Sunday, April 24, 2022

IMPACT OF THE WAR ON THE CYPRIOT ECONOMY

 Filenews 24 April 2022 - by Socrates Ioakim



  • What is mentioned in an analysis of the 7Q Investment Group obtained by Forbes

The rapid escalation on the Russia-Ukraine front and the invasion of Russian troops resulted in the imposition of economic and other sanctions on the Russian Federation. The imposition of the sanctions was coordinated by the Western allies (US, EU, NATO) and they are described as unprecedented, both in scale and in scope. 7Q Investment Group, in a recent analysis, records the possible impact of the war in Ukraine on the medium-term economic prospects of the Republic of Cyprus, examining the possible change of the GDP of Cyprus over a five-year horizon. As a small and open economy, the Republic of Cyprus is particularly vulnerable to international crises, especially those involving capital flows. The points highlighted in the study are the depiction of the dependence of the economy on the flow of Russian capital, the magnitude of the impact that a sharp pause will have on these flows and the areas of resilience of the Cypriot economy.

The war in Ukraine affects 30% of the world's grain exports, creating conditions for shortages of stocks and/or huge fluctuations and distortions in commodity prices. At the same time, Russia holds a dominant position in the energy sector, particularly with regard to the European continent, which is supplied with Russian oil and gas at rates exceeding 25% of total demand. Therefore, a major disruption in the supply infrastructure and the quantities of energy offered by Russia, either through diplomacy or as a result of military actions, has a significant impact on the world economy and especially on the European community.

The GDP mix

The Republic of Cyprus has developed multifaceted and multidimensional relations with Russia and other countries in the wider region of Eastern Europe/West Asia. These relationships concern business activities (with particular emphasis on the provision of legal and financial services, but also the headquartering in recent years), trade in primary production and minerals (although limited in value in recent years), transactions in the real estate sector and of course, the particularly important hospitality and catering sector.

According to PwC data, the GDP of the Republic of Cyprus amounted to €21.5 billion for 2021, with its composition consisting of a contribution of 22% from the Tourism, Trade and Transport sector, 19% from the Financial, Professional and Administrative Services sector, 16% from the Real Estate and Construction sector, 21% from the Public Administration sector, Defence, Education and Health, and 22% from Other Sectors.

Tourism

The hospitality and catering sector is a main pillar of the domestic economy with an estimated contribution to GDP of 22%. Despite the efforts of professional and state bodies, in recent years, to expand the tourism mix, the Russian market continues to hold a dominant position in the Cypriot tourism industry. Based on official data of the Cyprus Statistical Service, tourist arrivals from Russia accounted for 22% of total arrivals for the period May – October 2018, while at the same levels (21.10%) the percentage of expenditure by Russian tourists in the total expenditure was formed. In 2019, a record year for Cypriot tourism, rates of dependence on the Russian market remained at about the same levels (21.80% and 20.99% respectively). The COVID-19 pandemic has brought new data to the tourism industry and, in fact, has boosted dependency rates on the Russian market. Tourist arrivals from Russia increased to 29% of total arrivals for the period May – October 2021. Given the low competitiveness of the hospitality and catering sector in relation to neighbouring countries (with Turkey as a typical example) and the price increases already observed in commodities and energy, as well as the inability of the Republic of Cyprus to find alternative solutions to the issue of energy production, the relative competitiveness of the sector is expected to deteriorate. Moreover, according to 7Q's analysis, the war in Ukraine will enhance the medium-term impact of the COVID-19 pandemic on the overall demand for leisure travel. Transport costs are expected to remain high, mainly due to fuel increases, while combined with the impact on purchasing power (mainly due to inflation and, in some cases, a decrease in incomes) it is expected to have a negative impact on overall demand, not only from Russia but also from other traditional tourist markets.

According to sources in the Deputy Ministry of Tourism, there is optimism that the UK market, and secondarily Israel, will fill the gap, while at the same time Cyprus' air connectivity is increasing. Cyprus will remain a favourite destination for the British, and the likelihood of the industry's resilience to the impact of the war on Ukraine is significant. However, without there being, yet, substantial investments in the overall qualitative upgrading of the tourism product, Cyprus is at a disadvantage in the medium term, in the midst of a situation of increased introversion in the world's population and intense and qualitative competition. The above findings prompted 7Q to apply a 15% reduction in the contribution of the Tourism, Trade and Transport sector to its baseline scenario.

