country report - cyprus

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Country Report

Cyprus

Generated on August 6th 2014

Economist Intelligence Unit20 Cabot SquareLondon E14 4QWUnited Kingdom

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Cyprus

ForecastHighlights

Outlook for 2014-18 Political stability

Election watch

International relations

Democracy index: Cyprus

Policy trends

Fiscal policy

Monetary policy

International assumptions

Economic growth

Inflation

Exchange rates

External sector

Forecast summary

Data and charts Annual data and forecast

Quarterly data

Monthly data

Annual trends charts

Monthly trends charts

Comparative economic indicators

Summary Basic data

Political structure

Recent analysisPolitics Forecast updates

Analysis

Economy Forecast updates

Analysis

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Cyprus 1

Country Report 3rd Quarter 2014 www.eiu.com EconomistIntelligenceUnitLimited2014

HighlightsEditor: Robert O'Daly

Forecast Closing Date: July 9, 2014

Outlook for 2014-18Despite the bail-out programme the ruling Democratic Rally (Disy) partyperformed well in the European Parliament elections in May. However,implementing unpopular structural reforms will become more difficult.The Economist Intelligence Unit puts a 30% probability on a settlement ofthe Cyprus problem (up from 20% previously). However, progress has beenslow and mistrust between the two negotiating sides remains very high.Aftersuccessfullytappingthebondmarketstwoyearsearlywitha750mEurobond in June, the government may seek an early exit of the bail-outprogramme, which expires in early 2016 (an election year).We forecast that the budget deficit will narrow from 5.4% of GDP in 2013 toless than 4% by 2015 and less than 3% in 2017-18.We have revised down our public debt/GDP ratio to peak at less than 120%of GDP in 2016. However, with growth expected to be weak, there will remainquestions about the sustainability of the public debt over the long term.We expect real GDP to contract by 3.7% in 2014 and growth to return in 2015.However, high corporate and household debt ratios will keep growth ratesbelow 2% in 2016-18.Deflationary pressures persist in 2014 and we expect the EU's harmonisedindex of consumer prices (HICP) to fall by 0.7% in 2014 before picking up asdemand recovers.We expect the current-account deficit to widen over the forecast period, to3.6% of GDP by 2018, as demand picks up but lack of investment acts as adrag on export competiveness.

ReviewOn June 18th the government of Cyprus accessed international bondmarkets almost two years earlier than expected, with a five-year bond issueof750matayieldof4.85%.The improvement in investor sentiment towards Cyprus generally shouldmake it easier for Bank of Cyprus to issue more capital, which it is currentlyseeking to do.The US vice-president, Joe Biden, visited Cyprus on May 22nd tostrengthen bilateral ties. Efforts to push forward the negotiations thatresumed in February 2014 appear to have been unsuccessful.The Statistical Service of the Republic of Cyprus (Cystat) confirmed itsearlier flash estimate of a seasonally adjusted real GDP decline of 4.1% yearon year in the first quarter of 2014.

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Outlook for 2014-18Political stability

The main issue for the government will be tackling the social and economicconsequences of the economic crisis that erupted in March 2013, when theconditions of the bail-out from the EU and the IMF triggered a two-week closure ofthe banks and the imposition of capital controls. The haircut imposed on bankdepositsabove100,000,aswellasthecapitalcontrols,whichhavesincebeenrelaxed significantly, have hurt household and corporate purchasing power. Therehas been next to no social unrest despite the harsh terms of the bail-out and TheEconomist Intelligence Unit does not expect significant social unrest over theforecast period. Implementing the bail-out programme, particularly for privatisation,will become more difficult now that the junior coalition partner, the Democratic Party(Diko), has officially quit the coalition, although some of the new ministers also hailfrom Diko.

Another major concern for political stability in Cyprus stems from the decades-olddivision of the island into two parts, essentially a Greek Cypriot south and a TurkishCypriot north. Repeated efforts to end the division have failed, and the islandremains heavily militarised (some 30,000-40,000 Turkish troops are stationed in thenorth). Peace talks resumed on February 11th 2014 and, unlike previous efforts, arebeing cautiously supported by the business community and the influential head ofthe Greek Orthodox Church in Cyprus, Archbishop Chrysostomos. In April wetherefore raised our view of the chances of a settlement from 20% to 30%. However,talks have got off to a slow start and mistrust between the two communities remainshigh. The main challenges include agreeing on the future status of Turkey, Greeceand the United Kingdom, which are currently security guarantors under the 1960Treaty of Guarantee; how much dispossessed property is reinstated, exchanged forother property or compensated; how to handle the resettlement of those displacedas a result of the settlement; how compensation and resettlement might be financed;how power-sharing structures will be devised; and how the various levels ofgovernment will be funded. It remains to be seen whether the political price ofreunification,namelysharingpowerunderabicommunalbizonalfederalmodel,will be too high for two communities that have spent decades governing apart. Thedifficulties of sharing power have led some international actors to call for a two-state solution, although this remains anathema for Greek Cypriots, whosegovernment enjoys international recognition as representing the whole Republic ofCyprus territory.

Although the Greek Cypriots will seek to keep natural-gas exploration off the officialagenda of the talks, various statements by politicians indicate that they see thepotential for natural gas co-operation with Turkey (and probably Israel, which hasconsiderable natural-gas reserves) in the event of a solution. One option beingmooted (albeit more abroad than in Cyprus) is a pipeline to or through Turkey thatcould also supply the EU, although there is now discussion about instead sendingthe gas to unused liquefied natural gas (LNG) plants in Egypt.

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Election watchAs we had anticipated, the ruling Democratic Rally (Disy) party, from which thepresident, Nicos Anastasiades, hails, performed well in the European Parliamentelections on May 25th, as the Progressive Party of the Working People (Akel),which was in power in the run-up to the March 2013 crisis, took most of the blamefor the crisis. The next main election is for parliament in May 2016. As Cyprus has apresidential system, this will have little effect on government but will influencealliances in the run-up to the 2018 presidential election. The election for president ofthe unrecognised Turkish Republic of Northern Cyprus (TRNC), due in April 2015,could give a positive dynamic to the peace negotiations if it is won by a moderate.However, that is by no means guaranteed and it may yet be won by the incumbent,Dervish Eroglu.

