Eurozone. EY Eurozone Forecast September 2014

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1 Eurozone EY Eurozone Forecast September 214 Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Latvia Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain

2 Outlook for Cyprus Return to growth expected in 215 Finland Estonia Latvia Ireland Netherlands Germany Belgium Luxembourg France Italy Austria Slovenia Slovakia Portugal Spain Greece Malta Cyprus Published in collaboration with

3 Highlights GDP growth After an expected 2.6% contraction this year, we now forecast that the Cypriot economy will return to growth in 215, as a better-functioning banking system provides some support to domestic activity and overall confidence improves. Exports should also get a boost from a resilient tourism sector and an increase in demand from abroad. As a result, we forecast GDP growth of.5% in 215. While there are signs that the recession is starting to bottom out, the economy is nevertheless suffering. The near collapse of the banking sector has left deep scars the latest quarterly GDP contraction in Q2 214 was the 1th in a row. By the time the economy returns to growth, GDP is expected to be around 1% below its pre-crisis highs % GDP growth Although the outlook is expected to brighten, the risks remain skewed to the downside. While the banking sector has stabilized and all domestic capital controls have been lifted, the financial sector is still weak and is expected to weigh on growth. Looking further ahead, the rise in nonperforming loans (NPLs) is also a major challenge. And the downturn in Russia, the source of 25% of visitors to Cyprus in 213, is another key risk. But in spite of the major problems facing the economy, Cyprus continues to receive positive reports from its official lenders, with the Government outperforming all of its fiscal targets by a comfortable margin. But the risk of reform fatigue means that the improvement in the fiscal position could slow % While the labor market has shown some signs of stabilizing, unemployment was still above 15% in June and falling wages remain unsupportive for consumption. Overall, we expect household spending to grow by just.4% next year and then.6% in 216. With fiscal consolidation still in full effect, we expect government consumption to fall by around 1.5% this year. 214 Unemployment 15. 9% Consumer prices % EY Eurozone Forecast September 214 Cyprus 1

4 Return to growth expected in 215 GDP to fall 2.6% this year, but return to growth in 215 Cyprus economy remains stuck firmly in recession, with the flash estimate for Q2 214 showing that GDP contracted by.3% on the quarter, the 1th consecutive quarterly decline. However, the economy is holding up much better than had been feared initially after the collapse of the banking sector in early 213, with signs that the recession is bottoming out. We now expect the economy to contract by 2.6% this year and then return to growth of.5% in 215 compared with our June forecasts of 4.3% and.5% respectively. This improving outlook reflects the ongoing healing of the financial sector, which should start to be more supportive of household spending and investment, improving confidence boosting spending, and greater demand from abroad which should continue to lift tourism. boosted by a healing banking sector The stabilization of the banking sector has been impressive deposit withdrawals have stopped and the progress made has allowed policy-makers to remove all domestic capital controls. But many challenges remain. NPLs continue to rise, placing a strain on bank balance sheets and constraining lending. They now represent more than half of total loans and are equal to 14% of GDP. While the central bank has developed a framework to handle loan-restructuring negotiations, progress has been relatively slow there is little incentive either for banks to acknowledge bad assets or for consumers to pay back loans on negotiated terms. We expect the challenge of non-performing assets to be resolved in an orderly manner, but, given the scale of the task, a write-off is a risk. And by destroying confidence and encouraging further defaults, this could mean that the outlook for Cyprus might worsen again. Domestic activity will remain subdued Domestic demand will stay weak in the short term and be constrained over the next few years. Given the relatively muted upturn in economic activity, the unemployment rate is expected to stay above 15% for the next two years, before falling to about 12% in 218. Table 1 Cyprus (annual percentage changes unless specified) GDP Private consumption Fixed investment Stockbuilding (% of GDP) Government consumption Exports of goods and services Imports of goods and services Consumer prices Unemployment rate (level) Current account balance (% of GDP) Government budget (% of GDP) Government debt (% of GDP) ECB main refinancing rate (%) Euro effective exchange rate (1995 = 1) Exchange rate (US$ per ) EY Eurozone Forecast September 214 Cyprus

