The change in the ECB's monetary policy under the pressure of rising inflationary pressures is pushing up eurozone government bond yields, making lending and refinancing of government debt more expensive. This new monetary environment poses new challenges in the conduct of economic policy. Managing inflationary pressures and supporting the recovery must run without upsetting fiscal stability. Simply put, with the Cypriot debt over 100% and the cost of borrowing increasing, the desired policy would be to keep the debt on a downward trajectory. This is what the IMF is asking us, but also rating agencies. DBRS, which recently upgraded Cyprus, warns that it will proceed with a downgrade if it finds a significant deterioration in the public debt, possibly due to a prolonged period of weak growth, large fiscal imbalances or the implementation of large contingencies. >The safest way to reduce debt is to achieve high growth rates, as was done after the memorandum until 2019. Without taking any fiscal measures, instead taxes were reduced, and without the need to privatize the EAC and Cyta (as originally envisaged in the memorandum debt fell “silently” to 91% of GDP in 2019.
Achieving high growth rates today is not a given. It is recalled that the IMF predicts that the Cypriot economy will grow at a rate of 2% in 2022, compared to previous forecasts (before the war broke out in Ukraine) for growth beyond 4%. Less growth means less revenue. The IMF has already introduced the search for new revenue, throwing the idea of restoring real estate tax.
“Fiscal policy should continue to provide support as needed, but aim at the gradual reconstruction of security reserves. “The government's fiscal target of ¾% of GDP surplus in 2024 is consistent with this strategy, but achieving it may be challenging, given the war-related shocks.” ECB policy
Until now, ECB policy has been particularly supportive of the Cypriot economy. This is gradually changing.
The Governing Council of the ECB on Thursday decided to end the bond-buying program (APP), ie to cut off the supply of new liquidity to the real economy, and at the same time pave the way for raising interest rates from the current low of -0.50%. Analysts forecast a first 0.25% rise in ECB interest rates by the end of 2022 or early 2023, and another 0.25% increase after zero. (from -0.50% today).
In particular, the Governing Council of the ECB considered that the new data support the expectation that the net purchases of assets under the asset purchase program should be completed by the third quarter.
Adjustments to key interest rates will take place sometime after the end of the net purchases under the APP program and will be gradual (ie by the end of September).
Interest rate decisions will be made with the aim of stabilizing inflation at 2% in the medium term. Inflation expectations are not positive.
ECB survey of professional forecasts for the second quarter of 2022 showed that inflation expectations, based on the Single Consumer Price Index (HICP), were revised upwards by 3% for 2022 and by 0.6% for 2023 , but remained unchanged for 2024 and stood at 6%, 2.4% and 1.9% for 2022, 2023 and 2024 respectively. Inflation in Cyprus is lower than the eurozone average, but not far away. Eurostat estimates inflation in the eurozone in March at 7.5% and in Cyprus at 6.2%.
The upward revision for 2022 mainly reflects the higher expected inflation of energy and food prices. Long-term inflation expectations (for 2026) were revised upwards by another 0.1 percentage points and averaged 2.1%.
In terms of bond markets, net purchases under the APP will be € 40 billion a month in April, € 30 billion in May and € 20 billion in June. The formation of net markets for the third quarter, ie until the end of September, will depend on the data of the real economy.
The ECB will continue to fully reinvest the amounts due from the repayment of securities acquired under the APP program at maturity (ie will buy new bonds with the money it will receive) for an extended period after the date on which it starts to increase key ECB interest rates and for as long as necessary to maintain favorable liquidity conditions and a largely facilitative monetary policy stance.
In terms of bonds acquired under the Pandemic Emergency Asset Purchase Scheme (PEPP), reinvestment will continue at least until the end of 2024. In any case, the future roll-off of the PEPP portfolio will be regulated in order to avoid interference in the appropriate direction of monetary policy.
The Cypriot bond markets reached 6.86 billion euros at the end of February, 90% of which were bought by the CBC.
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These markets, especially after the announcement of the pandemic PEPP program, dropped the yield on the Cypriot 10-year government bond from 2.21% in March 2020 to 0.96% in June.
The consequences
The new situation, although expected due to the increase in inflation, poses new challenges for the public finances of Cyprus and in general, as we mentioned, in the formulation of economic policy.
Recall that the implementation of the extraordinary quantitative easing program for the pandemic had led in 2020 to the issuance of a bond with zero interest rate. Today we are far from that point. In fact, the yields of the Cypriot decade have returned to the levels of March 2020.
Cyprus, as a country in the euro area and with a relatively high public debt, is already under intense pressure, with the yield on the ten-year bond (expiring in 2032) reaching 2.18% when it carries a 0.95% coupon. This is the third highest yield in the eurozone, behind Greece (2.89%) and Italy (2.48%). The German ten-year trend is also on the rise, reaching 0.84% from 0.35% a month earlier.
What does all this mean? The maintenance of low levels of public debt service costs (interest payment) when we have demanding years ahead with significant repayments (until 2028 a debt of 14.923 billion euros must be refinanced in total 24 billion euros), requires the continuation of the reduce public debt and maintain primary surplus production (the difference in revenue & expenditure excluding debt service costs). This is not an easy exercise.
Inflation and the negative impact of the war in Ukraine are putting pressure on spending (aid to the primary sector was approved last week), taxes have been reduced (fuel and electricity) and revenues will be affected by lower growth.
Minister of Finance Konstantinos Petridis, speaking in Parliament, prepared the ground for non-fulfillment of the target for reduction of public debt to 94% of GDP by the end of 2022. He does not know, he said, how much this will be overthrown due to the economic crisis and war. .
The government has already taken steps to mitigate the effects of inflation in a year with less than budgeted revenue. The bill includes the reduction of the excise tax on fuels, the horizontal reduction of the VAT on electricity from 19% to 10% aiming at the reduction of 5% to the vulnerable, a 50% increase of the allowance in the mountainous areas and support to 26.5 million in stockbreeders and farmers.
Public debt currently stands at 103.9% of GDP, up from 115.4% in 2021, with the ultimate goal of falling to 75% in 2025, a goal unlikely to materialize with the new data./p>
