Cyprus Business Forecast Report Q3 2009

Cyprus Braced For Recession

There is growing evidence that the disastrous external economic climate is now having a real impact in Cyprus. Though headline national accounts data for 2008 remained relatively strong, a sharp deterioration in Q4 hints at the dominant trends this year. News emerging from the key tourism and construction sectors is decidedly downbeat. Furthermore, early data show retail activity dwindling, industrial output in freefall and unemployment soaring; all of which support our below-consensus view that Cyprus will enter into a sharp recession this year. We retain our forecast for negative GDP growth of -1.8% in 2009, with a modest recovery to 0.8% in the following year. Despite this bleak outlook, we see Cyprus continuing to outperform the eurozone average, with annual growth returning above 3% by 2012.

We remain convinced that this is the best chance in many years for finding a workable solution to the divided island. However, encouraging progress to date could yet be unravelled by heightened political instability on both sides of the island. In the ethnic Turkish northern Cypriot region, legislative elections are expected to bring the conservative opposition party, which opposes reunification with the south, into power, potentially with an absolute majority in parliament. Though President Mehmet Ali Talat will remain in charge of negotiations, an unsupportive government will be a major obstacle to reaching an agreement. Whereas in Nicosia, fractures in the governing coalition could also threaten the more conciliatory approach to settlement talks of late. In both cases, a worsening economic climate will also make it harder to encourage compromise. These growing risks have prompted us to revise our short-term political risk rating to 69.6 (from 71.2).

A silver lining to the coming economic slump can be found in falling inflation and current account pressures. Stagnant domestic demand should keep CPI below 1% for much of the year, while also helping to bring down the external deficit via weaker demand for imports. However, in both cases, international prices of oil and crops play a pivotal role, thus creating a significant degree of uncertainty in our forecasts. We expect inflation to remain above the eurozone average throughout our medium-term forecast period. Structural reforms to improve local competitiveness and boost productivity will be key to coping with external risks beyond the government's control.

Cyprus's business environment continues to improve as the country furthers its integration in the eurozone economy. However, investment activity in Cyprus will continue to be weighed down by the island's political problems and economic imbalances, which are a major deterrent for investors. In addition, the traditionally important sector of tourism is suffering from a decline in competitiveness relative to other popular destinations, and is expected to be hit hard in 2009. The banking sector - which has been developing rapidly in recent years - has weathered the financial storm so far, but will continue to come under strain from external risks, particular from neighbouring Greece.