The example of Cyprus and the spirit of its people are inspiring, since they are agile, resilient and can turn crises into opportunities, European Central Bank President Christine Lagarde said on Wednesday, addressing a conference organised by the Central Bank of Cyprus in Nicosia.
Referring to the likely effects Cyprus may have from the crisis in Ukraine, she noted that the country will be affected by the inflationary pressure of higher energy costs and the tourism will be hit, while professional services, such as legal and financial sectors, will be affected to a degree, pointing out however that “with the right policy response, we can mitigate the consequences of the war and manage the high level of uncertainty we are facing.”
In her address and quoting Greek poet Constantine Kavafy’s poem, “Ithaca”, Lagarde said that it captures well the story of Cyprus, which is full of adventure and obstacles, as well as the story of its people becoming stronger by overcoming them.
She referred to the crises of Cyprus modern history, from the Turkish invasion of 1974 to the financial crisis of 2013, noting that Cyprus proceeded to have in the next years an incredible economy growth of 6% from 2015 until the start of the pandemic.
She said that Cyprus results gave an answer to those who criticised the Cyprus economic model, since Cyprus managed to rally very well after the pandemic as well.
Referring to the war in Ukraine, she said that it is a significant shock for Europe, due to its proximity dependance from Russia and Ukraine.
“We should review the economic situation we are in, address the impact that the war will have on the economy and find what policies should be adopted to respond,” she said.
The post-pandemic economy was rebounding well from the pandemic, Lagarde noted, much faster than after previous crises. While it took seven years for the economy to recover after the previous crisis, at the end of 2021, in a matter of two years, the GDP levels surpassed the pre pandemic levels, while unemployment is at record low levels, similar to the ones in the ‘70s.
Cyprus GDP grew by 5.6% last year, returning to its 2019 level, and unemployment returned to the pre pandemic level of 6%.
The difference of the two crises, she said, was “the combined, coordinated policies decided at a European and national level, exceptional policy response, that brought together fiscal and monetary policy that worked hand in hand to protect incomes and demand.”
She noted that it was not so easy to restart supply, after the lockdowns, causing inflation pressures. Also, since June, energy and food have accounted for two thirds of inflation in the euro area, reaching 5.9% in euro area.
Lagarde said that the supply problems were expected to ease as conditions returned to normal, but then the war introduced considerable uncertainty in the outcome of the economy.
According to the ECB President the economic impact of war caused further supply shock, that simultaneously pushes inflation up and growth down. As she said, three factors are expected to take inflation higher: first, energy prices are expected to stay higher for longer, with gas prices up by 52% since the start of the war and oil prices up by 64%. Secondly, pressure on food inflation is likely to increase, since Russia and Ukraine are accountable for about 30% of global wheat exports. Finally, global manufacturing bottlenecks are likely to persist in certain sectors.
Also, she noted, there are a lot of risks for the growth in Europe, since it is a net importer of energy. Raising energy prices means the loss of purchase power for consumers. This has already reduced income by 1.2% GDP in the fourth quarter of 2021, which is equivalent to 150 billion euros per year.
The second impact will be through confidence, she said. Households are becoming pessimistic and could cut back on spending, while they expect inflation to rise further. Also, the investments of businesses are to be affected. While business activity held well during March, their expectations fell sharply, since supply delays have started to emerge again, she added.
As far as Cyprus is concerned, Lagarde said that the country will be affected by the inflationary pressure of higher energy costs and the tourism will be hit, since Russian and Ukrainian tourists were up to 27% and 5% respectively in 2021. Additionally, professional services, such as legal and financial sectors, will be affected to a degree.
However, Cyprus` fundamentals are very different from what they used to be in the previous crisis, she noted, since now the banking sector is in a different place, adding that NPLs have dropped from 50% of all loans in 2014 to single digit numbers this year.
“With the right policy response, we can mitigate the consequences of the war and manage the high level of uncertainty we are facing,” Lagarde pointed out. She said that national fiscal policies, such as tax caps and subsidies, can manage the short-term effects of the high energy prices. At a European level, rules have been loosened, so that governments can take necessary measures, she added.
The additional fiscal measures announced in the euro area since the invasion amount already to 0.4% of euro area GDP this year, she said.
“The war has underlined deep strategy vulnerabilities in our security and trade relationships, which we can only address by being more united and stronger together,” bringing autonomy to the front, she noted. This, according to the ECB President, is happening by certain decisions, such as the increase of semiconductors production in Europe, or the diversification of the energy sector, with LNG and clean energy. “The transition is going to be costly,” she acknowledged.
Lagarde also emphasised the need for a capital market union, to integrate EU markets, noting the necessity for private funds to contribute in the crisis as well.
