Fiscal Council: The effects of the war in Cyprus

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Next Previous Financial Council: The effects of the war in Cyprus HOME • INSIDER • KYP Fiscal Council: The effects of the war in Cyprus

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The economic situation caused by the Russian invasion of Ukraine will have far-reaching effects on the Cypriot market, according to the Fiscal Council. & nbsp;

It has already been reported that the shock suffered by both aggregate demand and the supply chain at the same time is leading to generalized price increases, resulting in high inflation but reduced growth. & Nbsp;

Below are the first estimates of the Fiscal Council in relation to the war in Ukraine: & nbsp;

“We consider it unnecessary to make an extensive reference to the global and horizontal pressure on price levels and production costs, as it would be unnecessary to make an extensive reference to the effects that current conditions will have on tourism, not only from Russia but also beyond. & Nbsp;

Stagnant inflationary pressures create dangerous circumstances, which may be further exacerbated by poor policy choices.

On the other hand, the temptations for the political authorities to follow popular but ineffective measures, on & nbsp; ad & nbsp; hoc & nbsp; basis and without comprehensive planning, with the hasty implementation of proposals and suggestions made by individual interest groups, have already begun to emerge. & Nbsp;

The principle of dealing with the situation must be based on a specific and given set of assumptions: & nbsp;

First, economic, fiscal or monetary policy cannot solve all problems, but it can alleviate them. & Nbsp; Second, any attempt to “redeem” inflation is dangerous, ineffective and undesirable, and political temptations in this direction must be dealt with with discipline. & Nbsp; Third, only a holistic approach will have a substantial impact. Such an approach must address the increase in aggregate demand in the economy (by measures that are inherently inflationary) and at the same time seek to de-escalate inflationary pressures. Finally, lessons from other episodes of stagnant inflation must be taken with great care as in our case monetary policy, which is central to dealing with similar episodes, both in historical experience and in theory, is exogenous. On the positive side is the fact that a monetary crisis due to the choices of Cyprus is not in the range of possible scenarios. & Nbsp; & nbsp;

Cyprus, however, despite facing a period of zero real growth and large price increases, at the same time has a number of options that must be sought collectively and collectively, without fragmentary moves such as those already in the realm of public debate.

Fiscal Policy Options

The Cypriot economy can take advantage of two conjunctural data which provide opportunities for immediate action. First, the existing architecture of the Sustainability and Development Plan, which has already embarked on significant moves by the state and which also frames the role of the private sector. Second, the high liquidity that exists in households, which record losses in their savings that take the form of deposits, while investment options remain limited to real estate where they continue to record abnormally high prices. & Nbsp;

The Cypriot peculiarity lies in the fact that, due to high liquidity in households and due to the small size of the economy, the shift to small and medium-sized investment (“retail investment”) is a much more effective choice than in other economies. & nbsp;

Although the discussions and analyzes for investment options in the Cypriot economy focus exclusively on high value investments by funds and large investors, this approach ignores the fact that there are corresponding significant amounts in the form of liquidity in the economy, which are not utilized, but are weight for the economy instead of acting as a means of creating Value Added. At the same time, in fact, there is a general difficulty in small-scale investments and in small and medium-sized enterprises, including very small/family-owned ones, which are important employers in the Cypriot economy. & Nbsp;

The field of “retail investment” is a strong opportunity for the Cypriot economy as it can, due to its peculiarities, contribute to a wide range of goals:

Immediate and rapid utilization of significant wealth which is currently depreciated due to negative real interest rates, at high cost to the depositor, the banking system and the economy in general. & Nbsp; Partial reduction of inflationary trends by “mopping” liquidity which can be utilized in alternative ways. Mitigating household losses from inflation, through small investments in collective activities, without increasing private debt and without lending or other leverage on the part of small investors [1] Opportunity to finance investments with wider benefits for society and the economy, with mitigation of growth in public debt. Support for economic activity and containment of employment without the corresponding deterioration in the already high inflationary pressure. & Nbsp;

Both experience and theory support a dual & nbsp; & nbsp; approach to the current emerging pressure on the economy. First, the stimulation of aggregate demand and economic activity, and second, the simultaneous and necessary exercise of anti-inflationary measures. & Nbsp;

The first option suffers from the growing pressure on public debt (despite the positive impact of a denominator due to inflation and rising government revenues), while in the second Cyprus lacks the traditional and most effective monetary policy tools. & Nbsp;

It is noted, however, with interest, the ongoing effort by the state to address the effects through individual measures, such as the search for alternative sources of tourism and the ongoing tackling of shipping problems. These moves already promise to tackle some of the problem, but even the greatest success can not overturn the data of declining aggregate demand and rising price levels. These moves are legitimate and necessary, but they will not be enough to address the problem, without implying that they are considered a failure. & Nbsp;