International relationsThe discovery of natural gas, and the involvement of both US and Israeli companiesinoffshoreBlock12,isleadingtoashiftinCyprussinternationalrelations.Inthepast, US (and UK) involvement in the Cyprus problem was viewed with suspicion,as the popular perception, whether justified or not, was that these countries tendedto favour Turkey. However, the US appears to be pushing Turkey on a long-standing demand of the Greek Cypriots (and the UN Security Council) for the returnof the uninhabited district of Varosha in Famagusta, which is under Turkish militarycontrol. A full return is unlikely before a settlement is agreed, but according tomedia reports there are suggestions that it could happen before a referendum. TheUK also won favour with Cypriots by sending technical assistance on the bankingsectorinthecriticaldaysinMarch2013whenCyprussfutureintheeurozonewasin doubt.

Meanwhile, relations with Russia, a traditional ally from the cold war days whenCyprus was a member of the (non-NATO) Non-Aligned Movement, may beweakening. In March 2013 the government failed in its attempts to get immediatefinancialsupportfromRussia(Russialaterrestructureda2.5bnloan),andmanyRussianswerecaughtbythebailinofuninsureddeposits.Cyprusalsovotedinfavour of the UN General Assembly resolution supporting the territorial integrity ofUkraine in March 2014, and joined other EU members in imposing sanctions againstRussia after the annexation of Crimea. However, Cyprus cannot afford to pushrelations with Russia too far. The professional services sector remains over-dependent on Russian business and Russia could overtake the UK as the primarytourism market in the next few years.

Democracy index: CyprusInTheEconomistIntelligenceUnits2013democracyindexCyprusranks42ndoutof 167 countries, down from 41st in 2012. It is classified as a "flawed democracy",mainly as a result of the decades-long division of the island and low politicalparticipation. Even though the de facto Greek Cypriot government is internationallyrecognised as the legitimate government of the entire territory of the Republic ofCyprus, it does not have control over the north. International efforts to find asettlement that is acceptable to the majority of the population on both sidesresumed in 2014, but progress has been slow because of low levels of trust on bothsides. The island is heavily militarised, with tens of thousands of Turkish troopsstationed in the north since 1974. This has had an influence on the political culture,as it encourages nationalist rhetoric and detracts attention from other pressingpolicy issues. With the exception of the Cyprus issue, public engagement in politicsis low and declining. A culture of cronyism still prevails and women are not wellrepresented in decision-making positions, although this is slowly improving.However, free and fair elections are held on both sides of the island and the transfer

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of power is a well-accepted process. Civil liberties are also generally well protected.In principle, freedom of expression is guaranteed in Cyprus, but objective reportingcan be compromised by the large business interests of many politicians, who candirectly influence a media outlet's advertising revenue.

Democracy index Regime type Overall score Overall rank2013 Flawed democracy 7.29 out of 10 42 out of 1672012 Flawed democracy 7.29 out of 10 41 out of 1672011 Flawed democracy 7.29 out of 10 40 out of 167

Public response to economic crisis has beenmutedThe economic crisis that erupted in the southern part of the island in early 2013 hasdriven up unemployment and hit living standards but has led to only a few smallprotests and no violent unrest. Economic conditions have been difficult in theunrecognised Turkish Republic of Northern Cyprus (TRNC) for much longer.Because the administration is not recognised internationally, except by Turkey, itdoes not have direct access to international trade and transport. As a result (andbecause of weak economic governance), it is economically heavily dependent onTurkey, which remains vulnerable to shifts in investor confidence. Failure to resolvethe division of the island has left the Turkish Cypriots in limbo, unable to tradedirectly with the EU or to accede to the Union.

Democracy index 2013 by category(On a scale of 0 to 10)

Electoralprocess

Functioning of government Political participation Political culture Civil liberties

9.17 6.43 6.11 5.63 9.12

A free white paper containing the full index and detailed methodology can bedownloaded from www.eiu.com/DemocracyIndex2013.

Note on methodologyThere is no consensus on how to measure democracy, and definitions of democracyare contested. Having free and fair competitive elections, and satisfying relatedaspects of political freedom, is the sine qua non of all definitions. However, ourindex is based on the view that measures of democracy that reflect the state ofpolitical freedom and civil liberties are not "thick" enough: they do not encompasssufficiently some crucial features that determine the quality and substance ofdemocracy. Our index therefore also includes measures of political participation,political culture and functioning of government, which are, at best, marginalised byother measures.

Our index of democracy covers 167 countries and territories. The index, on a 0-10scale, is based on the ratings (0, 0.5 or 1) for 60 indicators grouped in fivecategories: electoral process and pluralism; civil liberties; functioning ofgovernment; political participation; and political culture. Each category has a ratingon a 0-10 scale, and the overall index of democracy is the simple average of the fivecategory indices.

The category indices are based on the sum of the indicator scores in the category,converted to a 0-10 scale. Adjustments to the category scores are made if countriesdo not score a 1 in the following critical areas for democracy:

whether national elections are free and fair;the security of voters;the influence of foreign powers on government; andthe capability of the civil service to implement policies.

If the scores for the first three questions are 0 (or 0.5), one point (0.5 point) isdeducted from the index in the relevant category (either the electoral process and

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pluralism or the functioning of government). If the score for 4 is 0, one point isdeducted from the functioning of government category index.

The index values are used to place countries within one of four types of regime:

fulldemocraciesscoresof8to10flaweddemocraciesscoresof6to7.9hybridregimesscoresof4to5.9authoritarianregimesscoresbelow4.

Thresholds for regime types depend on overall scores that are rounded to onedecimal point.

