures  are  critical  to  achieve  a 
permanent  consolidation  and  maintain  a  primary  surplus  at  high  level  over  the  longer-term, 
leading to a primary balance surplus of 3% of GDP in 2017 and 4% of GDP in 2018, which 
should  be  maintained  at  such  level  thereafter.  The  range  of  fiscal-structural  and  structural 
reforms  agreed  in  the  MoU  include  establishing  a  medium-term  budgetary  framework, 
undertaking  pension,  health  care  and  welfare  system  reform  measures,  enhancing  revenue 
collection  and  tax  administration,  and  ensuring  improvement  to  the  public  finance 
management and the functioning of the public sector.  

The  majority  of  the  fiscal  adjustment  measures  for  2012-14  agreed  in  November  2012  are 
already  enacted.  Some  measures  agreed  in  November  2012,  amounting  to  around  0.6%  of 
GDP,  are  not  yet  implemented,  notably  the  revision  of  the  property  tax  and  of  the  social 
housing schemes. These measures will be legislated and implemented before disbursement of 
the  first  tranche  of  financial  assistance.  Moreover,  as  part  of  the  16  and  25  March  2013 
Eurogroup political agreements, additional fiscal consolidation measures for 2013 of around 
1.5% of GDP will be legislated and implemented before disbursement of the first tranche of 
financial  assistance,  namely  (i)  increase  in  the  statutory  corporate  income  tax  to  12.5%,  (ii) 
increase in the interest income withholding tax to 30% and (iii) increase in the bank levy to 
0.15%. Finally, some further measures, in particular additional public sector wage cuts and a 
contribution by public sector employees to their health care scheme, will also be implemented 
as prior actions. The total additional fiscal measures in 2013 therefore amount at minimum to 
2.5% of GDP.  

The  fiscal  consolidation  implies  that  the  improvement  in  the  primary  balance  over  2013-16 
will contribute to reducing the debt ratio substantially within the programme period, in spite 
of  the  rather  strong  debt-increasing  effects  from  interest  expenditure  and  the  projected 
recession  (Table  9).  Public  debt  developments  are  projected  to  be  largely  influenced  by  the 
financial  assistance  granted  to  finance  the  general  government  deficit,  the  redemption  of 
maturing medium- and long-term debt and the recapitalisation of some financial institutions, 
notably the cooperative credit sector. Debt is projected to jump from 85.8% of GDP in 2012 
to around 128% of GDP in 2015. Thereafter, on the back of solid primary surpluses and the 
projected  return  to  positive  GDP  growth  rates,  the  debt-to-GDP  ratio  will  start  falling  to 
around 124% of GDP in 2016. 

Medium-term downside risks to the projected debt developments are, however, material and 
linked  to:  (i)  a  possible  stronger  contraction  of  the  economy  and  further  worsening  of  the 
labour  market  outlook,  which  would  affect  expenditure  and  revenue  collection  and  have  a 
negative  denominator  effect,  (ii)  non-attainment  of  the  agreed  primary  surplus  targets 
established  in  the  programme,  (iii)  insufficient  structural  fiscal  measures  to  underpin 
sustained  high  primary  surpluses,  iv)  a  less  tax-rich  composition  of  growth  and  possible 
stronger  sensitivity  of  revenues  to  the  structural  adjustment  of  the  Cypriot  economy,  (v) 
lower-than-expected  privatisation  proceeds;  (vi)  a  worsening  of  the  economic  situation  in 
trade-partner  economies,  (vii)  lack  of  success  in  regaining  market  access  at  a  reasonable 
borrowing cost following the programme period.  

Table 9: Public debt trajectory 2013-2016 under the Programme Forecast  

Gross debt ratio (% of GDP) 
Changes in the ratio (pps) 
of which 

2013 
109.5 
23.6 

2014 
124.0 
14.5 

2015 
127.9 
3.8 

2016 
123.9 
-4.0 

17 

 
 
  
 
 
 
 
(1) Primary balance (pps) 
(2) Snowball effect (pps) 

Interest expenditure (pps) 
Growth effect (pps) 
Inflation effect (pps) 

(3) Stock flow adjustment (pps) 
Source: Commission services 

4.3 Extension of the EDP deadline 

2.4 
11.7 
4.1 
8.1 
-0.5 
9.6 

4.3 
7.4 
4.2 
4.5 
-1.2 
2.9 

2.1 
1.0 
4.2 
-1.3 
-1.8 
0.6 

-1.2 
-0.4 
4.2 
-2.4 
-2.2 
-2.4 

In view of the distance at end-2012 to the 3% of GDP reference value, and taking into account 
the  current  adverse  macro-economic  circumstances  and  the  perspective  of  a  longer-lasting 
deleveraging of the economy, it would appear that four additional years will be necessary for 
a sustainable correction of the excessive deficit.  

