COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the action taken by Cyprus in response to the Council Recommendation of 16 May 2013 with a view to bringing an end to the situation of excessive government deficit Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE COUNCIL Assessment of action taken by Cyprus in response to the Council Recommendation of 16 May 2013 with a view to bringing an end to the situation of excessive government deficit
Date: 2013-09-06
Institutions: European Commission
Subjects: Cyprus, budget deficit, budgetary equilibrium, gross domestic product, public debt, tax reform













EUR-Lex - 52013SC0327 - EN











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52013SC0327

COMMISSION STAFF WORKING DOCUMENT Analysis by the Commission services of the action taken by Cyprus in response to the Council Recommendation of 16 May 2013 with a view to bringing an end to the situation of excessive government deficit Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE COUNCIL Assessment of action taken by Cyprus in response to the Council Recommendation of 16 May 2013 with a view to bringing an end to the situation of excessive government deficit /* SWD/2013/0327 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 2012[1].
Cyprus' general
government deficit remained at high levels in recent years, despite a sizeable
consolidation effort. In 2011 and 2012, the headline balance reached 6.3% of
GDP, compared to 5.3% of GDP in 2010, the year of the initial EDP Council
recommendation. In 2012, less tax-rich growth, reduced revenue elasticities and
a one-off expenditure kept the deficit at high levels. 
On 25 April 2013, the
Council addressed a decision to Cyprus on specific measures to restore
financial stability and sustainable growth (‘the programme’). 
In parallel the European
Stability Mechanism (ESM) granted a financial assistance facility to Cyprus. In this context, a Memorandum of Understanding on Specific Economic Policy
Conditionality (MoU) was signed on 26 April 2013 by the Cypriot authorities and
the Commission, acting on behalf of the ESM.
On 16 May 2013, the
Council concluded that effective action over the years 2011-2012 had been
taken, and that an extension of the deadline by four years for the correction
of the excessive deficit procedure was justified. 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 was
estimated to be 2.4% of GDP. This was above the minimum average annual fiscal
effort of at least 1½% of GDP required by the Council recommendation,
indicating that Cyprus could be considered to have taken effective action in line with
the Council recommendations. 
This was supported by a
careful analysis[2] 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. 
Subsequently, the
Council recommended that "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 achieve the 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 351mn in
2013. Cyprus should fully implement the fiscal measures for 2014 that were
adopted in December 2012, amounting to at least 270mn 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". 
In its recommendations,
the Council established a deadline of 3 months for the Cypriot authorities to
take effective action, in accordance with Article 3(4) of Council Regulation
(EC) No 1467/97.
This document provides
an assessment of whether Cyprus has undertaken effective action towards the
correction of its excessive general government deficit in the 3 months
following the 16 May 2013 Council Recommendation. In particular, it examines the
budgetary developments since the May 2013 Council Recommendation.
2.           Recent macroeconomic developments
In 2012,
economic activity in Cyprus significantly weakened, with real GDP decreasing by
2.4%. The deterioration was driven by the unwinding of Cyprus' unsustainable economic imbalances, which led to a widespread loss of confidence
among economic agents. Domestic demand contracted markedly against the
background of falling domestic consumption and private investment. The largest
fall in economic activity took place in construction and in the broad
industrial sector, while growing financial stability concerns led to weakening
activity in financial services. The unemployment rate rose sharply, reaching
nearly 12%.
In the first
quarter of 2013, real GDP declined by 4.7% y-o-y, accelerating from -3.5% y-o-y
in the fourth quarter of 2012. Private and, particularly, public consumption
continued its downward movement, and the underlying growth momentum of gross
fixed capital formation remained weak. The weak domestic demand resulted in a
significant decline in imports of goods and services. With export of goods and
services displaying a small increase compared to the first quarter of 2012, net
exports provided a significant positive contribution to GDP growth. 
Activity in
the second quarter of this year was down 5.2% y-o-y[3]. Large
uncertainty in the composition of growth persists, particularly, due to the
restructuring of the banking sector and the imposition of administrative
measures on financial transactions to safeguard financial stability. However,
short term indicators suggest a continuation of the underlying weak trend in
both the household sector as well as the corporate sector. The spill-overs from
financial sector instability to the real economy are likely to have imposed a
significant drag on economic activity in the second quarter of 2013, mainly via
concerns over financial sector stability in the short and medium terms. Amid
declining lending, deposits were gradually finding their way out of the banking
sector, rendering efficient financial intermediation even more difficult.
Foreign investors were adopting a wait-and-see attitude, as future prospects
remained uncertain. International transactions were hampered by restrictions on
capital flows. 
Real GDP is
expected to decline drastically by 8.7% in 2013 as a whole, unchanged compared
to the Commission 2013 Spring Forecast (see Table 1). The envisaged contraction
is driven by the immediate restructuring of the banking sector and its impact
on net credit growth, the longer-lasting deleveraging of corporate and
household balance sheets, the fiscal consolidation pursued, and the high degree
of economic uncertainty which will strain domestic demand and investment. In
addition, the temporary imposition of capital controls and withdrawal
restrictions combined with the related uncertainty 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 is
expected to cause a loss of wealth, which will also affect private consumption
and investment. 
Compared to
the Commission 2013 Spring Forecast (which is identical to the programme
scenario of April 2013), the macroeconomic projection remains broadly unchanged.