ECB’s response to navigate the crisis is to emphasis three key principles, according to Lagarde: optionality, gradualism, flexibility.
That means to be prepared for a range of scenarios, based on data, move carefully and adjust policy, based on feedback and use ECB’s toolkit to transmit policy evenly in all euro area, she explained.
“Europe is entering a difficult phase”, she said, adding that “the longer the war, the greater the cost.”
She said that the Russian invasion is a turning point for Europe, pointing out for those who wanted to see Europe weakened and divided, that “Europe emerged unanimous.”
The example of Cyprus and the spirit of its people are inspiring, since they are agile, resilient and can turn crises into opportunities, she concluded.
Replying to a question on the effect of sanctions in professional services in Cyprus, Lagarde said that professional services can grasp changes along the way. “I would predict that the firms that are concerned, because their clients have to go, they will find new areas to develop,” she noted. According to Lagarde, Cyprus has a role to play and the professionals will find new areas, new fields, and new clients.
Asked about the women’s representation in Cyprus, Lagarde replied it is “not enough.” She said that all nations have an obligation to make sure that the choice is possible, providing child care, public infrastructure, to help both parents to stay in the job market if they want. She added that this is an economic cause, a good investment, since it results in higher productivity.
In a welcome speech Cyprus Central Bank Governor Constantinos Herodotou said that Lagarde’s visit is a recognition of the active role of Cyprus and Central Bank of Cyprus in particular, in contributing in the shaping of the common European monetary strategy.
He noted that at the beginning of the year, the economic confidence was improving and the GDP was recovering fast. The war in Ukraine changed everything, he said, as it has shaped an economical landscape of higher risks and uncertainties.
“The situation asks for a policy reaching to the core of our European values. I am confident that the eurozone will manage to address the challenges and come stronger out of this crisis,” he pointed out.
The most recent ECB policies have successfully guided the euro area economies out of pandemic, with the minimum possible scarring, he added. Both, the euro area, as well as Cyprus, have reached the pre-pandemic GDP level, within 2021, while a similar path has been recorded in the labour dynamics, he noted.
Herodotou said that the ECB took a series of policy decisions. Specifically, it enhanced its Asset Purchase Program, with the introduction of the Pandemic Emergency Purchase Program (PEPP), the size of which was 1.35 trillion euros, in order to lower the borrowing cost and reestablish favourable currency conditions within the Eurozone.
For Cyprus, the total amount of net asset purchases in government bonds reached almost 7 billion euros at the end of February, of which about 6.5 billion euros were purchased by the Central Bank of Cyprus, implementing the ECB policy, he noted.
As a result, he added, while at the beginning of the pandemic the Cyprus 10-year sovereign bond yield increased at 2.21%, within a quarter of this Eurosystem bond purchases it dropped by 1.25% to as low as 0.96% in June that year.
However, the Russian invasion in Ukraine has moderate expectations of a continued and strong GDP expansion in the Eurozone and in Cyprus, at least in the short-term, he said.
According to the Central Bank Governor there is increased uncertainty about the economic impact of the conflict, the degree of severity of currently enacted sanctions and the extent of possible economic retaliation by Russia.
He continued noting that the economic impact in Cyprus is expected to be channelled through the increase of oil prices, the trade in goods and services, such as minerals, oil, cereals, tourism, transportation and IT services and a negative impact on a specific part of the provisions of professional services. Also, he added, a significant confidence effect cannot be ruled out.
Herodotou said a set of internal scenarios managed by the Central Bank of Cyprus point to a downward impact on GDP growth, and an upward impact on inflation in 2022. In a scenario with a normalization of the situation by the end of 2022, GDP growth is expected to be at 2.7% in this year, compared to the initial expectation of 3.6% before the outbreak of the war.
“We still estimate a very strong recovery in the medium term of around 3.7%”, he said.
In 2021, he noted, the inflation registered a substantial rise, similar to the Euro area, reaching on average 2.3%, due mainly to the rise of oil prices.
The recent developments following the war will push inflation higher in 2022, with negative consequences in the purchasing power of households and investment decisions of firms. For this reason, the Central Bank is adjusting our policy accordingly.
“A fundamental difference of this crisis with the one we faced a decade ago is that the Cyprus banking system is not part of the problem now, but it can and must be part of the solution,” he noted, since they have the capability to fund the real economy through lines of credit to both viable businesses and households.
“In this ever-changing global terrain we should be neither optimistic nor pessimistic. Instead, we shall act. And we shall act with a responsible manner, with realism and honesty. The citizens of Europe need to be aware of the challenges and difficulties. An informed citizen acts more responsibly. And that’s the best answer to any challenge,” he concluded.