Lagarde: Cyprus will be affected by inflation and rising energy costs

Cyprus will be affected by inflationary pressures and higher energy costs due to its dependence on oil imports for electricity generation, according to European Central Bank President Christine Lagarde.

Ms. Lagarde also stressed that the tourism sector in Cyprus will see a decrease in the number of visitors from Russia and Ukraine, which accounted for 27% and 5% of total arrivals in 2021 respectively. Moreover, she said, given the importance of Cyprus as a hub for foreign direct investment to and from Russia, professional services such as accounting, consulting and legal services are expected to be affected.

However, the President of the ECB, in her speech at an event organized by the Central Bank of Cyprus, noted that the fundamental growth of the Cypriot economy has strengthened in recent years thanks to the hard work done after the banking crisis in 2013. In particular, non-performing loans have fallen from about 50% of total loans in 2014 to single digits at the end of last year. Overall, the banking sector is highly capitalized and liquidity and exposures in Russia are limited.

Ms. Lagarde said that Europe is now facing another crisis in the form of the Russian invasion of Ukraine. This is first and foremost a human tragedy, the cost of which is increasing day by day. But it is also a major economic shock, given our proximity to Russia and our dependence on its gas and oil.

"This shock will be felt here in Cyprus as well. So I applaud your country for opposing this unjustified act of aggression along with the rest of Europe.  But I recognize that Cyprus, like all of Europe, is now facing growing uncertainty. Therefore, in my remarks today, I would like to make a review of the economic situation in the euro area, drawing on what we know so far about the effects of the war, and how national and European policies can be combined to "to reduce costs and manage the current uncertainty," he said.

Mr. Lagarde emphasized that the Cypriot nation had recovered from the 1974 invasion and the subsequent division of the country, using its flexibility and resourcefulness to become a hub for operations in the Middle East and the North Africa region. Cyprus transformed from an island at the eastern tip of Europe into a core Member State, joined the EU in 2004 and adopted the euro in 2008.

She noted that Cyprus endured and then recovered from a crippling banking crisis in 2013, with the economy growing by about 6% each year from 2015 until the start of the pandemic. More recently, Cyprus has recovered well from the pandemic, despite the importance of tourism to the economy, which has been hit hard by lockdowns and travel bans.

The recovery from the pandemic

In her speech, Ms. Lagarde stressed that, before the Russia-Ukraine war began, the eurozone economy had recovered well from the pandemic. The recovery was much faster and richer in jobs than after previous recessions. For example, since the onset of the Great Depression, she recalled that it took seven years for eurozone GDP to return to pre-crisis levels and almost 12 years for unemployment to recover. This time, GDP had already surpassed pre-crisis levels late last year. Unemployment in the euro area has reached record lows and is at levels not seen since the 1970s.

"Cyprus has participated in this strong recovery dynamic. GDP grew by 5.6% last year, returning to 2019 levels. Unemployment has also returned to pre-crisis levels of around 6%. This strong performance is largely due to the excellent response in euro area policy, where fiscal and monetary policy has worked hand in hand to protect income and demand, but it has not been so easy to restart supply following the virus-induced lockdowns.  The global mismatch between rising demand and limited supply is leading to supply chain shortages and disruptions, creating strong inflationary pressures, given the interconnectedness of the global economy," she added.

Energy and food

In her speech, the President of the ECB noted that, since last June, for example, energy and food accounted for, on average, about two-thirds of inflation in the euro area. This reflects, in part, OPEC + 's decision to reduce oil supply by 9.7 million barrels per day in 2020, following the failure of some members to restore supply to previous levels. This in turn has contributed to the increase of natural gas, which is affecting food prices, making fertilizers more expensive and energy prices higher.

"These secondary effects on all markets have led inflation to reach 5.9% in the euro area at last reading, with energy inflation above 30%. Cyprus has seen similar price pressures, with inflation 5.8% - mainly due to higher energy and food prices (26.2% and 6.8%, respectively) We expected these disturbances to ease as economic conditions returned to normal after the pandemic. "The Russia-Ukraine war has now introduced significant uncertainty with regards to the prospects for the economy," she said.

The financial uncertainty brought by the war

The economic impact of the war is better reflected in what economists call the "supply shock", which is a shock that simultaneously pushes inflation and slows growth. According to Lagarde, there are three main factors that are likely to increase inflation. First, energy prices are expected to remain higher for longer periods of time, with gas prices rising by 52% since the beginning of the year and oil prices rising by 64%.

Second, the pressure on food inflation is likely to increase. Russia and Ukraine account for almost 30% of world wheat exports, while Belarus and Russia produce about a third of the world's potash, a key ingredient in fertilizer production, exacerbating supply shortages.

Third, global manufacturing bottlenecks are likely to remain in some areas. Russia, for example, is the world's leading exporter of palladium, which is key to the production of catalytic converters.