Overall activity is unchanged, however, private consumption has been revised
slightly down as the unemployment rate is projected to increase faster than
previously envisaged; this is reflected also in the downward revision of
imports.
Table 1:
Macroeconomic developments and outlook
   || 2012 || 2013 || 2014 || 2015 || 2016 
 Outturn || PF April || PF July || PF April || PF July || PF April || PF July || PF April || PF July 
 Real GDP            (% change) || -2.4 || -8.7 || -8.7 || -3.9 || -3.9 || 1.1 || 1.1 || 1.9 || 1.9 
 Contributions to real GDP growth (pp.): ||   ||   ||   ||   ||   ||   ||   ||   ||   
 Final domestic demand || -6.1 || -13.7 || -13.8 || -5.5 || -5.5 || 0.9 || 0.9 || 2.0 || 2.0 
 Changes in inventories || -0.8 || 0.0 || 0.0 || 0.0 || 0.0 || 0.0 || 0.0 || 0.0 || 0.0 
 Net exports || 4.4 || 5.0 || 5.0 || 1.6 || 1.6 || 0.2 || 0.2 || 0.0 || -0.1 
 Employment        (% change) || -4.1 || -6.6 || -7.8 || -3.1 || -3.7 || 1.1 || 1.1 || 1.3 || 1.3 
 GDP deflator       (% change) || 2.0 || 0.6 || 0.6 || 1.1 || 1.1 || 1.5 || 1.5 || 1.8 || 1.8 
 Output gap (% of potential GDP) || 0.0 || -6.2 || -5.8 || -7.6 || -6.6 || -4.3 || -3.0 || -0.9 || 0.8 
 Potential output growth (% change) || -1.3 || -2.6 || -3.0 || -2.5 || -3.1 || -2.3 || -2.7 || -1.6 || -2.0 
 Source: Commission staff estimates; Programme Forecast (PF) April: Commission 2013 Spring Forecast; PF July: Commission most recent forecast underlying the revised MoU from July 2013. 
Macroeconomic risks
remains important and tilted to the downside. Downside risks relate to the
tighter domestic credit conditions and a further deterioration of confidence in
the banking system, a further worsening of labour market conditions and a
non-negligible risk of household and corporate defaults propagating further
through the economy. Also, the deep restructuring of the Cypriot economy, and
its banking sector in particular, could cause stronger negative spill-overs on
related professional business services and financial services' exports. More
generally, the transition to a more varied 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 whose absorption will require
flexible factor and product markets. Upside risks for the Cypriot economy relate
mainly to possible improvements in the external outlook and, in the outer
years, investments in the energy sector and a more competitive tourist sector
could contribute increasingly to economic growth. 
3.           Assessment of effective action 
Following the expiry of
the deadline established for taking effective action in a recommendation under
Article 126(7), the Commission shall assess whether the Member State concerned has acted in compliance with the recommendation. This assessment should
consider whether the Member State concerned has publicly announced or taken
measures that seem sufficient to ensure adequate progress towards the
correction of the excessive deficit within the time limits set by the Council.
A Member State should be considered to have taken effective action if it has
acted in compliance with the recommendation, regarding both the implementation
of the measures required therein and budgetary execution. The assessment should
in particular take into account whether the Member State concerned has achieved
the annual budgetary targets initially recommended by the Council and the
underlying improvement in the structural balance. Where relevant, a careful
analysis should take into account whether expenditure targets have been met and
the planned discretionary measures on the revenue side have been implemented.
3.1.        Budgetary implementation
in 2013
Despite the
adverse macroeconomic environment and the faster-than-expected decline in
employment, the general government headline budget deficit for the first half
of 2013 amounted to 1.2% of GDP. This is significantly better than the
authorities' half-year target for 2013 (by 2.3% of GDP), which has been
established as an intermediary target in accordance with programme
conditionality[4]. It is also
a significantly better outcome than in the respective period in 2012 (by 2.2%
of GDP). Similarly, the primary balance exceeded the end-Q2 value targeted by
the authorities by 1.6% of GDP. 
Total revenue for the
first 2 quarters of the year was in accordance with what has been targeted by
the authorities, albeit around 1% of GDP lower than the same period in 2012.
The outcome in the first half of 2013 benefited from extraordinary high non-tax
revenues. These one-off revenues mainly comprised, inter alia, higher dividends
due to exceptional profits by the Central Bank of Cyprus. Due to these one-off
effects, one has to be cautious about overall revenue trends, since there are
risks to the future performance of key revenue items. Overall, the end-year
projection of total revenues remains in line with the projection underpinning
the Commission 2013 Spring Forecast.
Revenues from both taxes
on income and wealth and social contributions, in the first half of the year,
performed somewhat better than expected. The developments were driven by the
increased collection of taxes on interest and (deemed) dividends, which
mitigated the negative impact of falling wages, employment and profits on
income tax collection. In light of the large fall in banking sector deposits,
the decrease in deposit rates as well as negative employment trends eventually
showing up in the collection of social security contributions, this positive
performance is, however, not expected to persist.
Revenues from taxes on
production and imports at the end of the second quarter showed signs of
weakness. This was in particular due to a significant drop in Land and Survey
fees collections, associated with the continued contraction in the real estate
market, as well as a significant decline in excise duties collected. The latter
can be explained by cyclical conditions, a stronger-than-expected behavioural
change in the demand for tobacco products and a steep decline of new motor
vehicle purchases. Conversely, in spite of the shrinking tax base, VAT
collection turned out better than expected, most likely driven by the hikes in
the VAT rate of 2 pp. and 1 pp. in March 2012 and January 2013, respectively.