Policy trendsPolicy will be defined for the next few years by the need to meet the conditions ofthe three-year bail-out package that was agreed with the EU and IMF in March-April2013.Thisinvolvedaloanof10bnuptoearly2016,tocovermaturingdebtheldbyforeigninstitutionsandtherecapitalisationandmergeroftheco operativebanks.What made the Cyprus case in effect only a partial bail-out was that the euro zoneleaders insisted that the recapitalisation of the largest bank, Bank of Cyprus, and theparts of Cyprus Popular Bank that it absorbed, must come from private-sectorsources,intheformoflossesofaround1.5bnfor(mainlyjunior)bankbondholders,andtheconversionintosharesofaround7.4bnofbankdepositsinexcessof100,000.Owingtoastrongfiscalperformanceandfavourableinternational conditions, Cyprus was able to tap the financial markets two yearsearly,inJune2014,withafiveyear750minternationalbond,andthegovernmentmay seek to exit the bail-out programme earlier than expected.

The deposit conversion means that Bank of Cyprus is now comfortably capitalised,with a Core Tier 1 ratio at end-March 2014 of 10.6%, although it will also seekprivate-sector capital to ensure that it can meet the EU-wide stress tests. Capitalflight has eased and all domestic restrictions have been lifted. However, Bank ofCyprus still has a liquidity shortage, therefore external capital restrictions willprobably not be lifted before the end of 2014. Since the purpose of the controls is toprotect bank liquidity, rather than the value of the currency, we do not expect thecapital controls to last for years, as they have done in Iceland, for example.

Todate,thegovernmenthasmetallofthekeytargetsofthebailoutpro gramme.However, parliament has twice put the release of bail-out tranches in jeopardy bythreatening to reject the change in supervision of the co-operative banks, and byinitially rejecting the privatisation framework law. The risk of parliamentary rejectionhas increased now that Disy is governing alone and Diko is divided, although Dikohas indicated that it will remain supportive of reforms. The key resistance is toprivatisation, as all political parties benefit from the patronage system involved inrunning and managing state-owned enterprises.

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Fiscal policyIn 2013 the general government budget deficit narrowed to 5.4% of GDP, from 6.4%in 2012. From 2015 the severe economic contraction, combined with spending onrising unemployment and early retirement, will start to offset austerity measures andincreases in taxation. Thus, we expect the budget deficit to narrow to just under 4%of GDP by 2015 and to record a primary surplus (budget balance minus interestpayments) from 2017, which will reverse the upward trend in the public debt/GDPratio.

ByMay2014Cyprushadreceivedjustoverhalfofthe10bnEUIMFfundstherestwillbedistributedintranchesuntilthefirstquarterof2016.The1.5bntrancheapproved in September went towards recapitalisation of the co-operatives, andfuture tranches will be used to cover budget deficits and maturing debt. Thegovernmentusedthe750mbondissueinJunetopayoffpartofadomesticbondnot covered by bail-out funds, and may issue more debt to improve its maturityprofile further. The government debt/GDP ratio was 111.7% in 2013. As a result ofthe better than expected economic and fiscal performances we have revised downour debt projections. We now expect the debt/GDP ratio to peak at less than 120%of GDP in 2016. Given our outlook for weak growth there remains a risk that Cyprus'spublic debt will need restructuring, although the risk is considerably less than a yearago.Around1bnindomesticdebt(domesticbondholdersonly)aswellasthe2.5bnbilateralloanfromRussiahavealreadybeenrestructuredaspartofthebailout deal. To date, the troika authorities have ensured that foreign bondholders ofboth international and domestic bonds have been paid in full. This means thatofficial-sector creditors will eventually account for a large proportion of the debtstock. Therefore, if the debt needs to be restructured it may well have to be official-sector debt, although thus far the EU authorities have resisted this for any bail-outcountry.

Monetary policyThe European Central Bank (ECB) in early June made good on its pledge to easemonetary policy significantly. The ECB went even further than we had expected,cutting its deposit rate to below zero, introducing a variety of liquidity measures andsuggesting strongly that it would, at some point, begin purchasing asset-backedsecurities. Prior to this, the ECB had in effect been tightening policy for more than ayear: assets on its balance sheet have been falling, partly because banks werepaying back loans made to them during the depth of the debt crisis. This meant thatmonetary conditions in the euro zone were tightening throughout 2013 and the earlypart of 2014. The strong euro was acting as a headwind to euro zonecompetitiveness, and the ECB made no secret of its desire to see the currencyweaken (which, along with concerns about deflation, prompted the ECB to act).Markets foresee the policy at the Federal Reserve (the US central bank) and the ECBmoving in opposite directions, and this will support the US dollar.

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International assumptions 2013 2014 2015 2016 2017 2018Economic growth (%)Euro area GDP -0.4 1.1 1.5 1.6 1.6 1.7UK GDP 1.7 3.1 2.5 1.8 2.0 2.1OECD GDP 1.3 2.1 2.6 2.3 2.3 2.5World GDP 2.1 2.6 3.0 2.8 2.8 2.9World trade 2.7 4.4 5.0 5.3 5.4 5.5Inflation indicators (% unless otherwise indicated)US CPI 1.5 1.8 2.1 2.3 2.3 2.5Euro area CPI 1.4 0.8 1.3 1.5 1.6 1.7Manufactures (measured in US$) -3.1 0.0 0.9 1.8 1.9 1.6Oil (Brent; US$/b) 108.9 107.5 105.1 103.8 97.5 93.0Non-oil commodities (measured in US$) -6.8 -3.0 0.1 0.6 3.3 2.9Financial variables3monthinterbankrate(av%) 0.2 0.3 0.4 0.7 1.5 2.0Exchangerate:US$(av) 0.75 0.74 0.79 0.79 0.79 0.79Exchange rate US$:(av) 1.33 1.34 1.27 1.26 1.27 1.26

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Economic growthReal GDP declined by 5.4% in 2013. We expect a further full-year contraction in 2014as wages fall, unemployment remains high and the banks are forced to tackle non-performing loans, which now exceed 40% of all loans, in order to survive. This willhave a negative impact on private consumption. Real GDP fell by 4.1% year on yearin the first quarter of 2014. Given that the second quarter of 2013 exhibited thegreatest decline last year, the contraction for 2014 as a whole is likely to be milder.We therefore forecast a real GDP decline of 3.7% in 2014 and a return to modestgrowth in 2015-18. However, growth rates will be below 2%, held back by banks'reluctance to lend to the very highly leveraged corporate and household sectors.Corporate debt is around 200% of GDP and household debt is around 160% of GDP.

