Interview with Athanasios Orphanides, Governor of the Central Bank of Cyprus, conducted on 30 December 2007 by Ninos Hadjiroussos and Tassos Anastasiades, published in the December 2007 issue of the magazine which was circulated in January 2008
In an interview we had with the Governor of the Central Bank of Cyprus, Mr. Athanasios Orphanides he stated that overall, the Cypriot economy has made remarkable progress on its road to the euro, achieving both nominal and real convergence with the euro area. The economic prospects of Cyprus inside the euro area, with all the benefits of the common European currency, are very good. At the same time, important challenges remain: aging-related public expenditure threatens the long-term sustainability of public finances and productivity remains low. Taking the steps necessary to face these challenges will ensure greater prosperity for Cyprus inside the euro area. The response to this is to enhance long-term policies that increase productivity and maintain wages at competitive levels. Furthermore, disciplined fiscal policies can restrain current account deficits. Such policies are even more important for a country participating in the euro area.
To a relevant question Mr Orphanides answered that "The loss of the ability to conduct an independent monetary policy and exchange rate policy highlights the importance of fiscal and incomes policy and the need for structural changes in our economy. Sound fiscal policies and the implementation of structural changes that enhance productivity are the essential tools for containing inflationary pressures and preserving our competitiveness".
He also stated that the European Commission, the ECB, and the IMF have repeatedly stressed the danger on the sustainability of our public finances due to our demographic problem, with the percentage of persons over 65 expected to double by 2050. If no measures are taken, aging-related public expenditure is estimated to record the highest increase among EU countries.
The interview with Mr Orphanides follows:
Q. In January 2008 you have joined the Governing Council of the European Central Bank. What will this new role entail?
Following the EU Council’s decision of 10 July 2007 on the adoption of the euro by Cyprus, the Governors of the Central Bank of Cyprus and the Central Bank of Malta were invited to participate in the Governing Council of the European Central Bank (ECB) as observers. As from January 2008, we are participating in the Governing Council as full members, contributing to the formulation and implementation of the common monetary policy of the euro area for the benefit of Europe’s citizens. Naturally, this requires closer monitoring and analysis of international economic developments, particularly developments in the euro area. Furthermore, the Governing Council is also the main decision-making body for the ECB’s other important functions, including, among other, the promotion of the smooth operation of payment systems, the safeguarding of financial stability and the issue of euro banknotes. Membership of the Governing Council entails also systematic preparation in all these areas and demanding work for a small central bank like the Central Bank of Cyprus.
Q. What are the primary objectives of the European Central Bank and how does it function?
The primary objective of the ECB, as defined in the Treaty establishing the European Community is to maintain price stability. By clearly assigning overriding importance to price stability, the ECB’s legal mandate captures the essence of what we have learned from monetary history - that ensuring price stability is the most important contribution that monetary policy can make to a favourable economic environment with a high level of employment and ultimately to the welfare of the citizens.
Monetary policy decisions as well as decisions on other central bank matters are taken by the Governing Council of the ECB, in a consensus-oriented manner, and are implemented by the national central banks of the euro area countries. The Governing Council is assisted by the ECB services and by committees of experts from all the central banks of the Eurosystem, including the Central Bank of Cyprus. There is a strong team spirit towards meeting our common objectives, for the benefit of the European Union (EU) as a whole as well as our individual countries.
Q. Can we have your assessment of the Cyprus economy today?
Since the mid-1990s Cyprus has enjoyed steady economic growth at around 4% a year, with generally low inflation, low unemployment and a stable exchange rate. Per capita income has been gradually approaching that of the euro area. The macroeconomic stability of the Cypriot economy, particularly its satisfactory inflation performance over the years, largely reflects the prudent monetary policy of the Central Bank of Cyprus, which has been based on exchange-rate stability and supported by a relatively flexible labour market and efforts to liberalise product markets.
In the last few years, economic developments in Cyprus have been shaped by our efforts first to join the EU and subsequently to enter the euro area. Structural reforms have been undertaken, notably in the financial sector and the utilities sector, enhancing market efficiency and welfare. Under the requirements of the Stability and Growth Pact and the Maastricht convergence criteria, the fiscal deficit, which peaked at 6,5% of GDP in 2003 has been reduced to 1,2% of GDP in 2006, while a small surplus is expected for 2007. Public debt, which exceeded 70% of GDP in 2004 declined to 65,2% in 2006 and is expected to continue decreasing.