Fully-specified  consolidation  measures  of  around  4¾%  of  GDP  in  2013  are  agreed  in  the 
MoU.  This  consolidation  effort  includes,  as  described  above,  additional  fiscal  measures  in 
2013  therefore  of  around  2.5%  of  GDP,  due  to  (i)  the  additional  consolidation  measures 
decided by the Eurogroup as part of the political agreement on 16 and 25 of March 2013, (ii) 
the  remaining  0.6%  of  GDP  of  measures  to  which  Cyprus  agreed  in  November  2012  and 
which  are  not  yet  legislated  (i.e.  on  property  taxation  and  expenditure  cuts  in  housing 
schemes) and (iii) the public sector wage cuts and contribution by public sector employees to 
their health care scheme, amounting to about 0.4% of GDP. The Commission services' Winter 
2013  forecast  did  not  take  into  account  these  measures  and  nevertheless  estimated  an 
improvement  in  the  structural  balance  from  2012  to  2013  of  1.8%  of  GDP.  Against  the 
background of a worse-than-expected deficit outcome in 2012 and substantial revisions to the 
macroeconomic  outlook  and  potential  output  estimates,  the  improvement  in  the  structural 
balance  from  2012  to  2013  is  now  estimated  at  around  1.3%  of  GDP.  On  the  basis  of  the 
Programme Forecast of deteriorating macroeconomic conditions, the headline deficit in 2013 
is projected to increase marginally to 6.5% of GDP.  

In 2014, fully-specified further consolidation measures amount to around 1¾% of GDP and 
are projected to improve the structural balance by 0.3% of GDP. It should be noted that these 
policy measures for 2014 have remained unchanged compared to those that were laid down in 
the  November  2012  draft  MoU.  The  Commission  services'  Winter  2013  forecast  took  into 
account these measures and indicated an improvement in the structural balance from 2013 to 
2014  of  around  1.4%  of  GDP.  Based  on  the  Programme  Forecast,  the  structural  balance  is 
now  set  to  improve  only  by  0.3%  of  GDP.  This  lower  projected  improvement  of  structural 
balance in 2014 – in spite of an unchanged set of consolidation measures – can be explained 
by (i) the deterioration of the tax base of the permanent measures introduced in 2013, which 
implies  that  some  of  these  measures  are  projected  to  have  a  decreasing  impact  in  2014.  An 
example of this is the increase in the withholding tax on interest income from 15% to 30%, 
which  is  projected  to  yield  EUR  138mn  in  2013  but  only  EUR  83mn  in  2014,  due  to  the 
reduction  of  the  deposit  base  and  of  the  interest  rate  paid.  Albeit  a  permanent  measure,  it 
shows  up  as  a  deterioration  of  the  structural  balance  due  to  a  year-on-year  reduction  of  the 
measure's budgetary impact by around EUR 55mn (0.3% of GDP). The same is the case for 
the  increase  in  the  bank  levy;  (ii)  the  downward  revision  of  the  impact  of  some  of  the 
consolidation  measures  already  taken  in  light  of  the  worse  macroeconomic  conditions 
throughout the programme period; (iii) a projected  reduction of  revenue collection in 2014 of 
some tax measures (e.g. collection of income taxation and VAT), since their revenue depends 

18 

 
 
on economic activity of 2013 when the economy is projected to contract by 8.7% and, (iv) the 
fact  that  the  standard  elasticity  used  to  determine  the  split  between  the  cyclical  component 
and the structural balance may not capture well the erratic economic developments. This may 
imply  that  the  negative  impact  from  the  cyclical  conditions  is  underestimated,  which  for  a 
given  headline  deficit  would  arithmetically  reduce  the  calculated  structural  effort.  The 
bottom-up  forecast  of  individual  measures,  item-by-item,  may  under  the  highly  uncertain 
macroeconomic  conditions  give  a  more  appropriate  view  of  the  fiscal  effort,  not  least  in  a 
situation  of  significant  shifts  in  actual  and  estimated  potential  output.  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 and remains insufficient to reduce the headline deficit.  

It  should  also  be  noted  that  in  light  of  the  substantial  additional  consolidation  measures  for 
2013  agreed  in  the  Eurogroup  meetings  of  16  and  25  March  and  the  adverse  and  highly 
uncertain  macroeconomic  conditions,  inter  alia  due  to  the  imposition  of  temporary  capital 
controls, loss of confidence and financial sector instability, programme partners found that an 
ex-ante obligation to implement further fiscal consolidation measures for 2014 (additional to 
the  measures  adopted  in  December  2012  with  effect  from  1  January  2014)  would  not 
represent  an  appropriate  fiscal  policy  stance.  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. 

High-quality  permanent  measures  will  be  needed  in  2015-2016  and  beyond  to  achieve  the 
annual budgetary targets  as set  out  in  the MoU. For 2015-16, an additional around 2½% of 
GDP of measures would be required to achieve the MoU targets of a primary deficit of 2.1% 
of GDP in 2015 and a primary surplus of 1.2% of GDP in 2016. In line with the overarching 
principle  of  an  expenditure  based  adjustment,  the  measures  should  include,  in  particular, 
reducing  growth  in  expenditure  on  the  public  sector  wage  bill,  social  benefits  and 
discretionary  spending,  while  minimising  the  impact  of  consolidation  on  vulnerable  groups 
and  preserving  the  good  implementation  of  Structural  and  other  EU  Funds.  Based  on  the 
macroeconomic projection and estimated interest payments, the headline deficit is expected to 
be below the reference value in 2016.  