The collapse of the financial sector and the rise in unemployment led to a fall inprivate consumption of 5.7% in 2013. The negative trend will continue in 2014, andthe abovementioned high household debt will allow for only moderate growth in2015-18. Fixed investment was already in deep decline before the March 2013 crisisbecause of a declining property market, and fixed investment dropped by 21.6% in2013.Thepaceofcontractionwillslowin2014 16andweexpectfixedinvestmenttoreturn to growth at the end of the forecast period. Nevertheless, by 2018 we expectfixed investment spending to be about two-thirds below its 2008 peak in real terms,which raises serious questions about the economy's growth potential in the longerterm. The exploitation of gas reserves will eventually boost investment, but this willnot occur until the end of the forecast period. We expect a weaker contraction inpublic consumption, mainly because expenditure on unemployment benefits andjob-creation programmes will prevent a steep decline, with growth returning in 2016,the legislative election year.

The external sector will also suffer greatly from the meltdown of the banks andcontinued uncertainty. Financial services fell by 8.6% and professional services by4.6% in 2013, and tourism arrivals dropped by 2.4%, perhaps because of the badpublicity relating to initial limitations on cash withdrawals (which did not apply toforeign bank accounts and have now been withdrawn) and capital controls.

With so many uncertainties about the quality of the loan portfolio at the banks thereis a risk that the financial sector will suffer more than expected from the currentcrisis, and that the austerity measures will stifle growth for a longer period thanforecast. Tighter sanctions on Russia also constitute a risk to tourism and businessservices.

Economic growth% 2013a 2014b 2015b 2016b 2017b 2018b

GDP -5.4 -3.7 0.9 1.0 1.4 1.7Private consumption -5.7 -3.9 0.1 1.0 2.1 2.3Government consumption -5.0 -3.8 -1.0 1.0 0.5 0.5Gross fixed investment -21.6 -21.0 -8.0 -5.0 0.0 2.0Exports of goods & services -4.2 -1.4 2.3 2.5 2.8 2.9Imports of goods & services -14.1 -6.3 -1.8 5.5 3.6 3.5Domestic demand -10.2 -6.0 -1.0 2.2 1.7 1.9Agriculture -1.2 1.0 0.2 0.5 0.5 0.5Industry -18.0 -4.2 -3.0 1.5 3.0 3.0Services -3.2 -3.8 1.6 0.9 1.2 1.5a Actual. b Economist Intelligence Unit forecasts.

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InflationPlummeting demand has led to deflationary pressures that have more than offset theimpact of tax increases. The national consumer price inflation rate recorded deflationof -0.4% in 2013 while the EU harmonised rate, which uses different weights forsome categories, was (a positive) 0.4%. Deflationary pressures have continued andin January-May the EU harmonised index averaged a decline of 0.8%. We expectthat continued weak demand will offset the 1-percentage-point increase in thestandard value-added tax (VAT) rate, to 19% in January, and the recent increase ininternational oil prices. We therefore expect deflation in 2014 based on both thenational and EU harmonised measures, before a gradual turnaround in demand leadsto inflation rates averaging 2.1% in 2015-18. This will be higher than the euro areaaverage, reflecting in part the relative lack of competition in this small market. Onerisk to our forecast is if international oil prices continue to rise. In Cyprus oil priceshave a significant impact on inflation, since oil products are used for more than 90%of electricity production.

Average monthly earnings fell by 1.5% in 2013. We expect a further decline in bothnominal and real wages in 2014-15 owing to a 3% reduction in gross public-sectorwages due in 2014 and a historically high unemployment rate that will weaken wage-bargaining power. The unemployment rate rose to 15.9% in 2013, from 11.9% in 2012,but has shown signs of stabilising since. We expect it to peak at 16.5% in 2014 butto remain in double digits for many years owing to low real GDP growth rates. Ourforecast for unemployment would be higher were it not for the large number ofEnglish-speaking graduates, who we expect to emigrate or remain in the UK afterstudying.

Exchange ratesFollowing the ECB's decision to cut its deposit rate to below zero at its meeting inearly June, the euro began to weaken against the US dollar. From a peak of nearlyUS$1.40:1inearlyMay,theeurostartedtodepreciateintherunuptotheECB'smeeting and continued to be weaker thereafter, although it had recovered to aroundUS$1.36:1byJuly7th,owingtoweakerthanexpectedeconomicperformanceintheUS. We expect the euro to be weaker on average in 2014 than in 2013 and weforecastafullyear2014averageexchangerateofaroundUS$1.34:1.Thatsaid,wecertainly do not expect a collapse in the euro. The dollar could soften further if USeconomic activity does not gather pace.

External sectorThe current-account deficit narrowed to 1.9% of GDP in 2013, from 6.9% of GDP in2012, reflecting a massive drop in imports as demand collapsed. We expect thedeficit to widen in 2014 as the pace of domestic demand contraction eases slightly.Before the banking crisis, the deficit was often covered by "net other investment"on the financial account, dominated by bank deposits from abroad, but these havefallen sharply and will remain at much lower levels in the coming years. From 2015we expect the current-account deficit to widen as the economy slowly recovers.Investments for the exploitation of natural gas, and potentially oil, will lead to anincrease in imports in the longer term. Although significant hydrocarbon investmentcould start in three to four years' time, actual gas exports that would reduce thedeficit will take many more years to materialise.

