Speech by Athanasios Orphanides, Governor of the Central Bank of Cyprus, at the press conference for the presentation of the Bank’s 2007 Annual Report
Nicosia, 17 April 2008
With the completion of 2007 we bade farewell to the Cyprus pound as the legal tender. Our accession to the sound and financially stable euro area on 1 January 2008, was, I believe, one of our country’s most important achievements. This success was made possible despite the uncertainty in the international economic environment during the second half of 2007.
Economic developments in Cyprus throughout 2007 were overall positive. High rates of economic growth, improved fiscal aggregates, a relatively low inflation rate and low unemployment were registered. As a result, all of the convergence criteria were satisfied, which was a precondition for Cyprus’ accession to the euro area. The fulfilment of these criteria which, as is well known, refer to the fiscal deficit, public debt, interest rates, inflation and exchange rate stability, was confirmed by the Convergence Reports of the European Commission and the European Central Bank (ECB) issued in May 2007. These reports preceded the historic decision made by the Economic and Financial Affairs Council on 10 July 2007.
The adoption of the euro by Cyprus opens up new opportunities for the economy of Cyprus and its people. The benefits derived from the accession are well known and I will avoid repeating them. However, I do wish to emphasise a particular benefit, which has acquired added significance in light of the current political developments. The euro is a powerful unifying force which can be used to overcome numerous obstacles and facilitate the re-unification of our country.
Our accession to the euro area has also brought about important changes to the role and functions of the Central Bank of Cyprus (CBC). The Governor of the CBC is a member of the Governing Council of the ECB, which is the competent decision making body for formulating monetary policy for the euro area and taking other policy decisions of the Eurosystem. The Eurosystem’s primary objective is to maintain the purchasing power of the single currency, that is to maintain price stability in the euro area.
Our participation in the Governing Council of the ECB implies a closer monitoring and analysis of the economic developments in the euro area. Every Governor, however, is also in a very good position to assess these developments in relation to the economic situation of his own country. In this context, the CBC, apart from its broader responsibility for monitoring, analysing and assessing economic developments in the euro area, is also particularly interested in their relationship and impact on key variables in the domestic economy such as the economic activity, inflation, the fiscal situation and competitiveness.
In the framework of our new role, we offer analysis to the competent authorities of our country, expressing our views on the appropriate policy to be pursued in order to safeguard macroeconomic stability in Cyprus. Our policy recommendations are always based on thorough analysis concerning, for example, measures that would restrain inflationary pressures and ensure the sustainability of public finances. Our main concern is to help towards decision making that is in the best interest of the Cypriot economy and its citizens in the context of the new economic environment shaped by our entry to the euro area.
The 2007 Annual Report describes the domestic economic developments as well as important factors that have shaped the macroeconomic indicators and the economic activity of our country including the international developments.
At this point, I would like to note that in 2007 and in the first quarter of 2008, the Cypriot economy has not been affected by the negative international financial developments. Overall, our country’s economic fundamentals are sound whilst our banking system remains healthy and robust.
As it is concluded from the Report, 2007 was a good year from an economic point of view. Specifically, real GDP has expanded in real terms by 4,4% compared to 4% in 2006 while the unemployment rate has decreased to 3,9 from 4,5% in 2006. The data support the view that economic activity was growing at rates that exceeded somewhat our economy’s potential rate of growth. Simultaneously, public finances improved, recording a surplus of 3,3% of GDP mainly due to an unexpected increase in public revenue related to the surge in the real estate market.
However, our accession to the euro area has also brought about new challenges which we have to tackle. Therefore, we need to remain alert and continue with our forward looking approach in a systematic way. One of these challenges is related to the substantial decrease in the interest rates, which amounts to one of the most important benefits for the Cypriot economy, both with regard to households and the business sector. However, owing to the prevailing economic conditions, the decrease in interest rates has led to a short term challenge. This challenge refers to the need for dealing with the overheating of the economy brought about by the decrease in the interest rates compared to the level which would prevail had we not join the euro area.
Indeed, our biggest challenge at the moment is domestic inflationary pressures fuelled by external factors together with rising domestic demand. These factors include, for example, the huge increase in oil prices and the excessive increase in credit growth and other monetary aggregates, reflecting the excessive increase in demand.