5. 

CONCLUSIONS 

On current information, the average annual improvement of the structural budget balance over 
2011-2012, after correction for the effects of revised potential output growth and less tax-rich 
growth  is  estimated  to  be  2.4%  of  GDP.  This  is  above  the  minimum  average  annual  fiscal 
effort  of  at  least  1½%  of  GDP  required  by  the  Council  Recommendation,  which  is  an 
important indication for the assessment of whether Cyprus could be considered to have taken 
effective  action  in  line  with  the  Council  recommendations.  This  is  supported  by  a  careful 
analysis that shows that Cyprus adopted sizeable consolidation measures over 2011-12, with 
an estimated direct deficit-reducing impact of around 1½% of GDP in 2011 and around 4¼% 
of GDP in 2012, based on a bottom-up assessment.  

For the period 2013-2016, Cyprus has committed to a detailed consolidation path as outlined 
in the agreed MoU, which is fully underpinned by specified measures for 2013-2014, most of 

19 

 
 
which were already legislated in the 2013 Budget Law or legislated as prior actions before the 
disbursement  of  the  first  tranche  of  financial  assistance.  The  2013  Budget  Law  was 
accompanied by a three-year Medium Term Budgetary Framework that embedded the agreed 
deficit targets for 2013-2016. According to the MoU, the total amount of fiscal consolidation 
measures amounts to about 4¾% of GDP in 2013 and around 1¾% of GDP in 2014. Overall, 
the  measures  included  in  the  agreed  MoU  are  expected,  on  the  basis  of  the  realistic  macro-
economic scenario underpinning the MoU to lead to a sustainable correction of the excessive 
deficit situation by 2016. 

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  Council  Recommendation  implies  that  a  new  deadline  for  correction  of  the 
excessive deficit by Cyprus is needed. In view of the projected distance at end-2012 to the 3% 
of  GDP  reference  value  for  the  deficit,  after  taking  into  account  the  current  adverse  macro-
economic circumstances and the perspective of a longer-lasting deleveraging of the economy, 
it would appear that four additional years will be necessary for a sustainable correction of the 
excessive deficit.  

Granting  four  additional  years  for  the  correction  of  the  excessive  deficit  would  be 
commensurate with intermediate headline deficit targets of 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.  The  underlying 
improvement in the structural budget balance implied by these targets is 1.3% in 2013, 0.3% 
in 2014, 0.7% in 2015, and 1.8% in 2016. This would correspond to an average annual fiscal 
effort of 1% of GDP over 2013-2016 in order to bring the headline government deficit below 
the 3% of GDP reference value by 2016. 

Table 10: Comparison of key macroeconomic and budgetary projections 

2010

2011

2012

2013

2014

2015

2016

Real GDP

(% change)
Output gap1
(% of potential GDP)

COM PF

COM SF 10

COM PF

COM SF 10

General government balance

COM PF

(% of GDP)

Primary balance

(% of GDP)
Cyclically-adjusted balance1
(% of GDP)
Structural balance2
(% of GDP)

COM SF 10

COM PF

COM SF 10

COM PF

COM SF 10

COM PF

COM SF 10

Government gross debt

COM PF

(% of GDP)

COM SF 10

1.3

-0.4

0.9

-1.7

-5.3

-7.1

-3.0

-4.4

-5.7

-6.3

-5.7

-6.3

61.3

62.3

0.5

1.3

1.2

-0.7

-6.4

-7.7

-3.9

-4.8

-6.8

-7.1

-6.6

-7.1

71.1

67.6

-2.4

n.a.

0.0

n.a.

-6.3

n.a.

-3.1

n.a.

-6.3

n.a.

-6.7

n.a.

85.8

n.a.

-8.7

n.a.

-6.2

n.a.

-6.5

n.a.

-2.4

n.a.

-3.8

n.a.

-5.4

n.a.

-3.9

n.a.

-7.6

n.a.

-8.4

n.a.

-4.3

n.a.

-5.1

n.a.

-5.1

n.a.

1.1

n.a.

-4.3

n.a.

-6.3

n.a.

-2.1

n.a.

-4.4

n.a.

-4.4

n.a.

1.9

n.a.

-0.9

n.a.

-2.9

n.a.

1.2

n.a.

-2.5

n.a.

-2.5

n.a.

109.5

n.a.

124.0

n.a.

127.9

n.a.

123.9

n.a.

Note:
1 Output gaps and cyclically-adjusted balances according to the  programmes as 
recalculated by Commission services on the bass of the information in the programmes.
2 Cyclically-adjusted balance excluding one-off and other temporary meaures

Source:  COM 2010 SF - Commission services' 2010 Spring Forecast; COM PF - Programme Forecast

20