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Forecast summaryForecast summary(% unless otherwise indicated) 2013a 2014b 2015b 2016b 2017b 2018b

Real GDP growth -5.4 -3.7 0.9 1.0 1.4 1.7Industrial production growth -12.4 -4.9 -3.7 0.8 2.3 2.3Unemployment rate (av; EU/OECD standardised measure) 15.9 16.5 16.2 15.9 15.2 14.2Consumer price inflation (av; national measure) -0.4 -1.8 0.5 1.0 1.8 2.0Consumer price inflation (av; EU harmonised measure) 0.4 -0.7 1.4 1.8 2.5 2.7Short-term interbank rate 0.2 0.3 0.4 0.7 1.5 2.0Government balance (% of GDP) -5.4 -5.0 -3.9 -3.3 -2.8 -2.5Exports of goods fob (US$ m) 2,523 2,529 2,606 2,731 2,974 3,324Imports of goods fob (US$ m) -5,860 -5,557 -5,618 -6,356 -7,121 -7,968Current-account balance (US$ m) -423 -514 -494 -629 -697 -740Current-account balance (% of GDP) -1.9 -2.4 -2.4 -3.1 -3.4 -3.6Exchangerate:US$(av) 0.753 0.744 0.786 0.794 0.787 0.794Exchangerate:(av) 1.178 1.238 1.269 1.270 1.244 1.246Exchangerate:100(av) 0.771 0.729 0.768 0.778 0.780 0.794a Actual. b Economist Intelligence Unit forecasts.

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Data and chartsAnnual data and forecast

2009a 2010a 2011a 2012a 2013a 2014b 2015b

GDP Nominal GDP (US$ m) 23,481.4 23,094.4 24,881.0 22,781.1 21,919.4 21,441.3 20,167.8NominalGDP(m) 16,854 17,406 17,878 17,720 16,504 15,953 15,849Real GDP growth (%) -1.9 1.3 0.4 -2.4 -5.4 -3.7 0.9Expenditure on GDP (% real change) Private consumption -7.5 1.5 1.3 -2.0 -5.7 -3.9 0.1Government consumption 6.8 1.0 -0.2 -3.8 -5.0 -3.8 -1.0Gross fixed investment -9.7 -4.9 -8.7 -18.3 -21.6 -21.0 -8.0Exports of goods & services -10.7 3.8 4.4 -2.5 -4.2 -1.4 2.3Imports of goods & services -18.6 4.8 -0.2 -5.4 -14.1 -6.3 -1.8Origin of GDP (% real change) Agriculture -0.2 3.3 5.8 0.5 -1.2 1.0 0.2Industry -11.6 -4.0 -7.4 -12.8 -18.0 -4.2 -3.0Services 0.9 2.6 2.1 -0.3 -3.2 -3.8 1.6Population and income Population (m) 0.8 0.8 0.8 0.9 0.9 0.9 0.9

GDP per head (US$ at PPP) 28,152c 28,083c 28,055c 27,137c 25,940c 25,418 25,987

Recorded unemployment (av; %) 5.4 6.3 7.9 11.9 15.9 16.5 16.2Fiscal indicators (% of GDP) Public-sector balance -6.1 -5.3 -6.3 -6.4 -5.4 -5.0 -3.9Public-sector debt interest payments 2.6 2.2 2.4 3.2 3.4 3.2 3.1Public-sector primary balance -3.6 -3.0 -4.0 -3.2 -2.0 -1.8 -0.8Gross public debt 58.5 61.3 71.5 86.6 111.7 117.5 119.0Prices and financial indicators ExchangerateUS$:(endperiod) 1.441 1.336 1.294 1.309 1.366 1.298 1.260Consumer prices (end-period; %) 15.2 -9.9 3.9 1.1 -2.3 -1.8 0.7

Producer prices (av; %) 1.1 0.7 2.9 2.0 -2.0c -4.0 1.0

Stock of money M1 (% change) 2.0c 7.0c 6.2c 2.4c -3.7c 0.0 2.7

Lending interest rate (av; %) 7.5 6.8 6.8 7.0 6.9 6.9 6.7Current account (US$ m) Trade balance -5,275 -5,410 -5,202 -4,154 -3,337 -3,028 -3,012 Goods: exports fob 2,025 2,282 2,748 2,591 2,523 2,529 2,606 Goods: imports fob -7,299 -7,692 -7,951 -6,745 -5,860 -5,557 -5,618Services balance 3,994 3,967 4,143 3,442 3,745 3,695 3,539Primary income balance -928 -710 521 -588 -604 -962 -794Secondary income balance -271 -156 -269 -277 -227 -219 -227Current-account balance -2,480 -2,309 -808 -1,577 -423 -514 -494International reserves (US$ m) Total international reserves 1,289 1,144 1,207 1,191 915 924 950a Actual. b Economist Intelligence Unit forecasts. c Economist Intelligence Unit estimates.Source: IMF, International Financial Statistics.

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Quarterly data 2012 2013 2014 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 QtrCentralgovernmentfinance(m) Revenue & grants 1,480.61,893.51,861.11,394.41,596.71,694.21,970.51,565.6Expenditure & net lending 1,890.01,924.92,407.21,399.71,806.21,787.12,559.71,597.2Balance -409.4 -31.4 -546.1 -5.3 -209.5 -92.9 -589.2 -31.6Output

Industrial production index (2005=100)a 84.5 83.8 78.5 73.4 73.3 75.0 70.2 71.1

Industrial production (% change, year on year) -10.1 -4.9 -10.5 -14.8 -13.2 -10.5 -10.6 -3.2Employment and prices

EUharmonisedunemployment(000)a 50.7 54.7 59.3 64.7 70.3 73.3 74.7 73.3EU harmonised unemployment rate (% of the

labour force)a11.5 12.4 13.4 14.6 15.9 16.4 16.7 16.5

Consumer prices (2005=100) 106.4 105.5 106.7 106.0 106.1 104.7 104.6 103.3Consumer prices (% change, year on year) 2.6 2.5 1.3 1.5 -0.3 -0.8 -2.0 -2.6EU harmonised consumer prices (2005=100) 120.6 120.3 120.0 119.1 121.1 120.8 119.0 117.6EU harmonised consumer prices (% change,year on year)