Total expenditure has
been kept under strict control and has been restrained for key spending
categories. Consequently, total primary expenditure was in the first half of
the year significantly lower (by 1.7% GDP) than projected by the authorities.
Primary expenditure was also significantly lower than in the respective period
in 2012 (by 3.3% of GDP). Programme conditionality for total primary
expenditure (in cash terms) was over-achieved. 
Expenditure targets have
been met. Current expenditure was lower than projected, mainly due to
expenditure restraint in the categories of current transfers, goods and
services and wages and salaries. On the contrary, social transfers other than
in kind equalled the authorities' projection for the first half of the year,
but grew at a faster pace than expected in the second quarter of 2013. This
trend bears witness to the increasingly difficult labour market conditions.
Capital expenditure receded over the first six months of the year, driven
largely by the treatment of signing fees for gas exploitation as disposal of
non-produced assets and an administrative delay of land annexation compensations
during the first half of 2013. Interest payments for 2013 are on track, based
on the outcome of the first half of the year.
Overall, Cyprus has executed the 2013 Budget effectively in the first half of the year. The measures
taken by the authorities with regard to direct taxes are expected to counteract
the negative impact to this tax category of wage cuts in both the private and
the broader public sector. The projection of indirect tax revenue is broadly
unchanged, balanced between relatively resilient VAT collection and other
indirect taxes that appear more sensitive to adverse macroeconomic
circumstances over the coming quarters. On the expenditure side, the cautious
execution of expenditure measures is expected to continue compensating for higher
social payments driven by the increasingly difficult labour market conditions. 
Table 2: Composition of the budgetary adjustment
   || 2012 || 2013 || 2014 
 Outturn || PF April* || PF July* || PF April || PF July 
 % of GDP 
 Revenue || 40.0 || 39.6 (40.6) * || 39.6 (40.6)* || 39.1 || 39.3 
 of which: ||   ||   ||   ||   ||   
 - Taxes on production and imports || 14.8 || 14.1 || 14.1 || 13.8 || 14.2 
 - Current taxes on income, wealth, etc. || 11.1 || 10.9 || 11.2 || 10.8 || 10.7 
 - Social contributions || 9.1 || 8.5 || 8.4 || 8.0 || 8.7 
 - Other (residual) || 4.9 || 6.1 (7.1) * || 5.9 (6.9)* || 6.4 || 5.6 
 Expenditure || 46.3 || 46.1 (47.1) * || 47.9 (48.9)* || 47.5 || 47.6 
 of which: ||   ||   ||   ||   ||   
 - Primary expenditure || 43.1 || 42.1 (43.1) * || 43.8 (44.8) * || 43.4 || 43.6 
       of which: ||   ||   ||   ||   ||   
      - Compensation of employees || 15.8 || 15.8 || 15.9 || 15.4 || 15.9 
      - Intermediate consumption || 3.2 || 5.3 || 5.2 || 5.7 || 5.2 
      - Social payments || 15.0 || 15.8 || 15.7 || 16.4 || 16.7 
      - Subsidies || 0.5 || 0.6 || 0.6 || 0.6 || 0.6 
      - Capital expenditure || 4.0 || 2.4 (3.4) * || 2.4 (3.4)* || 3.3 || 3.2 
      - Other (residual) || 4.6 || 2.2 || 4.0** || 1.9 || 2.0 
 - Interest expenditure || 3.2 || 4.1 || 4.1 || 4.1 || 4.0 
 General government balance (GGB) || -6.3 || -6.5 || -8.3 || -8.4 || -8.3 
 GGB excl. compensation of pension funds || -6.3 || -6.5 || -6.5 || -8.4 || -8.3 
 Primary balance (PB) || -3.1 || -2.4 || -4.2 || -4.3 || -4.3 
 PB excl. compensation of pension funds || -3.1 || -2.4 || -2.4 || -4.3 || -4.3 
 One-off and other temporary measures || 0.4 || 1.5 || -0.2** || 0.0 || 0.0 
 Cyclically-adjusted balance || -6.3 || -3.8 || -5.8 || -5.1 || -5.4 
 Structural balance || -6.7 || -5.4 || -5.6 || -5.1 || -5.4 
 Change in structural balance || -0.1 || 1.3 || 1.2 || 0.3 || 0.1 
 Real GDP growth || -2.4 || -8.7 || -8.7 || -3.9 || -3.9 
 GDP deflator || 2.0 || 0.6 || 0.6 || 1.1 || 1.1 
 Nominal GDP || 17.9 || 16.4 || 16.4 || 16.0 || 16.0 
 Source: Commission staff estimates; PF April: Commission 2013 Spring Forecast; PF July: Commission most recent forecast underlying the revised MoU from July 2013. *: In April PF it was assumed that the signing fees for gas exploitation of EUR 174.8mn (1.1% of GDP) are recorded as sales revenue under Other (residual) but in July PF it has been reclassified as negative expenditure in ESA 95 terms (disposal of non-produced assets); for ease of comparison the table reports April PF numbers at face value (figures in brackets) and numbers corrected for this reclassification. **: This includes the compensation of pension funds amounting to 1.8% of GDP. 