The large expansion of domestic credit, mainly geared towards the construction sector, was the main reason why we applied, since July 2007, prudential measures with regard to lending. Our main concern was to safeguard the robustness of our banking sector. I believe that the measures which have been taken so far have to a large extent mitigated the risks to the banking sector. The credit growth, which was substantial during 2006 and 2007, has moderated, even though recently the rate of credit growth is registered to be expanding. The measures we have taken shielded to a large extent our economy from the international financial disruption emanating from the mortgage and banking sector of the US economy, which is still underway. We have avoided the problems faced by other banking systems abroad and even within the EU, such as in the UK, Ireland and Spain, where the real estate market exhibited significant downturn.
Close monitoring of the developments in this area is imperative for us. As I have mentioned before, decision making in the field of preventive measures related to lending by credit institutions is always based on current developments and the outlook and expectations for the specific sector and the economy in general. We consider that the risks we were faced with in relation to the robustness of our banking sector last summer have been mitigated owing to the preventive measures taken in July 2007 and we are now getting closer to a more stable situation. We monitor developments with the banks, the Ministry of Finance and other competent authorities with whom we exchange views and data. All information is scrutinized and evaluated to formulate an objective view on current and future developments in the banking sector in relation to the construction sector. Based on current data, it appears that the expansion of housing loans has been restrained while there are indications of deceleration in the near future. Against this background, the CBC anticipates that we are much closer to bringing back the measures which existed before July 2007 and this has been already communicated to the interested parties.
At the same time, internal and external challenges and their impact on the Cypriot economy should be a cause for concern. The inflation rate has already increased to 4,4% in March compared to 3,6% registered in the euro area in the same month and this trend seems to be continuing. This development continues the trend of higher domestic inflation compared to the euro area, as observed in recent months. Apart from the domestic factors exacerbating the overheating of the economy, a series of external factors, such as the increase in oil prices and wheat prices, contribute significantly to these inflationary trends.
Inflation is an issue of particular concern for our economy because, being in the euro area, we cannot restrain price increases through the implementation of domestic monetary policy.
Consequently, if inflationary pressures continue mounting in Cyprus, our competitiveness will inevitably be eroded due to increased prices and production costs. Unfortunately, this trend of adverse interest rate differentials vis-a-vis other competitor countries in the euro area is expected to continue due to the existence of the Cost of Living Allowance, contrary to the norm followed in other euro area countries. Evidently, this will have negative repercussions for the labour market, the domestic economic activity and subsequently the fiscal indicators, which may constrain the ability of the government to pursue economic and social policies.
Another related challenge before us is the expansion of the 2007 current account deficit, which is also affected by external factors and the increased domestic demand.
As this adverse situation can no longer be controlled by adjusting the interest rates domestically, this development is also a cause for concern. It should also remind us of the vital importance of a prudent fiscal policy in dealing with these issues. Under these circumstances, it is all the more important that our fiscal policy should be focused on the maintenance of macroeconomic stability and discipline.
Further to these short term challenges there are, as I have often mentioned in the past, long term challenges to our economy. These challenges are highlighted in the Convergence Reports of the ECB and the European Commission. First, we are faced with the pressing need for increasing our productivity at a rate not lower than that of wage increases in order to become more competitive and to improve further our living standard. If this does not happen our economy will suffer from the ensuing negative consequences to employment and real wages.
Moreover, economic policy should put emphasis on the long-term sustainability of public finances thus recognizing the great challenge of the ageing population in Cyprus and its long-term consequences for the Social Security Fund. According to international organisations, Cyprus is in the worst position among EU countries in this field. This needs to be taken into account seriously. It is therefore with great pleasure that I noted that a serious dialogue is conducted between the Ministry of Labour and Social Insurance and all related parties aiming at resolving the problem and reaching a viable solution.
We have completed the year 2007 in good conditions. We enter 2008 with a new currency and a new era for our economy. In the euro area the need for a disciplined fiscal policy and the implementation of structural changes becomes even more pressing. Moreover, the continuation of fiscal consolidation provides the potential for a targeted and sustainable social policy. Such a policy is conducive to the fostering of productivity and competitiveness, which are prerequisites for continuous progress and higher living standards.
Our accession to the euro area opens up new opportunities. They can be realized with firm commitment to the prudent policies I have outlined. With appropriate planning and determination, I am confident we will succeed.