5 Even those in jobs are feeling the pinch wages continue to fall (down nearly 9% on the year in Q1). Combined with the negative wealth effects of falling property prices, this continues to undermine household spending. Although consumption has been relatively resilient to the headwinds facing the economy, it has largely been supported by consumers drawing down their savings. As this cannot continue indefinitely, we see consumption losing some of its momentum in the short term. That said, and consistent with our improving GDP forecast, we expect consumption to increase by.4% in 215 (compared with the fall of 2% forecast in our last report). This reflects an improving confidence outlook and a betterfunctioning financial system. Investment has fallen drastically since the onset of the crisis, with the malfunctioning banking sector and reduced capital spending in the public sector causing falls of around 2% in both 212 and 213. We expect another large decline this year, with official statistics showing an annual fall of 18% in Q1. As the economy finally returns to growth and firms face a slightly more conducive environment, we expect investment to increase in 215 (although only by 2.4%). Trade to provide a boost and fiscal adjustment going well Following on from last year, we expect net trade to make a positive contribution to growth in 214 and 215 with subdued domestic demand limiting imports and the fall in exports arrested by a resilient tourism sector. However, increasing household spending and investment should start to provide a boost to import volumes, which we expect to increase by 4.9% next year. Alongside the admirable progress made in cleaning up the financial sector, Cyprus has also taken large strides in its fiscal consolidation program. It has exceeded many of the targets imposed by its official lenders, the International Monetary Fund (IMF), the European Central Bank and the European Commission. But public debt remains high (over 11% of GDP last year) and the IMF has warned that further policies need to be implemented if the Government is to hit its target of a primary surplus of 4% of GDP by 218. The IMF also suggested that these savings could be made in the public sector wage bill and reforms to education and pensions. Figure 1 Real GDP growth % Year 8 Forecast Figure 2 Real consumption and investment growth % Year 2 Forecast 6 4 Cyprus 15 1 Investment Eurozone 5 1 Consumption Table 2 Forecast for Cyprus by sector (annual percentage changes in gross added value) GDP Manufacturing Agriculture Construction Utilities Trade Financial and business services Communications Non-market services EY Eurozone Forecast September 214 Cyprus 3

6 Return to growth expected in 215 The economy has escaped deflation, but risks remain The economy appears to have escaped deflation, with consumer prices rising on an annual basis since June and hitting 1.2% in July 214. This is the highest level since October 212 and follows eight successive months of decline. With the euro expected to depreciate and Cyprus economy not as weak as previously expected, we now forecast that consumer prices will rise by.8% on average this year (up from.3% projected in June). Although the threat of deflation has eased, a return to falling prices cannot be ruled out given the highly uncertain outlook. Depressed demand, fiscal austerity, the path of the euro and falling energy prices all represent clear risks to our inflation forecast. If Cyprus were to face a deflationary episode, that would have significant downside effects on our growth forecasts. Falling prices would increase the real level of existing debts raising the burden on the heavily indebted private and public sectors. Deflation would mean that nominal GDP stagnates or even shrinks, contributing to a rise in the debt-to-gdp ratio and implying that the Government would have to cut even further to meet its fiscal targets. The health of the financial sector also represents a key risk. While private sector deposits have stabilized, they remain well down on pre-crisis highs, and are likely to stay that way until the banks return to full health. Aside from limiting the funds that are available for investment, they are also indicative of a general mistrust of the state of the financial sector. Our forecast assumes that the deleveraging process and the resolution of NPLs happen at a modest pace but if this is more drawn out, there is a chance that the return to growth could be delayed. Finally, on the external side, the main downside risk stems from the impact of geopolitical tension in Ukraine on Russia. With the Russian economy expected to contract by.1% this year and the West and Russia imposing sanctions and counter-sanctions, there is a risk that tourism could suffer significantly. Russia accounted for around 25% of all tourist arrivals to Cyprus in 213. Longer-term growth powered by gas Although we expect the Cypriot economy to exit recession next year, the damage caused will mean that the economy will be more than 1% smaller than its pre-crisis peak. And growth is likely to be modest as the economy suffers with a hangover from the credit crunch. But there are some drivers that could lift growth, particularly in the medium term. Tourism and business services have remained strong, while gas reserves (due to come on-stream in 218) should provide a boost to exports and investment. In addition to the Aphrodite field, which is thought to hold some trillion cubic feet of gas, Cyprus has recently signed a memorandum of understanding with an Italian- Korean energy consortium to drill for further offshore gas resources this could be supportive of more dynamic growth. Figure 3 Inflation Figure 4 Current account deficit % Year 5 4 Cyprus Forecast 5 b % of GDP (right-hand side) % of GDP 5 1, , , 2 1 Eurozone 2,5 b (left-hand side) Forecast 3, EY Eurozone Forecast September 214 Cyprus

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