"Ukraine supplies about 70% of the world's neon gas, which is crucial for the construction of semiconductors. At the same time, the war poses significant risks to growth. As the eurozone is a net importer of energy, rising energy prices mean a loss of purchasing power for consumers here and profit for our import partners.  This result has already reduced revenue by 1.2% of GDP in the fourth quarter of 2021, compared to the same quarter of 2019 before the pandemic.  This amount would mean a loss of about 150 billion euros in one year. The conflict is also starting to drain trust through at least two channels," she added.

According to Ms. Lagarde, first, households are becoming more pessimistic and could cut spending. Consumer confidence this month has fallen to its lowest level since May 2020 and is well below its long-term average. According to national surveys, households' expectations for growth have deteriorated, while their inflation expectations have increased. This suggests that people expect to see their real income (ie their income adjusted for inflation) compressed. Households are likely to save less, which will absorb some of this shock, but they have also revised their spending plans.

Second, business investments are likely to be affected. The latest data from the survey suggest that business activity was relatively well maintained in March, but business expectations for a year fell sharply. The delivery times of the suppliers, recording interruptions in the supply of the production, worsened again. How much inflation rises and how much growth slows will ultimately depend on the evolution of the conflict and sanctions. Reflecting this uncertainty, at the last meeting of the Governing Council, ECB staff prepared different scenarios to record some of the possible outcomes. Clearly, the longer the war lasts, the higher the financial cost and the more likely we are to end up with more adverse scenarios. That is why we are constantly monitoring the incoming data and updating our analysis accordingly," she noted.

Implications for policies

With the right political response, Ms. Lagarde said, we can mitigate the economic consequences of war and manage the high levels of uncertainty we face. To offset the short-term effects of higher energy prices and sanctions, national fiscal policies have a number of tools to implement, such as tax cuts and subsidies. EU rules are also being relaxed so that governments can take the necessary steps to protect their people.

The additional fiscal measures announced in the euro area as the invasion amounts to 0.4% of euro area GDP this year. Similarly, Cyprus is working to reduce energy taxes and diversify tourism flows through new flight schedules and programs to encourage domestic tourism.

"But in the long run, we need a European approach, which works across borders, to adapt to the post-invasion world. War has highlighted the deep strategic vulnerabilities in our security and trade relations, which we can only tackle if we are autonomous.   This justifiably brings to the fore Europe's goal of achieving strategic autonomy," she said.

The European Commission has already announced some ambitious goals, such as doubling Europe's share of the global semiconductor market by 20% by 2030. Last week, European leaders agreed to reduce demand for Russian fossil fuels and boost our energy security by diversifying liquefied natural gas (LNG) supplies and more investment in clean energy.

This is clearly desirable but will incur some costs during the transition. Supply chains need to be restructured and energy supply reorganized, while the green economy is likely to increase pressure on some of the already depleted metals and minerals. Electric vehicles, for example, use more than six times more minerals than conventional cars.

Thus, Europe needs a plan to ensure that the necessary investments are made as quickly and smoothly as possible, with public and private funding mutually reinforcing.

The EU Next Generation Facility - the € 750 billion fund set up to help recover from the pandemic - will help boost public investment in the coming years. Almost 40% of the expenditure has been allocated for the green transition. Here in Cyprus, you are already building a new LNG import terminal, which is largely financed by EU grants and loans from the European Investment Bank.

But we also need private funding to strengthen it, and that is why we need to better mobilize Europe's large pool of private capital. At present, capital markets in Europe are fragmented into national lines instead of covering the continent. That is why the capital markets union - the task of unifying Europe's capital markets - has become more important than ever.

For its part, the ECB has made it clear that, in the context of the ongoing conflict, we will take what is needed to pursue price stability and safeguard financial stability. We have also implemented a political response that is adapted to the uncertainty we face today.

Prioritization

"As I explained last week, the best way monetary policy can address this uncertainty is to emphasize the principles of voluntariness, phasing-out and flexibility," she said.

First, she said, optionality means that we are ready to react to a series of scenarios and the course we will follow will depend on the incoming data.

In particular, if the inputs support the expectation that the medium-term inflation outlook will not weaken even after the end of our net asset purchases, we will complete net purchases under the Asset Purchase Program (APP) in the third quarter. However, if the medium-term outlook for inflation changes and financing conditions become inconsistent with further progress towards the 2% target, we are ready to revise our net asset markets timetable in terms of size and/or duration.

Secondly, gradual action means that we will move carefully and adjust our policy as we receive feedback on our actions. Any adjustments to key ECB interest rates will be made shortly after the end of our net purchases under the APP and will be gradual.

And thirdly, flexibility means that we will use our toolbox to ensure that our policy is evenly distributed across all parts of the euro area.

[This article was translated from its Greek original]