"In previous episodes of geopolitical instability in the region, Cyprus had presented significant advantages related to the stability and security of the island. But the timing was very different, in a world that was rapidly moving towards globalization. While there has been no significant and long-term impact on the sector in the recent past from geopolitical events, this time, conditions push us to adopt assumptions, where we estimate a medium-term negative impact on GDP from the sector of up to 3.3%, with the decline amounting to 4.4% in the adverse scenario," the analysis states.

Financial Services

The sector of Financial, Professional and Administrative Services is also a main pillar of the domestic economy with a contribution to GDP estimated at 19%. The Republic of Cyprus has emerged as an important centre for the provision of financial, professional and administrative services, creating a large and connected ecosystem for the provision of related services. Until the period 2008 – 2013, Russian capital was the main source of foreign capital inflow, with Russia holding a significant share in Cyprus' financial account. The period that followed was characterized by the banking crisis of 2013, the events in Crimea and the beginning of the cold climate between the West and Russia with the imposition of the first sanctions (on both sides) in 2014, as well as by the subsequent decisions of the Kremlin that favored the repatriation of Russian capital from offshore financial centres, among them Cyprus.

As a possible sign of a gradual de-dependence on Russian capital flows, deposits of Russian capital in Cypriot banks decreased drastically over the period from 2014 onwards, while Cyprus' trade balance with Russia remained unchanged and of very little value to be significant. Looking at these statistics, Russian funds seem insignificant. But there are indications that Russian funds still define a significant part of the financial, professional and administrative transactions carried out through the Cypriot financial ecosystem. In recent years, Cyprus has brought onshore a large assets in value, which is difficult to estimate but is estimated to be close to €8.6 billion, a large part of which concerns Russian funds. The installation incentives given from time to time by the Republic of Cyprus, such as the policy of attracting the headquarters of large organizations from abroad, have resulted in the significant presence of Russian economic interests in Cyprus. According to data from Ernst & Young, the Sector of Financial, Professional and Administrative Services constitutes 19% of the total Russian business activity on the island. Moreover, the global market has entered a new era of effective supervision and financial innovation, with the result that Cyprus has remained an important financial centre, both of the remaining Russian offshore funds and of Russian funds with a physical presence in Russia but based in Cyprus (holding companies). During the period up to 2010, commercial banks in Cyprus operated International Business Centres (RPs), which contributed, at their peak, up to 30% of total operating revenues. Dependence on the Russian factor has since been great, and the bank managements consciously tried to reduce it, leading to deleveraging from international transactions. The contraction in the activity of the RPS limited the revenues of commercial banks from non-interest income. This coincided with the dramatic fall in lending rates and the precipitation of interest income, so commercial banks in Cyprus faced a double challenge. Low overall profitability and increase in the contribution of their non-interest income. The latter, while desirable under certain circumstances, in the case of Cyprus operates negatively since there is a significant dependence on transactions involving Russian financial interests, and can create strong volatility in the revenues and profitability of commercial banks.

The capital position of banks

Domestic banking institutions have significantly strengthened their capital position, in figures that are now compared favourably with comparable European averages. At the same time, the legislative framework was adapted to practices that allowed banks to deleverage through the sale of non-performing loans (NPEs). While the overall level of NPEs continues to be judged to be particularly high, the downward trend of recent years underlines the significant improvement in the quality of the balance sheet of banking institutions, which, combined with their capital position, increases their resilience to exogenous shocks. While Cypriot banks maintain high levels of capital adequacy and have improved their asset quality, the current development is not favourable for their profitability prospects as they are expected to have an impact on their Income Statement. Based on the latest data from the Central Bank of Cyprus, the impact of the war in Ukraine is estimated to amount to a loss of revenue of €70m annually.

