Cyprus' economic and financial stability was affirmed during the 17th post-programme surveillance mission by the European Commission and the European Central Bank (ECB) with input from the European Stability Mechanism (ESM), from September 30 to October 7. However the report issued on Tuesday noted significant sectoral and geopolitical risks highlighting the need for vigilance.

According to the report, Cyprus’s economic fundamentals remain solid, underpinned by strong fiscal discipline and a resilient banking sector. However, the country faces risks in energy, tourism, and investment model, exacerbated by geopolitical tensions and climate-related uncertainties.

It is noted that economic growth accelerated to 3.7% year-on-year in the first half of 2024, buoyed by robust investment spending and rebounding net exports. Household purchasing power and savings rates continue to recover, supporting private consumption. Inflation is forecast to stabilize at around 2% over the medium term, aligning with the ECB's price stability target. Unemployment is approaching its lowest point in over a decade.

However, it is noted that geopolitical tensions present a significant downside risk. Disruptions to supply chains and increased production costs could impact key sectors, including tourism, which is still recovering from previous shocks. Additionally, Cyprus' heavy energy dependence and limited integration into the European electricity market leave it vulnerable to volatile energy prices.

Cyprus’s fiscal outlook is strong, with a budget surplus of 3.5% of GDP projected for 2024 and public debt-to-GDP expected to decline to 56.7% by 2026. This progress reflects prudent fiscal management and robust economic growth.

Nonetheless, significant risks loom over large infrastructure projects. It is noted that delays in the construction of a liquefied natural gas terminal at Vasiliko Bay could lead to costs up to 1% of GDP linked to state guarantees or additional investment costs for the continuation of the project, while the Great Sea Interconnector project may temporarily affect public accounts. Expenditure overruns are also a concern, driven by rising public wages, pensions, and health expenditures.

Banking sector resilience and vulnerabilities

The report noted that the Cypriot banking sector continues to demonstrate resilience, supported by strong profitability and declining non-performing loans (NPLs). It is added that the Mortgage-to-Rent scheme, launched in late 2023, has exceeded expectations, with the first properties expected to be acquired by year-end.

However, risks remain in certain areas. Less significant institutions (LSIs) still face challenges in resolving legacy NPLs, with an average NPL ratio of 21%. Structural barriers to lending expansion persist, as banks maintain high levels of assets with the central bank rather than increasing loans to households and businesses. Rising interest rates have also driven a surge in loan renegotiations, though repayment capacity remains strong.

External balances and investment concerns

The report also pointed out that Cyprus’s current account deficit remains elevated, reflecting a high import dependency and significant profit outflows from foreign-owned corporations. While foreign direct investment (FDI) inflows remain strong, much of it is channeled through Special Purpose Entities (SPEs) with minimal contributions to domestic output and employment. This raises concerns about the sustainability of Cyprus’s economic model and potential vulnerabilities to aggressive tax planning.

Sectoral and emerging risks

Risks are particularly pronounced in sectors like hospitality and real estate, which account for over 60% of total business lending. It is noted that the hospitality sector, while recovering, remains vulnerable to geopolitical and climate-related disruptions. Commercial and residential real estate prices continue to rise, with signs of regional overheating, especially in Limassol.

Emerging threats from geopolitical tensions, climate risks, and cyberattacks add another layer of uncertainty, it is noted.

The report concluded by saying that Cyprus’s debt servicing capacity remains robust, supported by long maturities, substantial cash buffers, and declining debt ratios. Despite the strong market perception, geopolitical uncertainties and sector-specific vulnerabilities could impact investor confidence if left unaddressed.

The first repayment to the ESM is scheduled for 2025, with annual repayments averaging €0.99 billion until 2031.