Thus, Cyprus will inevitably proceed with whatever options it has at its disposal, with a third necessary axis of political action, the relief policies aimed at supporting the most vulnerable groups of the population. This category should be considered to include small and medium-sized enterprises due to their multiplier role in employment and the development of Value Added, but also for clear social reasons that are self-evident. & Nbsp;

In each In this case, it is reiterated that the temptation for horizontal measures must be tackled with greater discipline by the political authorities and the legislature. & nbsp;

Horizontal measures, in addition to being wasteful, are also ineffective in terms of the desired result, while creating a series of incentives for behaviors that the State attempts with other measures to discourage, such as increasing the environmental footprint and the energy security of the place. These policies are being undermined by horizontal measures, with the main result being the waste of resources and the inability to achieve their main goal, which is to protect and support vulnerable groups. & Nbsp;

It also reiterates that Optimal Policies must be pursued and that, in a small, open, island economy, inflationary pressures on production costs and consumer prices can not be expected to be “redeemed” through indiscriminate tax cuts and other means of expansionary fiscal policy. & nbsp; & nbsp;

Based on the above, it is noted that the policy attitude that is in line with Best Practices is always preferable to other options. In some cases, however, the only option is to increase the intensity of existing policies and not to change course, while it will be important to optimize some existing means of action. & Nbsp;

A) Immediate government investments & nbsp;

Under the Sustainability and Development Plan, projects that can proceed immediately should be accelerated. Such a policy will have a dual benefit: on the one hand it will contribute to the strengthening of the total demand in the economy, and on the other hand it will contribute to the transition of the country towards its long-term goals and needs, through infrastructure projects. It is recognized, however, that the state of the state machine over time, due to its structural slowness, does not fully justify the hope for a full acceleration of state investment [2]. & Nbsp;

The first remarks also note the fragmentation of various measures, which either operate canniballyically with each other, or can complement each other but are unconnected, or still operate in opposite directions. For example, incentives and sponsorships for photovoltaic promotion, electric car promotion and electric car charging stations (traditional or photovoltaic) are not interlinked. At the same time, while significant amounts are being spent on the promotion of photovoltaics, no options other than sponsorships have been considered, such as accelerating depreciation or tax exemptions, which, under the current circumstances, could for a period of time to further encourage private sector investment. & nbsp; & nbsp;

However, in addition to the opportunities created to enhance the efficiency of the measures through a horizontal approach, it is noted that many of the development measures are currently facing increases in production costs, which will significantly affect the overall expenditure in the budget of the Republic. These budget increases must be addressed in two ways: & nbsp;

First, by focusing on projects that are multiplier in terms of their benefits to the economy and society. Thus, green and digital transition measures as well as the adoption of new technologies can be considered as priorities at the expense, for example, of new road network extensions. & Nbsp;

Second, with an assumption about the impact of increased costs on the budget, meaning that this assumption will imply a tough budget, with a pre-declared quantitative increase in costs and no future revisions. & Nbsp;

B) Aggressive promotion of private investment with a shift to retail investment

It is reiterated that the “retail investment”, with strong and brave incentives to individuals for small margin investments, is a Cypriot peculiarity in the current situation. It is already noted that Cypriot households have increased their deposits in the banking system by 1.8 billion euros from the beginning of the Pandemic (March 2020) until the end of 2021. The total deposits of households exceed 25 billion euros. The potential absorption of liquidity through an aggressive program may, under certain conditions, even approach 2 billion euros. This increase in domestic retail liquidity reflects the absence of alternatives, combined with the structural inability of the financial system to turn it into investment through financial intermediation. And the increase in credit risk, combined with the already increased total lending, make the choice to turn these deposits into loans, not only difficult, but also undesirable. It is noted that high liquidity is not related at all to the ability of the banking system to increase the credit it provides, since banks do not lend liquidity, but capital. & Nbsp;

An aggressive policy that includes strong incentives for retail investment will be able to absorb some of this liquidity, which today, not only is not utilized but is also saved by losses for the depositor (due to negative real interest rates) and costs in the banking system, which ultimately burdens the customers of the banking system.