Against the background
of these developments in the first two quarters of 2013, an updated projection
of the fiscal accounts confirms that the underlying budgetary trends in the
first half of 2013 remain in line with the adjustment path established in the
EDP recommendation. However, taking into account the compensation for provident
and retirement funds in Cyprus Popular Bank (CPB) to ensure equal treatment
with such funds in Bank of Cyprus (BoC) following the conversion of deposits
into equity, the 2013 deficit is likely to be substantially higher than the
government deficit of 6.5% of GDP recommended by the Council (see Table 2)[5]. 
The first review mission
under the programme established that the rate of compensation will be no larger
than 52.5% of the total deposit balance held in CPB, based on a rate of
conversion of 47.5% of deposits into equity in BoC. This implies that the total
budgetary costs of compensation would amount to around 1.8% of GDP, of which
about half can be released by the time of the second review of the adjustment
programme. Based on the currently available information, it is expected that
the budgetary commitment can be fully accounted for in 2013. In this case, the
corresponding 2013 primary balance deficit would amount to around 4¼% of GDP
and the headline deficit would amount to around 8½% of GDP, thus exceeding the
2013 target set in the 16 May Council Recommendation. The Cypriot authorities
have committed to adopt the modalities of this scheme before the release of the
second tranche of assistance, after review by and consultation of the programme
partners. Due to its extraordinary one-off nature, the compensation for
provident and retirement funds would not impact on the budgetary outcomes in
the outer years, and the headline deficit for 2014 is projected to meet the EDP
target of 8.4% of GDP. Further, the EDP deadline for correction of the
excessive deficit in 2016 appears achievable based on currently available
information.
The 16 May Council
Recommendation focused on the headline balance targets and the bottom-up
effort, given the exceptional situation of highly uncertain macroeconomic
environment in Cyprus at that time, with structural balance estimates being
more uncertain and subject to variation over time than under more stable
macroeconomic conditions. Since Cyprus can be expected not to meet the 2013
target for the headline balance recommended by the Council, due to the
budgetary impact of the compensation of pension funds, a careful analysis
should be conducted in order to assess whether expenditure targets have been
met and the planned discretionary measures have been implemented. 
An in-depth bottom-up
assessment of the implemented fiscal measures is of particular relevance in the
case of Cyprus, since the Council Recommendation of 16 May 2013 explicitly
specifies also the recommended amount of discretionary consolidation measures.
An assessment of the consolidation measures that have a fiscal impact in the
years 2013 and 2014 is therefore required to assess if Cyprus has taken
effective action. 
Cyprus has
implemented fiscal consolidation measures in three different rounds. A first
set of measures was implemented in December 2012, including immediate cuts in
public sector wages and pensions. A second set of measures was adopted via the
2013 Budget Law in December 2012. After the MoU negotiations were finalised in
April 2013, a third round of measures was adopted. These measures were prior
actions and were implemented before the granting of the first disbursement of
financial assistance. 
Including the
effect of two additional measures that were not prior actions and that are
expected to be implemented by end-2013, consolidation measures with an
estimated direct deficit-reducing impact amounting to around 4.5% of GDP in
2013 and 2.2% in 2014 (see Table 3) will have been implemented. In both years,
the figures include a negative impact of -0.1% of GDP related to an
extraordinary dividend from a semi-government organisation, which is expected
to be successively reduced in 2013 and 2014. Table 4 gives an overview of the
main measures with budgetary impact in 2013 and 2014. 
For 2013 the
majority of consolidation measures are on the expenditure side. The 2.6% of GDP
of expenditure measures notably refer to sizeable reductions in social
transfers, public sector wage and pension cuts and reduced transfers to
state-owned enterprises and other semi-governmental organisations. On the
revenue side, the effort in 2013 amounts to close to 2% of GDP and comprised of
increases in both indirect taxes (VAT and excise duties on energy, alcohol and
tobacco) and direct taxes (e.g., tax on interest income, corporate income tax
and property tax).
Table 3: Fiscal consolidation measures, 2012-2014
 % of GDP || 2012 || 2013 || 2014 || 2013-2014 
 Total measures || 0.3 || 4.5 || 2.2 || 6.7 
 Revenue measures || 0.2 || 2.0 || 1.6 || 3.6 
 Expenditure measures || 0.1 || 2.6 || 0.6 || 3.2 
 Source: Commission staff estimates. 
For
2013, the Council recommended that the agreed consolidation measures should
amount to at least EUR 351mn (2.1% of GDP). These measures comprise first and
foremost an increase in the statutory corporate income tax rate to 12.5%
(expected to yield EUR 88mn), an increase in the tax rate applied to interest
income to 30% (EUR 97mn), and an increase in the bank levy to 0.15% (EUR 8mn).
As part of the prior actions, the immovable property tax was increased substantially
(expected to yield EUR 53mn), further wage and pension cuts were implemented
(EUR 8mn), social transfers to pensioners and for housing purposes were reduced
(EUR 47mn) and measures to control healthcare expenditure were introduced (EUR
16mn). Furthermore, the government streamlined social transfers by more than
the EUR 113mn required (additional EUR 78mn). While these additional savings
from social transfers were already included in the 2013 Budget Law, they were
not taken into account for the fiscal projection underpinning the Council
Recommendation of 16 May 2013. Hence, the agreed measures implemented amount to
more than EUR 351mn for 2013. 