3.4 4.0 1.8 1.7 0.4 0.3 -0.8 -1.2

Industrial output prices (2000=100) 112.4 113.6 113.1 111.7 110.8 109.7 107.7 106.4Financial indicators ExchangerateUS$:(av) 1.283 1.251 1.297 1.320 1.307 1.325 1.361 1.370ExchangerateUS$:(endperiod) 1.259 1.293 1.319 1.281 1.308 1.351 1.379 1.379Lending rate (av; %) 7.0 7.1 7.1 7.0 6.9 7.0 6.6 6.4CSE general index (end-period; Sep 3rd2004=1,000)

140 106 115 n/a 96 93 103 118

Sectoral trends

Manufacturing production (2005=100)a 84.1 82.2 78.7 73.4 72.5 73.8 69.4 70.8

Mining production (2005=100)a 66.5 59.4 52.1 44.8 37.8 40.6 34.9 35.7

Retail trade turnover, volume (2005=100) 91.5 96.3 95.6 76.1 84.6 92.7 94.6 76.0Tourism,arrivals(000) 768.1 927.4 997.01,000.5 901.2 657.0 418.1 205.8Foreigntrade(m) Exports fob 380.1 375.3 351.9 334.1 330.1 349.8 350.7 328.1Imports cif 1,623.61,610.81,625.01,585.21,578.11,548.61,538.81,450.4

Trade balance-

1,243.5-

1,235.5-

1,273.1-

1,251.1-

1,248.1-

1,198.7-

1,188.1-

1,122.3Foreign payments (US$ m) Merchandise trade balance -1,061 -1,110 -1,050 -808 -625 -945 -959 n/aServices balance 1,013 1,110 831 452 1,013 1,382 899 n/aPrimary income balance -97 -98 -301 -249 -32 -58 -264 n/aNet transfer payments -88 -43 -67 -51 -43 -90 -43 n/aCurrent-account balance -233 -140 -587 -656 312 289 -367 n/aReserves excl gold (end-period) 537 463 449 400 324 383 379 331a Seasonally adjusted.Sources: IMF, International Financial Statistics; Department of Statistics & Research, Monthly Economic Indicators; CyprusTourism Organisation.

Monthly data Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov DecExchangerateUS$:(av)2012 1.291 1.322 1.320 1.316 1.279 1.253 1.229 1.240 1.286 1.297 1.283 1.3122013 1.329 1.336 1.296 1.303 1.298 1.319 1.308 1.331 1.335 1.364 1.349 1.3702014 1.361 1.366 1.382 1.381 1.373 n/a n/a n/a n/a n/a n/a n/aExchangerateUS$:(endperiod)2012 1.318 1.344 1.336 1.321 1.240 1.259 1.228 1.261 1.293 1.299 1.299 1.3192013 1.355 1.313 1.281 1.307 1.301 1.308 1.328 1.324 1.351 1.364 1.361 1.3792014 1.352 1.381 1.379 1.385 1.361 n/a n/a n/a n/a n/a n/a n/aDeposit rate (av; %)2012 3.9 3.9 3.6 4.1 4.0 3.5 4.2 4.1 3.5 4.1 4.2 4.12013 4.1 4.3 4.2 3.2 2.2 2.2 2.1 2.0 1.9 2.0 1.9 2.3

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2014 2.0 2.2 2.2 n/a n/a n/a n/a n/a n/a n/a n/a n/aLending rate (av; %)2012 6.9 7.0 7.0 6.9 7.0 7.1 7.2 7.3 6.9 7.3 7.1 6.82013 7.0 6.9 7.2 7.2 6.9 6.8 6.8 7.0 7.2 7.1 6.6 6.02014 6.3 6.4 6.4 n/a n/a n/a n/a n/a n/a n/a n/a n/aIndustrial production (% change, year on year; 2005=100; seasonally adjusted)2012 -10.7 -8.6 -13.8 -7.9 -10.9 -11.4 -5.7 -2.5 -6.4 -8.7 -9.8 -13.12013 -13.1 -17.6 -13.5 -13.2 -14.4 -12.0 -13.5 -4.9 -13.4 -10.6 -13.4 -7.72014 -5.9 -1.8 -1.8 n/a n/a n/a n/a n/a n/a n/a n/a n/aRetail trade turnover, volume (non-seasonally adjusted; 2005=100)2012 84.0 80.9 84.6 88.0 89.6 97.0 99.5 96.8 92.5 89.5 86.8 110.52013 81.2 73.8 73.3 79.1 88.1 86.5 96.1 94.0 88.1 89.4 84.9 109.42014 78.9 72.5 76.7 n/a n/a n/a n/a n/a n/a n/a n/a n/aEU harmonised unemployment (seasonally adjusted; '000)2012 43.0 44.0 47.0 49.0 51.0 52.0 54.0 54.0 56.0 58.0 59.0 61.02013 64.0 65.0 65.0 69.0 70.0 72.0 72.0 74.0 74.0 75.0 74.0 75.02014 72.0 73.0 75.0 72.0 n/a n/a n/a n/a n/a n/a n/a n/aEU harmonised unemployment rate (seasonally adjusted; % of the labour force)2012 9.9 10.2 10.7 11.2 11.6 11.7 12.3 12.2 12.7 13.2 13.3 13.82013 14.4 14.7 14.7 15.6 15.9 16.2 16.1 16.5 16.6 16.8 16.7 16.72014 16.2 16.4 16.9 16.4 n/a n/a n/a n/a n/a n/a n/a n/aCSE general index (end-period; Sep 3rd 2004=1,000)2012 386 298 247 230 139 140 111 88 106 143 122 1152013 111 109 n/a 98 97 96 93 94 93 96 111 1032014 105 140 118 113 105 n/a n/a n/a n/a n/a n/a n/aConsumer prices (av; % change, year on year)2012 3.1 3.1 3.4 3.1 3.0 1.8 2.2 2.7 2.5 1.7 1.2 1.12013 1.8 1.6 1.1 -0.3 -0.7 0.1 -0.3 -0.9 -1.0 -1.6 -2.1 -2.32014 -2.9 -2.6 -2.3 -1.6 n/a n/a n/a n/a n/a n/a n/a n/aProducer prices (% change, year on year; 2005=100)2012 8.7 8.4 8.3 8.0 8.7 8.6 5.7 6.3 5.6 5.9 4.5 4.22013 1.8 2.3 1.0 0.5 -2.2 -2.6 -2.7 -3.3 -4.3 -4.5 -5.0 -4.82014 -4.9 -4.9 -4.5 -4.3 n/a n/a n/a n/a n/a n/a n/a n/aTotal exports fob (US$ m)2012 120.2 143.6 164.7 184.8 171.8 161.0 158.4 125.7 154.3 167.9 142.7 133.72013 155.0 138.5 150.0 256.9 173.3 175.9 202.1 133.8 194.3 200.5 147.0 147.82014 150.8 145.7 186.2 n/a n/a n/a n/a n/a n/a n/a n/a n/aTotal imports cif (US$ m)2012 540.6 610.5 691.0 676.7 614.2 602.2 680.1 572.3 591.2 655.6 588.7 557.92013 541.7 521.8 490.0 469.5 464.9 529.9 607.6 499.1 569.3 576.8 550.5 567.02014 519.5 452.6 584.7 n/a n/a n/a n/a n/a n/a n/a n/a n/aTrade balance fob-cif (US$ m)2012 -420.3 -466.9 -526.3 -491.9 -442.4 -441.2 -521.7 -446.5 -436.9 -487.7 -446.0 -424.22013 -386.7 -383.3 -340.0 -212.6 -291.6 -353.9 -405.5 -365.3 -375.0 -376.4 -403.6 -419.22014 -368.8 -306.9 -398.5 n/a n/a n/a n/a n/a n/a n/a n/a n/aForeign-exchange reserves excl gold (US$ m)2012 534 536 474 491 528 537 511 460 463 459 457 4492013 447 436 400 309 324 324 325 326 383 369 359 3792014 324 326 331 330 n/a n/a n/a n/a n/a n/a n/a n/aSources: IMF, International Financial Statistics; Haver Analytics; Eurostat.

