By Les Manison
In the period 2003-2008, the Cyprus economy experienced a bank-financed construction/property boom which contributed significantly to the subsequent financial crisis of 2012/2013. And in the post-crisis period from 2014 onward the rapid recovery of real GDP growth has, to a considerable extent, resulted from a spectacular increase in production in the construction sector based considerably on substantial financing from the issuing of EU passports.
Will the construction sector go into a sharp decline as happened in the years 2009 to 2013 and contribute to another financial crisis and recession? In answering this question this article focuses on developments in the segment of the construction/property sector financed mainly by investments under the ‘Naturalisation by Investors in Cyprus by Exception’ or citizenship-through-investment scheme?
In the wake of the measures taken, including capital controls and a deposit haircut to deal with the financial crisis, property sales and construction activity bottomed out at extremely low levels in 2013 and 2014. In response to the depressed state of the property market and a reluctance and inability of banks to extend loans to developers and households, the government introduced property tax incentives and the citizenship-through-investment scheme. This scheme, instituted in 2013, allowed foreigners to gain Cyprus passports through “investments” of at least €2 million in real estate and other Cyprus assets and was primarily responsible for encouraging large cash down-payments by foreigners for expensive (to-be-built) apartments and luxury villas in Cyprus. This foreign demand and financing contributed to a strong revival of activity in the construction sector from 2015 onward.
More specifically, it is estimated that property sales to foreigners more than trebled between 2015 and 2018 reaching over 47 per cent of total property transactions. And this surge in demand contributed to the building segment component of the construction sector rising by 129 per cent between the first halves of 2015 and 2019, and accounting for over 20 per cent of the growth of real GDP over this period.
The large absorption of labour resources by the sector is indicated by the increase in employment and hours worked in construction activity of 48 per cent and 63 per cent, respectively, over these four years. Furthermore, with the increase in production, such as those involving real estate agents and the legal and accounting professions, the rise in GDP attributable to the boom in construction and related activities over the period from 2015 to mid-2019 was much greater.
Payments by foreigners to gain Cyprus passports have been of key importance in financing the construction boom, especially in the building of high-rise apartments and luxury villas in tourist areas. Indeed, Finance Minister Harris Georgiades has recently stated that from 2013 to end-2018 the government approved 1,864 passport applications involving transactions (mostly for property) yielding some €6.6 billion, with virtually all of this amount going to private sector entities. However, given the recent tightening of conditions for obtaining Cyprus passports by foreigners (the outlay for a passport has increased to €2.5 million with additional payments of €75,000 to the Land Development Agency (COAG) and €75,000 to a research and innovation fund), there are serious concerns about whether the rapid increase in largely externally financed construction activity can be sustained.
At the peak of the property boom in 2008 construction and related real estate activity accounted for nearly 21 per cent of real GDP. In the first half of 2019 the level of such activity, though increasing at a very fast rate, was lower, accounting for 18 per cent of GDP. But will the recent frantic increase in construction activity, particularly of high-rise apartments, continue? Finance for the construction of high-rise apartment buildings, at least those which begun before mid-2019, has come largely from foreigners investing under the investment for passports scheme. However, there is now fear that a significant portion of the planned construction and supply of many new high-rise apartment buildings and luxury units may not be supported by sufficient demand. Accordingly, such investments could be wasteful, and be reflected in an increasing number of unsold and unoccupied apartments. This in turn may cause renewed financial problems for developers, but also for the economy as a whole.
Already from June 2019 property sales to foreigners, especially to non-EU nationals, have fallen considerably resulting partly from the tightening of criteria and the belated exercise of due diligence under the investment scheme. In fact, following a surge in passport applications in May 2019 under this scheme, a precipitous fall in such applications occurred. According to COAG and the Research and Innovation Fund only nine passport applications had been processed under the stricter criteria in the four months to October 2019 compared with the issue of 581 passports in 2018 and 550 in the first five months of 2019.
Furthermore, will the most recent adverse publicity on the past lax implementation of criteria under the passport investment scheme, reflected in the delivery of Cyprus passports to certain non-EU Nationals with dubious backgrounds, hasten the downturn in passport applications? Or will there be applicants for passports from countries in the region, such as Lebanon, which are experiencing upheavals?
Many property developers appear to be making large profits from their existing building projects geared at meeting foreign demand. But given their past and reportedly ongoing experience in not using the proceeds of property sales to repay their large amounts of debt they are unlikely to quickly moderate the fast pace of actual and planned construction activity in the face of shrinking foreign demand. Indeed, figures for the first seven months of 2019 show spectacular increases of 57 per cent in quantity and 170 per cent in the value of building permits issued for residential apartment blocks as compared with the same period of 2018.
What is different from the construction boom/bust period of 2003 to 2014 is that in the current recovery Cyprus banks appear less exposed to construction-related finance in part because developers have relied largely on funds from foreign investors to finance their projects. Also, banks have been reluctant to lend directly to developers and many property buyers who remained highly indebted after the bail-in. However, it is possible that banks partly under rescheduling arrangements may have raised their stakes in property developers either directly or indirectly (through other entities) by taking equity and quasi-equity positions.
With the issue of building permits, particularly for high-rise apartments, continuing to rise at a rapid rate, an imminent and sharp slowdown in the growth of construction activity does not seem likely. What is more probable is that over the medium to long-term, there will be a large over-supply of apartment units that were initially targeted at foreigners. And the extent of a deceleration in production of the construction sector could in turn depend on the ability and financial capacity of developers and building contractors to diversify their activities in areas such as social housing, health care centres, and civil engineering projects where domestic demand may exist or may be possible to develop.
While a financial crisis is not imminent, a major concern is that banks may not have learnt their lessons from the 2012/2013 crisis and raise their exposure to developers through financing non-viable projects in order to help them sustain their production in the face of declining foreign demand. Such a development may postpone the eventual slump in construction activity but would considerably raise the risk of ushering in another financial crisis.
What are the probable macroeconomic consequences of substantial declines in construction activity and its external financing? Most importantly, the large non-debt inflow of funds from foreign investments in Cyprus property during the recent recovery period has not only supported buoyant construction activity, but has enabled the large deficits in the current account of the balance of payments to be financed at a time when domestic savings has been very low. Thus, any substantial reduction in foreign inflows under the passport scheme could emerge as a significant external constraint on future economic growth. In this context, it is noted that the IMF now projects current account deficits of 7.8 per cent and 7.5 per cent of GDP respectively in 2019 and 2020.
Furthermore, a sizable contraction in construction and related activity is likely to impact harshly on an economy which is highly indebted and not sufficiently diversified and where the other main sources of growth, namely tourism and private consumption, are facing headwinds.
Banks with their large portfolio of non-performing loans and many non-creditworthy customers cannot lend to stimulate spending at a time when a government aiming at producing fiscal surpluses is unwilling to take expansionary fiscal action. Thus, there is the prospect that with any substantial faltering of foreign demand the government and banks would fail to take offsetting action to boost domestic demand. Economic growth would therefore suffer as a result.
Leslie G Manison is an economist and financial analyst, specialising in macroeconomic policy analysis, bank viability assessments and international financial relations. He is a former senior economist at the International Monetary Fund, an ex-advisor in the Cyprus finance ministry and a former senior advisor at the Central Bank of Cyprus