For 2014, the
estimated direct deficit-reducing impact of the consolidation measures amounts
to 2.2% of GDP. On the expenditure side, the biggest impact comes from a
further cut of public sector wages and measures to contain the growth in social
transfers and health care expenditures. However, most of the effort comes from
the revenue side (1.6% of GDP) with further increases in indirect taxes (VAT
and excise duties on energy) and increases in contributions on wages and
pensions. The increases in 2013 in property tax, the tax on interest income and
VAT reach their full-year effects only in 2014, contributing to the
revenue-bias of the fiscal effort in that year.
Under the
updated fiscal and macroeconomic projections, Cyprus would achieve a budgetary
impact for 2014 of more than the EUR 270mn recommended by the Council by fully
implementing the agreed fiscal measures. Public sector wages and pensions will
be cut by another 3% (expected to yield EUR 53mn) and social transfers will be
further streamlined (EUR 29mn). The scaled temporary contribution of up to 3.5%
on wages and pensions will be extended until the end of 2016 with the
introduction of a new band at the lower end (EUR 58mn), and the contribution to
the General Social Insurance Scheme will increase by 0.5 pps for both employers
and employees (EUR 43mn). Further hikes of the standard and reduced-rate VAT and
the full year effect of the 2013 VAT increase are estimated to contribute a
sizeable amount (EUR 67mn), and so does another increase in the excise duties
on petrol and gasoil by 5ct/litre (EUR 30mn). Finally, savings are expected
from the increase in the bank levy to 0.15% reaching its full-year effect (EUR
9mn) and from the introduction of a fee on monthly transportation cards for
students and pensioners (EUR 10mn). 
In spite of
their implementation, some measures on the revenue side are expected to underperform.
For example, a shortfall will likely occur for the withholding tax for interest
income, where for constitutional reasons, the increase was enacted only as of
29 April 2013 instead of 1 January 2013. Also the yield of the increase in the
bank levy (paid by credit institutions) has been revised downwards, due to a
change in legislation, which effectively reduced the tax base for 2013 in order
to avoid financial institutions paying levy on a deposit base substantially
higher than the current amount of deposits. With regard to the motor vehicle
tax reform, generating additional revenues turned out more difficult than
anticipated due to Cyprus' steeply deteriorating motor vehicle market, but it
was agreed to cover the shortfall by compensatory measures. 
Table 4: Main discretionary budgetary measures with
budgetary impact in 2013 and 2014 
 2013 (% of GDP) || Expenditure || Revenue 
 December 2012 || ·   Public sector wage and pension cuts (-0.9%) ||   
 2013 Budget law || ·   Reduction in outlays for social transfers (-1.0%) ·   Reduction in transfers to SOEs and in budgetary appropriations to semi-governmental organisations    (-0.3%) ·   Reduction of allowances to public sector employees          (-0.1%) ·   Freezing pensions under the General Social Insurance Scheme (-0.1%) || ·  Increases in excise duties on energy, tobacco and alcohol products (0.3%) ·  Increase in the standard VAT rate (0.2%) 
 April 2013 prior actions || ·  Reduction in outlays for social transfers (-0.3%) ·  Measures to control health care expenditure (-0.1%) || ·  Increase in the tax rate on interest income (0.6%) ·  Increase in the corporate income tax rate (0.5%) ·  Increase in property tax (0.3%) 
 2014 (% of GDP) ||   ||   
 2013 Budget law || ·  Public sector wage and pension cuts (-0.4%) ·  Reduction in outlays for social transfers (-0.2%) || ·  Increases in the standard and reduced VAT rates (0.4%) ·  Increase in excise duties on energy products (0.2%) ·  Extension of the temporary contribution on wages and pensions (0.4%) ·  Increase in the contribution to the General Social Insurance Scheme (0.4%) 
 April 2013 prior actions || ·  Measures to control health care expenditure (-0.1%) || ·  Increase in the tax rate on interest income (0.1%) ·  Increase in the corporate income tax rate (-0.2%) ·  Increase in property tax (0.1%) 
 Note: A positive sign implies that revenue / expenditure increases. Only measures yielding more than 0.1% of GDP are listed, which explains discrepancies with Table 3. The loss in tax income due to public sector wage and pension cuts and increases in contributions is not accounted for in the numbers. In total, the loss amounts to 0.3% of GDP for 2013 and another 0.3% for 2014. Source: Commission staff estimates. 
Summing up, expenditure
targets have been met, the discretionary measures on the revenue side have been
implemented and the agreed consolidation measures are currently assessed to
amount to more than the required EUR 351mn in 2013 and EUR 270mn in 2014. Thus,
the in-depth bottom-up assessment of measures that have a fiscal impact in 2013
and 2014 suggests that Cyprus has taken effective action with regard to the 16
May Council Recommendation. 
The exceptional
situation of highly uncertain macroeconomic environment in Cyprus makes it difficult to accurately estimate the fiscal effort in structural terms.
Moreover, as noted in the analysis of the Commission services[6], swings in
potential growth estimates are quite strong in the case of Cyprus, and the variation over successive forecasts in the contributions to potential
growth from total labour, capital accumulation, and productivity (TFP) has been
large. These
shifts in estimated potential output and the highly uncertain macroeconomic
conditions
imply a corresponding impact on the estimated structural effort, even when
no changes occur to the budgetary execution or the implementation of individual
consolidation measures. 