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Annual trends charts

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Monthly trends charts

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Comparative economic indicators

Basic dataLand area9,251 sq km, of which 3,355 sq km is controlled by the Turkish Cypriotadministration, 151 sq km is in the UN-monitored buffer zone (Green Line) and 254sq km constitute the Sovereign Base Areas under the jurisdiction of the UK

PopulationTotal population of the Greek Cypriot south of the Republic of Cyprus was 840,407

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at the census in 2011; the Turkish Cypriot census in the same year put the de jurepopulation in the north (excluding Turkish military) at 286,257, of which 80,550 wereTurkish citizens and 104,641 were born in in Turkey

Main townsPopulation in '000 (2011 census):

Nicosia (Lefkosia) district (capital): 327

Limassol (Lemesos) district: 235

Larnaca district: 143

Paphos district: 88

Ammochostos (Free Famagusta) district: 46

ClimateMediterranean

Weather in Nicosia (altitude 160 metres)Hottestmonth,July,2237C(averagedailyminimumandmaximum)coldestmonth,January,515Cdriestmonth,July,2mmaveragerainfallwettestmonth,December,59 mm average rainfall

LanguagesGreek and Turkish; English is also widely spoken

MeasuresMetric system

CurrencyEuro()=100centsreplacedPound(C)=100centsonJanuary1st2008attheirrevocableexchangerateofC0.585274:1

Fiscal yearCalendar year

Time2 hours ahead of GMT (3 hours ahead in summer)

Public holidaysJanuary 1st; January 6th; Green Monday (50 days before Greek Orthodox Easter);March 25th; April 1st; Good Friday and Easter Monday (Greek Orthodox calendar);May 1st; Pentecost-Kataklysmos (50 days after Greek Orthodox Easter); August15th; October 1st; October 28th; December 24th; December 25th; December 26th

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Political structureOfficial nameRepublic of Cyprus; the government is the internationally recognised governmentof the island, but its writ does not run in the north, which has been occupied since1974 by Turkish troops; in 1983 the Turkish Cypriot administration declared thenorthern territory to be an independent state called the Turkish Republic ofNorthern Cyprus (TRNC), which is recognised only by Turkey. Reference to theTRNC or "Turkish Cypriot zone" in this report does not imply recognition as asovereign state by The Economist Intelligence Unit. Unless clearly indicated,economic statistics in this report refer to the economy in the area controlled by thegovernment of the Republic of Cyprus

Legal systemBased on the constitution of 1960

LegislatureUnicameral House of Representatives elected for a five-year term by direct universalsuffrageatpresent,only56membersallGreekCypriotsitinthelegislatureanadditional three special representatives of the Maronite and Armenian minorities areelected in a separate vote

National electionsFebruary 2013 (presidential) and May 2011 (legislative); next legislative election isdue in May 2016; next presidential election is due in February 2018

Head of state

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Directly elected president with executive powers, who serves a five-year term; theoffice is currently held by Nicos Anastasiades (Disy), who replaced DemetrisChristofias (Akel) after the February 2013 presidential election

ExecutiveCouncil of Ministers appointed by the president, who convenes and presides overits meetings; ministers may not sit in the House of Representatives, but mayintroduce bills

Main political partiesDemocratic Rally (Disy); Progressive Party of the Working People (Akel,communist); Democratic Party (Diko); Movement of Social Democrats (Edek,formerlyknownastheSocialDemocraticMovementKisos)UnitedDemocrats(Edi); European Party (Evroko). The government formed in 2013 comprisedrepresentatives of Disy, Diko and Evroko, although Diko formally left the coalitionin February 2014

Principal ministersAgriculture, natural resources & environment: Nicos Kouyialis (Evroko)

Communications & public works: Marios Demetriades (Diko-allied)

Defence: Christoforos Fokaides (Disy)

Education & culture: Costas Kadis (Diko-allied)

Energy, commerce, industry & tourism: Georgios Lakkotrypis (independent)

Finance minister: Haris Georgiades (Disy)

Foreign affairs: Ioannis Kasoulides (Disy)

Government spokesman: Christos Stylianides (Disy)

Health: Philippos Patsalis (Disy)

Interior: Socratis Hasikos (Disy)

Justice & public order: Ionas Nicolaou (Disy)

Labour & social security: Georgia (Zeta) Emilianidou (Disy)

Central Bank governorChrystalla Georghadji

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Recent analysisGenerated on August 6th 2014

The following articles were published on our website in the period between our previous forecast and this one, and serve here asa review of the developments that shaped our outlook.