"The above findings push us to apply a 30% reduction in the contribution of the Financial, Professional and Administrative Services sector to our baseline scenario. While the rate may seem excessive, the sector faces a highly competitive environment, while its profitability mix is not very dispersed and remains concentrated in business activities in the wider Region of Eastern Europe/West Asia. The important position of the sector (in terms of assets, as well as in jobs) makes us think that a negative impact of the war in Ukraine will have a multiplier effect on the rest of the economy, and will create conditions of feedback on the balance sheet of banking institutions. According to Moody's data, in the third quarter of 2021, private borrowing reached 139% of GDP2021, as confirmation of the high leverage of the Cypriot economy at a time of intense geopolitical instability, a folding of cheap liquidity policies and an increase in risk premia, especially in the European periphery. These conditions push us to adopt assumptions, where we estimate a medium-term negative impact on GDP from the sector of up to 3.8%, with the decrease amounting to 7.6% in the adverse scenario", the analysis states.

Real Estate and Construction

The real estate and construction sector is a traditional pillar of development of the domestic economy with a contribution to GDP estimated at 16%. The sector attracted early foreign demand, starting with the tourist residence and peaking with high end real estate developments. According to the latest official data of the Cyprus Statistical Service, a percentage between 30% and 35% concern foreign transactions. Of these, according to the same data, 50% concern transactions outside the EU, with this percentage being higher in previous years. The installation incentives that have been given from time to time by the Republic of Cyprus, such as the policy of attracting headquarters, have resulted in the rapid increase of high-value developments, especially in cities with the most intense presence of foreigners, such as Limassol, with a share estimated at 10% of the total construction activity.

The environment of low lending interest rates that we are going through has resulted in the escape of liquidity from the banking system for the purchase of real estate, for the purpose of owner-occupied housing or, to a greater extent, for their commercial exploitation. The Real Estate sector in Cyprus is now mature and presents a wide dispersion in its mix of supply and demand. As long as lending rates remain at the current low levels, aggregate demand is not expected to change significantly from current levels, with the high-value growth sector facing the biggest challenges, and possible losses reaching a total of €400m. The main concern recorded in 7Q's analysis of the Real Estate and Construction sector is its close connection with the tourism sector, and the real economy. In particular, it estimates that in an inflationary environment of low growth, combined with the restriction of tourist arrivals, the loss of income in real terms will weigh on the balance sheets of property owners, and thus may affect the wider real economy.

"The above findings push us to apply a 10% reduction coefficient in the contribution of the Real Estate and Construction sector, in our baseline scenario. While the sector is widely dispersed in its mix of supply and demand, and appears more resilient than the above-mentioned sectors, its close connection with the real economy leads us to think that a negative impact of the war in Ukraine will multiply and possibly create feedback conditions for the rest of the economy and the balance sheet of banking institutions. These conditions push us to adopt a medium-term negative GDP impact from the sector of up to 2.4%, with the decrease amounting to 3.2% in the adverse scenario", the analysis emphasizes.

Other sectors

The sectors where the vast majority of transactions concern the purely domestic economy constitute 43% of the GDP of the Republic of Cyprus.

"This is the truly defensive part of the Cypriot economy, and we have no particular reason to believe in a major turmoil due to external factors. We note, however, that these sectors can be affected by recessionary conditions, due to the reduced consumption that will be caused by the negative impact on the rest of the economy, the decrease in tax revenues, etc. Therefore, although defensive sectors, we estimate a small negative impact on GDP from the sector up to 1.1%, with the decrease amounting to 1.7% in the adverse scenario", says 7Q.

Assessment of the impact on GDP

7Q Investment Group estimates that the impact on the GDP of the Republic of Cyprus from the war in Ukraine could reach 13.10% in the medium term, in the baseline scenario.

"Since second round effects are expected (from the negative impact on the sectors of the economy, inflation, the reduction of tax revenues, etc.), we estimate, in the baseline scenario, that the total impact on the GDP of the Republic of Cyprus can reach up to 15.72%. The final outcome to GDP will depend on any balancing actions and activating other reflexes by economic and political actors. The purpose of our note is to highlight the potential size of the problem so that through coordinated and planned actions, the resilience and sustainability of the Cypriot economy can be ensured", concludes 7Q in its analysis.

*From the April issue of Forbes magazine