Nevertheless, the
recommended headline balance targets under the April Programme Forecast implied
an estimated structural fiscal effort of 1.3% of GDP in 2013 and of 0.3% in
2014. Under
the updated July Programme Forecast a worse labour market projection impacts
negatively on potential output which was revised downwards by 0.4 pp. in 2013
and 0.6 pp. in 2014[7]. This, in
turn, reduces the estimated output gap in both years. As a result, given the
unchanged projection of real GDP growth, the cyclical component is estimated as
less negative than in the April Programme Forecast. Thus, the structural
improvement for 2013 and 2014 ("Uncorrected fiscal effort") is
slightly lower than implied in the 16 May Council Recommendation (see Table 5).
Correcting
for the revision of potential output growth ("α"), the
fiscal effort improves to 1.3% and 0.4% for 2013 and 2014[8]. 
Table 5: Change in the structural balance corrected for
revisions in potential output gap and revenue windfalls/shortfalls 
 Uncorrected fiscal effort || Fiscal effort corrected for α || Fiscal effort corrected for α and β || Average implicit fiscal effort recommended (2013-2014) || Deadline for correction 
 2013 || 2014 || 2013 || 2014 || 2013 || 2014 || 0.8 || 2016 
 1.2 || 0.1 || 1.3 || 0.4 ||  0.9 || 0.7 
Source: Commission
services
In contrast, tax revenue
elasticities appear slightly lower in 2013 and slightly higher in 2014,
compared to the April Programme Forecast, which leads to a reduction of the
corrected fiscal effort in 2013 of 0.4% and an increase in 2014 of 0.3%. The
assessment of the yield of certain revenue measures has been revised down for
2013. This includes those revenue measures, where the implementation was
delayed (see above) and where the full-year effect therefore materialises only
in 2014. Hence, while the agreed amount of total discretionary measures have been
implemented by the Cypriot authorities, the downwards adjustment of the effect
of discretionary revenue measures is predominantly driven by a shift in timing
of revenue collection as several revenues foreseen for 2013 in the April
Programme Forecast were shifted to 2014 in the July Programme Forecast. 
Correcting for both of
these effects ("α"
and "β"), the fiscal effort amounts to 0.9% and 0.7% in
2013 and 2014. On average, the corrected fiscal effort for 2013-2014 is
therefore in line with the implicitly recommended effort.
3.2.        Budgetary prospects for
2014-16
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 is to achieve a strengthening of
the primary balance over the programme period and a further strengthening in
the years that follow. The authorities are bound to stand ready to preserve the
programme objectives by taking additional measures in the event of fiscal
underperformance, taking into account adverse macroeconomic effects. 
On the revenue side,
fiscal performance in the programme years is expected to reflect broadly the
macroeconomic developments. Specifically, revenues from taxes on production and
imports are expected to be in line with trends in nominal private consumption,
with a sizeable drop in 2014 followed by a steady rebound in 2015 and 2016.
Similarly, the collection of direct taxes is expected to initially follow a
decreasing trend. Social contributions are expected to be on a downwards trend
in 2014 and 2015 and start increasing again in 2016, reflecting the
developments in employment and wages.
On the expenditure side,
total expenditure is expected to be kept tight, despite the increased
unemployment. Specifically, the compensation of employees is projected to
decline throughout the programme period, both due to the reduction of employees
and the reduction of wages and allowances. Moreover, the reform of the welfare
system is expected to contain the growth in social transfers. Public investment
is expected to be reduced even further in 2014, but then to increase again in
2015 and 2016, along with the amelioration of the overall macroeconomic
conditions. Lastly, only minor fluctuations in interest payments are expected
throughout the programme period.
All in all, the annual
targets established in the Council recommendation are projected to be met,
leading to a correction of the excessive deficit by 2016.
3.3.         Budgetary
framework and fiscal structural measures
The adoption and
implementation of fiscal-structural measures are critical to achieve a
permanent consolidation 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. 
Moreover, the
implementation of the fiscal-structural measures specified in Decision
2013/236/EU will support the achievement of long-term sustainability of public
finances. The fiscal-structural measures are far-ranging and comprise, inter
alia, establishing a medium-term budgetary framework, undertaking reforms of
the pension, health care and welfare system as well as the revenue
administration, and ensuring improvements to the public finance management and
the functioning of the public sector. 
Significant pension
reform measures were implemented as of 1 January 2013. An actuarial study is
underway to help decisions on further reforms to ensure the long-run viability
of the national pension system. 
For healthcare reform,
an updated actuarial study of the National Health System (NHS) has now been
completed, leading to the implementation of a financially sustainable NHS by
end-2015. In the meantime, co-payments for using public healthcare services
have been introduced, expected to raise revenues and to control demand, while
eligibility for free public healthcare has been constrained, particularly
through the introduction of a compulsory health care income-based contribution
for public sector employees and pensioners. Also, efficiency increasing
structural measures have been initiated; these include the re-organisation of
hospitals, the introduction of protocols and clinical guidelines and the
introduction of an IT-infrastructure. 
A reform plan was
announced by the government that will form the basis for a comprehensive reform
of the welfare system, to be prepared in stages and enter into force on 1 July
2014. The reform aims to provide better protection of vulnerable groups, to
ensure efficient use of public funds within the welfare system, while at the
same time ensure balance between welfare benefits and incentives to take up
work. The authorities' reform plan makes clear that the reformed welfare system
must be consistent with the programme's fiscal targets. In a situation where
the total spending envelope for social protection may have to be reduced in the
coming years, the authorities have decided that priority should be given to
protecting the most vulnerable people and that sufficient budgetary means for
fundamental social policies should be ensured. The core of the reform is
therefore the introduction of a guaranteed minimum income (GMI) scheme together
with the elimination of duplicate benefits.
