Council opinion

of 8 March 2005

on the updated convergence programme of Cyprus, 2004-2008

(2005/C 177/02)

THE COUNCIL OF THE EUROPEAN UNION,

Having regard to the Treaty establishing the European Community,

Having regard to Council Regulation (EC) No 1466/97 of 7 July 1997 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies [1], and in particular Article 9(3) thereof,

Having regard to the recommendation of the Commission,

After consulting the Economic and Financial Committee,

HAS DELIVERED THIS OPINION:

(1) On 8 March 2005 the Council examined the updated convergence programme of Cyprus, which covers the period 2004 to 2008. The programme complies with the data requirements of the revised "code of conduct on the content and format of stability and convergence programmes".

(2) The programme contains four different scenarios for the macroeconomic and budgetary projections: a "central" scenario, an "upper" scenario, "lower" scenario and "higher interest rate" scenario. The so-called "central" scenario is considered as the reference scenario for assessing budgetary projections because, on the basis of currently available information, it seems to reflect plausible growth assumptions. It projects real GDP growth to pick up from 3,6 % in 2004 to 4,3 % on average over the rest of the programme period. The programme's projections for inflation also appear realistic.

(3) On 5 July 2004, the Council decided that an excessive deficit existed in Cyprus and recommended that this be corrected by 2005. The update aims at reducing the government deficit to below the 3 % of GDP reference value in 2005, in line with the Council recommendation under Article 104(7). Compared to the May 2004 convergence programme the update maintains the deficit target for 2005 but sharpens the targets after 2005. It foresees the general government deficit to sharply decline from 4,8 % of GDP in 2004 to 2,9 % in 2005 and to decline more gradually thereafter, to 0,9 % in 2008. Since interest expenditures are projected to remain constant at around 3,5 % of GDP the path of the primary balance is similar to that of the overall balance, improving from - 1,3 % in 2004 to 2,5 % at the end of the programme period. To this end, the update envisages a series of mostly structural measures to restrain expenditure and to increase revenue. Expenditure limits contribute 2,3 percentage points to the overall deficit reduction of almost 4 percentage points of GDP over the period 2004-2008. The adjustment path reflects the government commitment to improve public finances with the intention of early adoption of the euro. This is the main factor behind the frontloading of the fiscal adjustment which would reduce the general government budget deficit by 1,9 percentage points of GDP in 2005.

(4) The risks to the budgetary projections in the update appear broadly balanced. In particular, the main downside macroeconomic risks are the economic outlook in the US and the EU (notably the UK and Germany, main tourist source countries), tensions in the Middle East, and oil price developments [2]. The update further indicates that several planned measures for 2005 onward are to be "studied" further, which leaves some uncertainty. On the other hand, the estimated deficit outcome for 2004 has been better than expected. This positive result was achieved despite delays in a number of consolidation measures originally planned for 2004. These are now to be implemented in 2005, the budgetary impact of which is prudently considered as a safety margin for 2005 in case of e.g. delays in other measures, to keep the target of 2,9 % of GDP as an "upper limit" while at the same time expenditure is to be kept under strict control. Although expenditure overruns were a main problem in the past, the consolidation measures now emphasize structural expenditure control, especially on government consumption. In addition, several of the planned measures for 2005 have now been successfully negotiated with the social partners. The Commission services autumn 2004 forecast projected a deficit of 3,0 % of GDP for 2005, given a slightly lower GDP growth forecast for that year. However, the update reiterates that "additional measures" will be taken if lower growth would risk leading to a higher deficit in 2005. All this would facilitate the adjustment to 2,9 % of GDP for 2005. All in all, the planned deficit reduction for 2005 looks challenging but increasingly feasible. For the period 2006-2007 the adjustment path is slightly tightened to reach lower deficits compared to the previous May 2004 programme. However, it is not clear how this tightening will be achieved, given that the planned measures and GDP growth path have broadly remained the same. The adjustment path has to be underpinned by measures of a permanent nature.

(5) In view of this risk assessment, the budgetary stance in the programme seems sufficient to reduce the deficit to below 3 % of GDP by 2005 and seems to provide a sufficient safety margin against breaching this threshold with normal macroeconomic fluctuations from 2006 onward. It is however not sufficient to ensure that the Stability and Growth Pact's medium-term objective of a budgetary position of close to balance is achieved within the programme period.