Overall, the Cypriot economy has made remarkable progress on its road to the euro, achieving both nominal and real convergence with the euro area. The economic prospects of Cyprus inside the euro area, with all the benefits of the common European currency, are very good. At the same time, important challenges remain: aging-related public expenditure threatens the long-term sustainability of public finances and productivity remains low. Taking the steps necessary to face these challenges will ensure greater prosperity for Cyprus inside the euro area.
Q. Being a member of the euro area we lose our independence of monetary and exchange rate policies. So how important will fiscal and incomes policies be?
With our entry into the euro area, the Central Bank of Cyprus will no longer have the ability to conduct a national monetary policy, but will instead participate in the implementation of the common monetary policy decided by the Governing Council of the ECB. Steering domestic interest rates to contain inflation at the national level will no longer be possible. At the same time, the need to maintain domestic inflation at low levels will become more imperative. Otherwise, a higher domestic inflation within a unified market with a common currency would cause domestic goods and services to be more expensive and hence less competitive, leading to higher unemployment and larger fiscal and current account deficits.
The loss of the ability to conduct an independent monetary policy and exchange rate policy therefore highlights the importance of fiscal and incomes policy and the need for structural changes in our economy. Sound fiscal policies and the implementation of structural changes that enhance productivity are the essential tools for containing inflationary pressures and preserving our competitiveness.
With our accession to the euro area, our fiscal policy should be more vigilant and disciplined to maintain a stable macroeconomic environment and to allow the pursuit of social objectives. The current favourable economic conditions in Cyprus provide an opportunity to further consolidate and strengthen public finances, creating room for manoeuvre in less favourable times. As the Vice President of the ECB, Lucas Papademos, eloquently pointed out during his recent visit to Cyprus, the best time to repair a roof is when the sun is shining. Let us not forget that the recent major improvements in public finances are mainly due to temporary factors, such as the increase in revenues from real estate which are not expected to continue at such high rates.
Q. What is the role of the Stability and Growth Pact? Will Cyprus benefit from this Pact?
The Stability and Growth Pact is an essential element for macroeconomic policy success in the euro area. While monetary policy in the euro area is centralized in the hands of the ECB, fiscal policy remains decentralized in the hands of the governments. Recognizing that sound fiscal policies are an essential condition for monetary stability and the efficient functioning of the Economic and Monetary Union, the EU leaders adopted the Stability and Growth Pact in 1997, with the aim of ensuring fiscal discipline and coordination among EU member states. The Stability and Growth Pact consists of fiscal monitoring, with a preventive early-warning system based on peer support to correct budgetary slippages, and a dissuasive set of rules including sanctions against countries that fail to take appropriate measures to end an excessive deficit (the "excessive deficit procedure"). In particular, the following criteria must be fulfilled: (a) the government deficit does not exceed 3% of GDP, and (b) government debt does not exceed 60% of GDP or is approaching this reference value at satisfactory pace.
The Maastricht convergence criteria ensure that countries fulfil these fiscal criteria before entering the euro area, while the Stability and Growth Pact ensures that they continue to respect them. The Pact applies to all EU countries, but the sanctions apply only to euro area countries. Furthermore, the Pact requires an annual improvement in the structural balance of 0,5% of GDP in order to reach a nearly balanced budget in the medium term. This implies that unexpectedly high revenues will be used for fiscal consolidation rather than additional spending; there should be savings in good times to create sufficient room for manoeuvre in bad times.
Cyprus was in an excessive situation for a number of years, with unsustainable fiscal deficits and a high public debt. The rules of the Stability and Growth Pact have led Cyprus to reduce public debt and fiscal deficit considerably, ending its excessive deficit situation. The Pact’s monitoring system provides additional incentives and guidance to the Cypriot government for fiscal consolidation, which becomes even more imperative in view of the aging-related burden on public finances.
Q. What are your views on facing the expected deficit in the Social Insurance Fund?
The European Commission, the ECB, and the IMF have repeatedly stressed the danger on the sustainability of our public finances due to our demographic problem, with the percentage of persons over 65 expected to double by 2050. If no measures are taken, aging-related public expenditure is estimated to record the highest increase among EU countries. According to IMF estimations, if no structural measures are taken, the VAT would need to be increased by 10 percentage points to cover the higher expenditure of the Social Insurance Fund. This is not a projection and is surely not a good a solution; however, it indicates the graveness of the problem.