In public finance
management, the Fiscal Strategy Statement adopted for the first time in May
2013 was a step forward in better fiscal planning. Meanwhile, the authorities
decided to adopt an umbrella law covering budgetary processes in the broad
sense, which would rescind the MTBF law and would also encompass the provisions
grounding the Fiscal Council. To improve the effectiveness and efficiency of
the revenue administration, the Cypriot authorities agreed to implement
a comprehensive reform. Under the reform, a new integrated tax department
covering direct and indirect taxes will be established and a compliance
management strategy will be implemented. Lastly, work on public administration
reform has been initiated with the reduction of impediments to staff mobility
and the change of working hours. An independent external review has been
commissioned, to identify further areas of public administration reform.
3.4.        Public debt
Public debt rose by
almost 10 pp. in 2011 and in 2012, reaching almost 71.1% of GDP in 2011 and
85.8% of GDP in 2012, mostly driven by higher stock-flow adjustments related to
the government's participation in the recapitalisation of one commercial bank
in June 2012. In addition, higher-than-expected deficit outcomes in the past,
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-to-GDP ratio.
The general government's
gross debt stock remained broadly stable over the four first months of 2013,
reflecting favourable fiscal developments. The Cypriot authorities announced on
27 June an exchange of some EUR 1bn of domestic-law bonds held by residents
(higher than foreseen in April) with new bonds maintaining the same coupon
rates. This exchange was completed on 1 July 2013. Further, the first
disbursement of programme money by the ESM and the IMF took place in May and
June 2013, amounting to EUR 2.1bn and EUR 1bn, respectively as was foreseen in
April. In the absence of significant long-term debt maturities, debt redemption
in the first half of 2013 was linked almost exclusively to short-term
obligations. The first disbursement provided the Cypriot authorities with
sufficient funds to cover needs for debt service and deficit financing until
the next cash disbursement foreseen by the end of the fourth quarter 2013.
During the second quarter, funds were used to reimburse in particular the
foreign-law bond worth EUR 1.4bn which matured on 7 June and to cover fiscal
needs of about EUR 300m. Hence, the government's cash buffer has also increased
and will be sufficient to cover estimated third quarter fiscal financing needs
of between EUR 600 and 700m. 
The fiscal
consolidation implies that the improvement in the primary balance over 2013-16
will eventually contribute to reducing the debt ratio, in spite of the rather
strong debt-increasing effects from interest expenditure and the projected
recession (see Table 6). Provided that the budget execution remains on
track, the debt-to-GDP ratio can be expected to reach 115% at the end of 2013
and to around 127% 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 is set to start falling to around 123% of GDP in 2016. This
is in line with the April Programme Forecast and the debt sustainability
assessment presented. 
Table 6: Public debt
trajectory 2013-2016 under the updated Programme Forecast 
   || 2012 || 2013 || 2014 || 2015 || 2016 
 Gross debt ratio (% of GDP) || 85.8 || 115.0 || 123.2 || 126.9 || 122.5 
 Changes in the ratio (pp.) || 14.7 || 29.2 || 8.2 || 3.6 || -4.4 
 of which ||   ||   ||   ||   ||   
 (1) Primary balance (pp.) || 3.1 || 4.2 || 4.3 || 2.1 || -1.2 
 (2) Snowball effect (pp.) || 3.6 || 11.7 || 7.6 || 1.0 || -0.5 
 Interest expenditure (pp.) || 3.2 || 4.1 || 4.3 || 4.1 || 4.2 
 Growth effect (pp.) || 1.8 || 8.2 || 4.6 || -1.3 || -2.4 
 Inflation effect (pp.) || -1.4 || -0.6 || -1.3 || -1.8 || -2.2 
 (3) Stock flow adjustment (pp.) || 8.1 || 13.3 || -3.6 || 0.6 || -2.7 
 Source: Commission staff estimates. 
4.           Fiscal adjustment Path
The Council
Recommendation of 16th May 2013 was based on the Commission 2013
Spring Forecast. The updated fiscal and macroeconomic projections in the
context of the July review of Cyprus' programme are largely unchanged compared
to the Commission 2013 Spring Forecast.
Given that the deviation
from the headline target set in the 16 May Council Recommendation is explained
by the extraordinary one-off compensation of provident and pension funds in
CPB, no additional measures appear needed at this stage. 
At present, Cyprus continues to
rigorously implement the 2013 Budget Law and the agreed additional
consolidation measures, which at this point in time are assessed to amount to slightly
more than the required EUR 351mn in 2013 and at least 270mn EUR in 2014. The situation
will have to be monitored closely and further corrective action would have to
be taken early on if deviations from budgetary plans were to materialise. The total
amount of fiscal policy measures required to underpin the 2014 budgetary
targets will be assessed in the context of the 2014 Budget Law consultation.
For 2015-2016, Cyprus should achieve a deficit in the 2015 general government
primary balance of no more than EUR 344mn (2.1% of GDP) and a surplus in the
2016 general government primary balance of at least EUR 204mn (1.2% of GDP),
which under the updated programme forecast will require further measures to be
specified in the outer years. 
