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Uncertainty due to health crisis and geopolitical developments

18/07/2022 16:38

The Cypriot economy in 2021 saw a strong recovery, according to the Financial Stability Report published by the Central Bank of Cyprus on Monday. However, the geopolitical and energy crisis and the significant increase in inflation have increased uncertainty in the macroeconomic environment, creating new or reinforcing existing risks to financial stability, leading to a significant slowdown in Cyprus' economic growth in 2022.

According to the report, in 2021, the Cypriot economy recorded a strong recovery, greater than initially expected. On an annual basis, the Gross Domestic Product (GDP) recorded a positive growth rate of 5.5% for the whole of 2021, compared to a recession of 5% the previous year. Concerns about an increase in insolvent companies and, by extension, non-performing loans (NPLs) have been contained, households seem to be coping with the challenges of the pandemic, while non-financial companies managed to emerge from the health crisis with a manageable impact.

The report demonstrates that Cyprus' banking sector has demonstrated considerable resilience, continuing to inject liquidity into the real economy and playing a catalytic role in its recovery. Specifically, net new loans to households for residential purposes reached €1,121 million in 2021 compared to €783 million in 2020, while net new loans to businesses reached €1,544 million in 2021 compared to €1,330 million in 2020.

However, due to Russia's invasion of Ukraine at the end of February 2022, the CBC forecasts that GDP is expected to slow to 2.7% in 2022, while inflation is expected to reach 7%. The significant increase in inflation associated with high household and business debt has weakened consumer purchasing power, and may limit consumption as well as investment, the report says.

Non-financial businesses operating in the tourism, trade and transport sectors, which are the sectors of the economy most affected by the pandemic, as well as the professional services sector, may face further capacity challenges of their debt and their long-term sustainability.

In addition, a possible increase in lending rates may further affect debt servicing while at the same time increasing the monthly installments of borrowers affecting the disposable income of households and the profits of non-financial businesses. The ECB plans to raise its key interest rates by 25 basis points at its July 2022 monetary policy meeting, with another hike expected in September 2022.

In 2021, credit institutions continued the process of deleveraging their balance sheets, mainly through the sale of NPL portfolios but also through accounting and non-accounting loan write-offs. By the end of December 2021, the NPLs of the banking sector were limited to around €3 billion (percentage of 11.1% of total loans), marking a remarkable progress and a noticeable decline. The CBC notes, however, that this rate is still considered high compared to the European average of 2%.

According to the report, the direct exposure of the entire banking sector to Russia and Ukraine is relatively limited. The only credit institution exposed to the sanctions imposed on Russia due to the invasion was RCB Bank Ltd, due to its business model. In particular, a decision was taken to voluntarily phase out the banking operations of RCB Bank Ltd and to convert it, within due time, into an asset management company.

The consequences of the invasion mainly in the tourism, trade and professional services sectors are expected to have a negative impact on the quality of credit institutions' assets, according to the report. The impact can be limited thanks to initiatives of the state to attract tourists from other markets, while the banking sector's exposure to the professional services sector is limited.

The real estate sector, however, has generally proved resilient to the effects of the pandemic so far, as fiscal measures adopted to address the effects of the pandemic have boosted domestic demand for residential properties. In 2021 the House Price Index (HPI) of the CBC started to show signs of recovery after the marginal stability observed in 2020, while the prices of residential properties in Cyprus seem to remain at levels lower than their potential value.

Finally, the CBC report shows that the risk of climate change, and its consequent effects on the financial sector, is becoming increasingly important. The economic cost of climate change for all EU countries is significantly higher in the absence of timely and effective adaptation plans and that credit institutions are not properly prepared to deal with this risk. Therefore, the CBC as the supervisory Authority, urges credit institutions to meet the expectations set by the ECB for their preparation regarding the risk of climate change.

At the same time, the rapid developments in technology related to financial transactions are a great challenge for credit institutions and financial institutions in general. The transition to digitization, redefining the business model of credit and financial institutions and providing new innovative services could lead to an improvement in low profitability.

Finally, the report notes that cyber security risk has now increased, with increased incidents of cyber attacks seen in the euro area amid geopolitical tensions.