Cyprus Business Forecast Report Q4 2009

Sticking To Our Recession Outlook The economy of Cyprus has so far shown considerable resilience to the global economic crisis, being one of only two EU states to post positive annual real GDP growth in Q109. Nonetheless, the economy has suffered a sharp slowdown in growth from recent years, which would have been even more pronounced had it not been for the intervention of the government. Ongoing weakness in domestic demand will drag the economy into a recession this year, in our view. With this in mind, we retain our target for -1.8% economic growth in 2009, though acknowledge the upside risks given the data so far this year. Our below-consensus forecast is based largely on the assumption of further deterioration in the critical tourism and property industries in the coming quarters. We expect the economy to recover from 2010, continuing to outperform the eurozone average over our five-year forecast period.

Negotiations between Dimitris Christophias and Mehmet Ali Talat - the respective leaders of the ethnic-Greek and ethnic-Turkish communities - continue, though with few tangible breakthroughs.

There is still hope among all involved that an agreement can be reached this year, but we see this as unlikely given ongoing divisions. We believe conditions continue to be the most positive for a resolution since 2004, but the window of opportunity is closing as presidential elections in North Cyprus next year could remove Talat from the equation. Just as important is Turkey's role: Ankara continues to support the regime in the northern part of the island, and could encourage a breakthrough to boost its own EU membership ambitions.

Cyprus will emerge from this economic downturn with twin fiscal and current account deficits.

Tumbling revenues and a large fiscal impulse will take the budget deficit over the Maastricht Treaty's 3% ceiling in 2009, with entrenched spending making it very difficult to bring the budget back into balance. Measures to cut tax evasion and boost revenues are positive for the future of public finances, though this will have little impact in the short term, in our view. At the same time, it is important to remember that Cyprus' deficit and debt position is relatively healthy compared to many EU states, which will limit the immediate risks to stability.

Cyprus continues to hold a status as a regional financial hub, due to its strong rule of law, eurozone membership and extremely low corporate tax rate (10%). However, investment activity 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, particularly from neighbouring Greece.