Table 7: Baseline scenario
(Commission 2013 Spring Forecast) 
 % of GDP (unless indicated otherwise) || 2012 || 2013f || 2014f || 2015f || 2016f 
 Revenues || 40.0 || 40.6 || 39.1 || 39.4 || 40.8 
 Current revenues || 39.9 || 40.6 || 39 || 39.4 || 40.7 
 Discretionary measures with impact on current revenue (EUR bn) || 0.362 || 0.631 || 0.167 || -0.021 || -0.027 
 Expenditure || 46.3 || 47.1 || 47.5 || 45.7 || 43.7 
 Nominal GDP (EUR bn) || 17.9 || 16.4 || 16.0 || 16.4 || 17.0 
 Nominal GDP growth || -0.5 || -8.2 || -2.9 || 2.6 || 3.7 
 Real GDP growth || -2.4 || -8.7 || -3.9 || 1.1 || 1.9 
 Potential GDP growth || -1.3 || -2.6 || -2.5 || -2.3 || -1.6 
 Structural balance || -6.7 || -5.4 || -5.1 || -4.4 || -2.5 
 Primary balance || -3.1 || -2.4 || -4.3 || -2.1 || 1.2 
 General government balance || -6.3 || -6.5 || -8.4 || -6.3 || -2.9 
 p.m CAB methodology revenue elasticity || 1.0 || 1.0 || 1.0 || 1.0 || 1.0 
 p.m Apparent revenue elasticity || 9.5 || 1.9 || 1.4 || 1.3 || 2.0 
 p.m Output gap (% of potential output) || 0.0 || -6.2 || -7.6 || -4.3 || -0.9 
Source:
Commission staff estimates; f: forecasted data
Table 8: Updated
Programme Forecast, July 2013
   ||   || 2012 || 2013 || 2014 || 2015 || 2016 
 Potential Growth (annual % change) || PF April || -1.3 || -2.6 || -2.5 || -2.3 || -1.6 
 PF July || -1.4 || -3.0 || -3.1 || -2.7 || -2.0 
 Actual Growth  (annual % change) || PF April || -2.4 || -8.7 || -3.9 || 1.1 || 1.9 
 PF July 
 Output gap (% of potential GDP) || PF April || 0.0 || -6.2 || -7.6 || -4.3 || -0.9 
 PF July || 0.1 || -5.8 || -6.6 || -3.0 || 0.8 
 Source: Commission staff estimates; PF April: Commission 2013 Spring Forecast; PF July: Commission's most recent forecast underlying the revised MoU from July 2013. 
5.           Conclusion
Based on currently
available information, it appears that Cyprus remains on track towards
correcting the excessive deficit by 2016 as recommended by the Council on 16
May 2013. 
The current forecast
suggests that, due to the compensation of provident and pension funds in Cyprus
Popular Bank, the headline deficit target for 2013 will not be achieved.
However, the underlying budgetary trends and the execution of the 2013 budget
remain in line with the adjustment path established in the EDP recommendation.
Given the extraordinary nature of the pension funds compensation, the EDP
deadline for correction of the excessive deficit in 2016 appears achievable
based on currently available information.
Further, an in-depth
bottom-up analysis shows that Cyprus has adopted sizeable consolidation
measures with a direct deficit-reducing impact in 2013 of around 4.5% of GDP
and around 2.2% of GDP in 2014. In line with the Council Recommendation, Cyprus continues to rigorously implement the 2013 Budget Law, has met expenditure targets
and implemented the agreed discretionary consolidation measures, which are
assessed to amount to more than the required EUR 351mn in 2013 and EUR 270mn in
2014.
[1] OJ L 186, 20.7.2010, p. 30. 
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] Commission Staff Working Document accompanying the 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, 7.5.2013.
[3] On 14 August, a Q2 GDP flash estimate was released by ESTAT. Since
it was published after the finalisation of the macroeconomic forecast by the
programme partners and due to its flash nature, this preliminary figure has not
been taken into account. The programme projection will be reviewed and updated,
if needed in the context of the second review mission.  
[4] CYSTAT publishes accrual data (ESA95) for the General Government on
a quarterly basis. For monitoring purposes, the Ministry of Finance establishes
quarterly targets in ESA95 terms which are in accordance with the annual EDP
targets.
[5] In the Memorandum of Understanding on Specific Economic Policy
Conditionality for Cyprus' adjustment programme (as approved on 24 April 2013 by
the ESM Board of Governors) was explicitly mentioned that "the 2013
deficit target may be revised to incorporate compensation for provident and
retirement funds in Cyprus Popular Bank to ensure equal treatment with such
funds in Bank of Cyprus following the conversion of deposits into equity".
It was moreover agreed that "given the social welfare nature of provident
and retirement funds, the Cypriot authorities will use the necessary amount out
of programme financing for such compensation". For this purpose,
indicative financing of close to 2.5% of GDP was earmarked for the third
quarter of 2013 in the assessment of Cyprus' financing needs (note to the ESM
pursuant to Article 13.1 of the ESM Treaty). At the time of adopting the
Council recommendation, the budgetary impact of this compensation could,
however, not be established with precision, since it would depend on the
conversion rate to be determined for deposits in BoC. The primary and headline
balance deficit targets for 2013 were therefore set without explicitly taking
into account the budgetary impact of this compensation.
[6] Commission Staff Working Document accompanying the 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, 7.5.2013.
[7] The revision of the labour market forecast is driven both by a
larger fall in employment and a significant upward revision of unemployment.
[8] For an explanation of the methodology of calculating the corrected
structural fiscal effort, please consult http://ec.europa.eu/economy_finance/publications/occasional_paper/2013/op151_en.htm