03 Jan 2016 Cyprus economic outlook for 2016

Cyprus should enjoy its second year of growth in 2016. In the monthly Sapienta Country Analysis Cyprus, we are forecasting real GDP growth of 1.9%, after an estimated 1.5% in 2015. However, much will depend on a continuation of the factors that drove growth in 2015, in particular deflation and a strong sterling.

Deflation likely to end

Sapienta Economics expects an EU-harmonised inflation rate of 0.2% in 2016 after deflation of around 2% in 2015, mainly owing to a 13.6% drop in prices of petroleum products. Oil prices have a significant impact as more than 95% of electricity comes from burning diesel and heavy fuel oil. Oil prices also affect the cost of road transport and construction materials.

The jury is still out about the direction of oil prices in 2016. Saudi Arabia’s budget is coming under pressure, therefore the world’s largest producer could decide to cut production in order to restrict supply and push up prices. Either way, even if prices stay as low as they are today, at around $37 per barrel, they are unlikely to fall much further. This means that the deflationary effect will be smaller in 2016.


Consumer-led demand in 2016

We expect growth in 2016 to be driven mainly by domestic demand – household and government consumption and fixed investment – and less so by external demand. The University of Cyprus Economic Sentiment Indicator (ESI), which has proven to be a good predictor of growth, continues to be positive (above 100), although the 106.3 index in November was slightly lower than in the previous month, underling that the recovery is still a little fragile. According to the ESI, consumers have recently begun to expect their financial situation to improve. Household consumption accounts for almost 70% of GDP, so once households start spending more, the whole economy tends to grow, although the rising imports that accompany higher consumption also act as a drag on growth.

Government consumption, the second biggest category after households at 15.8% of GDP, is also expected to expand in the run-up to the parliamentary elections in May. We might even see some growth in fixed investment in 2016 after many years of steep decline. It has been rather volatile on a quarterly basis, but housing investment has already started to climb consistently, jumping by 18.4% year on year in the third quarter of 2015, albeit from a low base.

We expect the contribution of exports (net of imports) to be minimal in 2016. Transport and re-exports of goods are still under pressure owing to low oil prices, and rising imports will dampen the overall net exports.


The sector winners in 2016

Professional services should again be the fastest growing sector in 2016. While media attention tends to focus on tourism and retail, the lawyers and accountants have weathered a range of internal and external shocks. The sector surged by 5% on average in the first three quarters of 2015, compared with 1% for the economy as a whole. New opportunities are opening up as a result of the double taxation agreement with Iran, so we expect this sector to continue expanding.

Tourism arrivals rose by 8.2% in January-November 2015. However, the rise was largely because of strong sterling, which appreciated by almost 10% between January and November and pushed up UK arrivals (40% of the total) by 19%. The euro has climbed almost 5% against sterling since its low of 0.699 on November 17, so next year may be tougher for the UK market. Expanding air routes, helped by the closure of Cyprus Airways, will offset this to some extent.

Retail trade is likely to be mixed. The sector as a whole grew by 3% in January-September but the performance was uneven. Those selling computer equipment and electrical goods did well, whereas food sales rose by only 0.7% and the subsector that includes clothing declined slightly. Moreover, much of the expansion in volume might have been the result of falling prices.


The long arm of the crisis

The very steep decline of investment in 2009-14, combined with high corporate and household debt, will take many years to work through. Whether Cyprus can maintain growth rates of around 2% (its 20-year average) in the medium term depends critically on an increase in productive capacity.

This will partly depend on a strong recovery in machinery and equipment investment, which in turn is likely to depend on an expansion credit to the business sector. Household and corporate deleveraging will also be important. While this has a negative impact on demand in the short term it will have a positive impact in the longer term by encouraging banks to lend again.

Natural gas production, which remains many years away, will have a minimal impact on the economy in 2016.

Local pressure

Upward pressure on prices could also come from Cyprus. Services prices have already started to climb, probably as a result of rising demand.

As noted, the end of deflation also means that there will be less disposable income in consumers’ pockets, which could have a negative impact on retail, although this could be offset by overall increasing demand.


Unemployment stays in double digits

We expect the unemployment rate to drop to 15.1% from an estimated 15.5% in 2015. The rate will not fall below double digits any time soon, even if the labour force continues to shrink as non-Cypriots leave and Cypriot students stay in countries like the UK after graduating.

According to the Sapienta Economics unemployment model, Cyprus would need growth rates of above 3% to cut the unemployment rate below 10% by 2019. The only chance of achieving these kinds of growth rates would be with a solution of the Cyprus problem.


Impact of a Cyprus solution

Even if a solution is achieved in 2016, the impact on growth will take time to be felt. There could be an initial upsurge in sentiment, and the new federal government will need to start spending money on shifting certain responsibilities from the central government to the constituent states.

However, the main impact will start to be felt around two years after a solution as the whole of Cyprus opens up to the massive new market in Turkey, the real estate market is normalised and investment to upgrade Famagusta and revitalise Varosha accelerates.