Some indicative options can be recorded as indicative of the style and texture of such options, in view of an urgent but subsequent discussion of the whole subject:

Allow private investors (individuals) to participate in the & nbsp; net & nbsp; metering system through their investments in new collective developments such as photovoltaic parks (Virtual Netting), with & nbsp; & nbsp; additional incentives. & Nbsp; Acceleration of depreciation in photovoltaic and capital goods and technology services. Brave tax breaks for new investments in green growth, including the full tax exemption for individuals and small and medium-sized enterprises, up to € 20,000. Extension of tax exemptions for new investments of natural persons, up to 10,000 euros in newly established or small enterprises where the investors are natural persons. Adoption of the SELK proposal for reform simplification of the audited results for small and medium enterprises and reduction of the administrative burden. Strengthening Sponsorship Plans for the energy upgrade of a home or workplace, with a simultaneous tax exemption. & Nbsp; Further encouragement to the banking system to contribute to “green” sponsorship schemes, including the energy upgrading of buildings. & Nbsp;

These measures should create immediate and strong incentives for investment, but have a tough timeline, with a strict expiration date, and political authorities should begin to deal more explicitly with the expiration of such programs, without constant renewal. & nbsp ;

It is repeated that the above examples are indicative and are given as an example. & Nbsp;

C) Collection of liquidity from the market & nbsp; & nbsp;

Beyond the above measures & nbsp; & nbsp; utilization of micro-liquidity of households, there are additional measures that the State could utilize. & nbsp;

It is noted that households are expected to want to maintain liquidity reserves in view of the expected increase in price levels. However, at the same time, the continuous increase of retail deposits and the stagnation of these resources there is a burden for the economy and for society. Households have a recorded debt of 11.5 billion euros, with the actual amount of liabilities estimated at close to 13 billion euros. Based on the available data, the savings that can potentially be absorbed by the economy can even reach 1.8 to 2 billion euros if a serious and aggressive absorption policy is followed. & Nbsp;

One such instrument could be the 6-year domestic bonds issued by the Republic: a good choice for small investors, which, however, is neither widely known nor the subject of significant publicity and could absorb an amount in the form of a large number of small investors more important than the 7 to 10 million currently recorded in each issue. & nbsp;

Equally unknown to the general public are the tax incentives for small investments, for example in start-ups and start-ups. tax exemption, not only of profits but also of the investment itself, could on the one hand absorb the excess liquidity and on the other hand significantly strengthen the economic activity, at the same time that they will contribute to the financing of the unfortunately increased nominal public debt, but with domestic . & nbsp;

An even more aggressive policy, which, however, would require political courage, would be a corresponding shareholding of selected state activities. For example, in the context of an extensive state investment in photovoltaics, individuals could be allowed to participate up to a certain amount (eg 10,000 euros) in combination with a virtual & nbsp; net & nbsp; metering program. & Nbsp ; & nbsp; This way the state will be able to make large investments without a corresponding increase in public debt. & nbsp;

The above suggestions are food for discussion and alone are not able to fully address the problem formed in the economy after the Russian invasion of Ukraine. However, such a discussion is urgent, and a number of such measures will have multiple benefits for the place, especially if combined with targeted measures to support vulnerable groups of the population: & nbsp;

First, they will mitigate the effects of the crisis, holding back & nbsp; & nbsp; even partial growth and employment. & Nbsp; Second, they will enhance the future perspective of the place as they will create conditions for development through the utilization of existing resources. & Nbsp; Third, they will prevent, albeit partially, unruly and indiscriminate choices with the stated aim of supporting consumers, which, however, have no counterpart beyond their communicative value. Fourth, it will also serve important local targets, for which large sums of money will have to be spent in the future, such as the Green and Digital Fifth Transition, which will contain, even in part, the increase in public debt. & Nbsp;

The current economic climate will increase inequality and shift wealth from traditional sectors to other, new, industries. There is already intense interest from companies based in Ukraine, mainly high-tech, for their installation in Cyprus. The efforts of the Ministry of Finance continue and promise to make a significant contribution to supporting aggregate demand in the economy. However, even this possibility implies an increase in structural unemployment in Cyprus. Unemployment should be expected to increase in some sectors, such as tourism, despite the use of foreign labor, while demand for labor will increase in sectors where there is insufficient supply. In addition, price levels will continue to rise. & Nbsp;

These effects are inevitable in the short term, but they can be mitigated, and this mitigation can be done in a way that creates prospects for the future of the place. & Nbsp;

The public debate on this direction, and far from great promises that the wider problem will be addressed quickly and completely, is, not only imperative, but also urgent. The difficulties that arise in 2022 should serve as an excellent opportunity to make decisions like the ones above, and this painful situation should leave the country at least more prepared for the future. “& Nbsp;

[1] & nbsp; Such phenomena, which characterized the economy during the period 2008-2013, can be avoided through well-structured incentives. & Nbsp;

[2] & nbsp; Economic and social blessing would be radical restructuring of the public sector and rationalization of its procedures, which, however, is not expected for political reasons. & nbsp;