Consequently, further fiscal consolidation and the savings of unexpectedly high public revenues is imperative. We can no longer afford to postpone the changes necessary to ensure the sustainability of the Social Insurance Fund. A number of measures to face this challenge have been included in the government’s convergence programme, and other measures have also been proposed. We need to come to an agreed upon decision soon. It is not wise or fair for future generations to postpone such decisions and to transfer such a huge burden to our children.
Q. How can we reduce the perennial current account deficit?
Cyprus has consistently reported deficits in its current account, which have at times been rather large. Being a small open economy, Cyprus is highly affected by external factors. Moreover, given Cyprus’s high dependence on oil, the large consecutive increases in oil prices in recent years have significantly affected the current account deficit, which increased from 2,0% of GDP in 2003 to 5,9% in 2006.
In addition to exogenous oil shocks, the current account deficit may reflect in part loss of competitiveness in some sectors of the economy. The response to this is to enhance long-term policies that increase productivity and maintain wages at competitive levels. Furthermore, disciplined fiscal policies can restrain current account deficits. Such policies are even more important for a country participating in the euro area.
Q. The productivity of the Cyprus economy is 76% of the average of the EU while the per capita income is 92% of the average. To what extent this leads to loss of competitiveness of the Cyprus economy and how can we face this problem?
This is a key area of concern. In order to maintain our standard of living at high levels we need to increase our productivity. The European trend chart on innovation for 2006 finds Cyprus economy to be based mainly on low technology-intensity activities, on which the international competition is continuously growing. The productivity in Cyprus is only about 76% of the average of the euro area, mainly due to the low performance of Cyprus in the area of innovation.
To remedy this situation, the structural reforms set out in the National Lisbon Programme should be implemented as soon as possible, to increase our productivity and competitiveness in a sustainable manner. These include the diversification of the economy into high value added activities, the promotion of research and development, and the strengthening of the competitive environment. There is also tremendous scope for raising efficiency in the public sector and for bringing down barriers that perpetuate inflexibility in product and labour markets. It is critical to realise that our success following our joining the euro area hinges on our willingness as a nation to change old methods and habits that have hindered such improvements in the past and our determination to make reforms.
Q. To what extent the indexation of wages and salaries leads to inflexibility in the labour market and is a factor leading to inflationary pressures?
The indexation of wages and salaries in some sectors is one of the legacies of the past that can potentially create problems for our economy in the euro area. Indeed, the trend in the EU in recent decades has been to move away from such schemes, with the Governing Council of the European Central Bank repeatedly urging for further progress to be made. For example, in the introductory statement following the last Governing Council meeting on monetary policy, on 6 December, it was noted that "any explicit or de facto indexation of nominal wages to prices should be eliminated".
In general, wage increases should be in line with productivity growth and developments in competitor countries. Otherwise, wage increases would lead to higher inflation risks and a loss in our competitiveness in international markets. In the public sector in particular, through the current wage indexation mechanism, an increase in inflation would be permanently incorporated in salaries, further increasing the already high state payroll. In addition, the indexation of wages makes labour less flexible as it reduces incentives for workers to move from sectors of low profitability to more profitable ones.
Of course, keeping wage developments in line with productivity does not imply that wages should be kept low. Rather, the focus should be on increasing productivity, as I have already mentioned. As long as we achieve high productivity, wages will also keep increasing at a high and sustainable rate, consistent with sustainable economic growth.
Q. By our entry to the eurozone is there going to be a change in the way the Central Bank supervises and controls the commercial banks and the cooperative credit societies?
Joining the euro area does not entail a change in the supervision of banks by the Central Bank of Cyprus. The Central Bank of Cyprus has always been guided in its supervisory role by the recommendations of the Basle Committee on banking supervision and the EU directives on banking, which apply to all EU countries both in and outside the euro area. The Central Bank’s role in safeguarding financial stability will be enhanced with the entry into force on 1 January 2008 of new provisions in the Central Bank of Cyprus Law, which formally assign this competence to the Central Bank.
Cooperative credit institutions will continue to be supervised by the Authority for the Supervision and Development of Cooperative Societies, with which the Central Bank of Cyprus cooperates closely. A change arising from the requirements of the monetary policy framework of the ECB is that, as from January 2008, the cooperative sector as a whole will maintain minimum reserves with the Central Bank of Cyprus.