(6) The debt ratio is estimated to have reached 74,9 % of GDP in 2004, above the 60 % of GDP Treaty reference value. The programme projects the debt ratio to decline by almost 17 percentage points over the programme period. The evolution of the debt ratio is partly driven by debt-reducing stock-flow adjustments linked to the gradual phasing out of sinking funds, the accumulation of which had earlier on led to debt-increasing stock flow adjustments.

(7) Cyprus presents some risks with regard to long-term sustainability of the public finances, reflected by the projected budgetary costs of an ageing population. The strategy outlined in the update is mainly based on the budgetary consolidation in the next few years and additional reforms of pension and health care system to be implemented in the future. It is imperative to pursue the reform process in order to reduce the sustainability risks associated with the future evolution of age-related expenditures, together with the planned and necessary budgetary consolidation in the medium term.

(8) The economic policies outlined in the programme are broadly consistent with the country-specific broad economic policy guidelines in the area of public finances. In particular, the fiscal consolidation programme aims to reduce the general government deficit within a multi-annual framework. The fiscal consolidation measures both on the expenditure and revenue side are mostly of a structural nature, and there is still some uncertainty surrounding the implementation of some of the planned consolidation measures. The deficit objective path, particularly for 2005, is ambitious but does not look implausible.

In view of the above assessment and in the light of the recommendations made by the Council under Article (104(7), the Council is of the opinion that Cyprus should:

(i) implement with vigour the measures envisaged in the updated convergence programme to bring the deficit below 3 % of GDP by 2005 and ensure through measures of a permanent nature that budgetary consolidation towards the medium term budgetary position of close to balance or in surplus is sustained after the excessive deficit has been corrected;

(ii) ensure that the debt ratio will start to decline from 2005 onward; and

(iii) pursue the reform process in the pension and health care system in order to reduce the sustainability risks associated with the future evolution of age-related expenditures, together with the planned and necessary budgetary consolidation in the medium term.

Comparison of key macroeconomic and budgetary projections

Convergence programme (CP); Commission services autumn 2004 economic forecasts (COM); Commission services calculations

| 2004 | 2005 | 2006 | 2007 | 2008 |

Real GDP(% change) | CP Dec2004 | 3,6 | 4,0 | 4,4 | 4,5 | 4,5 |

COM Nov 2004 | 3,5 | 3,9 | 4,2 | n.a. | n.a. |

CP May 2004 | 3,5 | 4,3 | 4,4 | 4,5 | n.a. |

CPI inflation(%) | CP Dec2004 | 2,1 | 2,6 | 2,2 | 2,1 | 2,0 |

COM Nov 2004 | 2,4 | 2,2 | 2,1 | n.a. | n.a. |

CP May2004 | 2,0 | 2,0 | 2,0 | 2,0 | n.a. |

General government balance(% of GDP) | CP Dec2004 | ‘�4,8 | ‘�2,9 | ‘�1,7 | ‘�1,5 | ‘�0,9 |

COM Nov 2004 | ‘�5,2 | ‘�3,0 | ‘�2,4 | n.a. | n.a. |

CPMay2004 | ‘�5,2 | ‘�2,9 | ‘�2,2 | ‘�1,6 | n.a. |

Primary balance(% of GDP) | CP Dec2004 | ‘�1,3 | 0,7 | 1,8 | 2,0 | 2,5 |

COM Nov 2004 | ‘�1,8 | 0,5 | 1,1 | n.a. | n.a. |

CP May2004 | ‘�1,6 | 0,7 | 1,4 | 2,0 | n.a. |

Government gross debt(% of GDP) | CP Dec2004 | 74,9 | 71,9 | 69,2 | 65,7 | 58,1 |

COM Nov 2004 | 72,6 | 72,4 | 69,4 | n.a. | n.a. |

CP May2004 | 75,2 | 74,8 | 71,5 | 68,4 | n.a. |

[1] OJ L 209, 2.8.1997, p. 1. The documents referred to in this text can be found at the following website:http://europa.eu.int/comm/economy_finance/about/activities/sgp/main_en.htm

[2] It should also be noted that future economic developments in Cyprus remain subject to unusual uncertainty: In case of reunification, the economic situation of the entire island would fundamentally shift.

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