PoliticsForecast updatesMay 27, 2014: Election watch

Mainstream parties hold seats at European elections

EventAt the European Parliament elections on May 25th all of the mainstream parties heldon to their share of Cyprus's six seats in parliament, but voter turnout was low at42.4%, 17 percentage points down on the 2009 European Parliament elections.

AnalysisThe ruling Democratic Rally (Disy), a member of the right-leaning European People'sParty (EPP) grouping in the European Parliament, retained its two seats and received37.8% of the vote, compared with 35.7% in the previous European elections in 2009.

The communist Progressive Party of Working People (Akel), part of the ConfederalGroup of the European United Left/Nordic Green Left (GUE/NGL), also retained itstwo seats but its share of the vote dropped to 27% from 34.9% in 2009. Akel was inpower at the height of the financial crisis that forced the government (belatedly) toapply for a bail-out from the EU/IMF.

The Democratic Party (Diko), part of the Progressive Alliance of Socialists andDemocrats (S&D), fared reasonably well considering recent infighting caused by itsexit from the coalition in late February. It received 10.8% of the vote compared with12.3% in 2009 and held its one seat. A joint ticket of the Movement for SocialDemocrats (Edek) and the Green Party received 7.7% of the vote compared with9.9% in 2009 to obtain one seat. The Edek candidate elected from the list will also sitin the S&D group.

Cyprus: European Parliament election results(% of vote)

2009 2014

Democratic Rally (Disy) 35.7 37.8

Progressive Party of the Working People (Akel) 34.9 27.0

Democratic Party (Diko) 12.3 10.8

Movement of Social Democrats (Edek)/Greens (Edek only in 2009) 9.9 7.7

Greens (Greens only in 2009) 1.5 -

Citizen's Alliance - 6.8

Message of Hope - 3.8

National People's Front (Elam) 0.2 2.7

European Party (Evroko) 4.1 -

Others 1.5 3.5

Total 100.0 100.0

Source: Ministry of the Interior.

Although the mainstream parties held on to their seats, they are still being

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challenged by other, newer groupings. It was only by joining forces that Edek-Greens managed to beat a recently formed party called the Citizen's Alliance, run bya former minister, George Lillikas, which received 6.8% of the vote. Althoughsupport for the far-right National People's Front (Elam) edged up, it was still low, at2.7% of the vote compared with just 0.2% in 2009, when it had only just beenformed. This placed it seventh behind another new, mixed grouping called Messageof Hope. However, because this group is unlikely to survive until the generalelection, Elam has a chance of gaining one seat at the legislative elections in 2016,as there is no percentage threshold in the national parliament. However, it may yetbe kept out by the Citizen's Alliance.

Impact on the forecastWe are likely to maintain our forecast that the president, Nicos Anastasiades, whohails from Disy, will continue to follow broadly the EU/IMF bail-out programme.

AnalysisApril 25, 2014: Election watch

European Parliament election: key implicationsThe May elections for the European Parliament will mostly be met by apathy acrossthe continent, and many of those who do vote will either vote with national issues inmind or use the occasion to deliver a negative verdict on the EU project as a whole.We expect the election outcome to be decided by a fairly small core of voters in thelarger member states, which should favour the established centre-right andcentre-left parties at the European level. Overall this should mean that thelegislative agenda in Brussels is not significantly disrupted, although there will besome implications for the European Commission. The most important fallout willbe felt domestically, with parties away from the political mainstream likely to use astrong showing in May to raise their profile and generate momentum at thenational level.

The European Parliament elections will take place across the continent on May22nd 25th.TheywilloccuratatimewhentheParliamentismorepowerfulthanever,and is showing itself to be increasingly willing to challenge the EuropeanCommission, the EU's executive arm. However, the elections will also see a host ofEurosceptics from across the continent lining up to challenge the legitimacy of theParliament itself. This legitimacy, as measured by turnout at elections, is at an all-time low.

The outcome of the election will have an important impact on the EU at a crucial

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time, particularly as it will have an important bearing on the next president of theEuropeanCommission.Forthe2014electionthemaingroupsintheParliamentnotably the centre-right European People's Party (EPP), the centre-left Party ofEuropean Socialists (PES) and the centrist Alliance of Liberals and Democrats forEurope(ALDE)haveputforwardcandidatesforthepresidentoftheCommission(currentlyJosManuelBarroso).Thisinturnwillinfluencewhobecomespresidentof the Council (currently led by Herman Van Rompuy) and the high representativefor foreign affairs and security policy (a position currently held by CatherineAshton).

The big themes that will decide the electionMuch to the chagrin of many in Brussels, few Europeans are likely to cast their votewith the programme of a European-wide party in mind. The fact is that mostEuropeans will not vote, and those that do will mostly do so with national factors inmind. The following themes are likely to be significant:

Country-specific factors will probably have the largest impact on how voterscasttheirballots.DynamicsinthesixbiggestcountriesGermany,France,Italy,theUK,SpainandPolandwhichbetweenthemwillcontribute421ofthe751membersofthenextParliamentwillthereforebecrucial.Many will simply use their vote to deliver a negative verdict on the EU as awhole by voting for anti-EU parties. The 2008-09 global financial crisis, andsubsequent euro crisis, has increased anti-EU sentiment in many countries.This has created an opportunity for extremist groups to gain a strongerpublic profile, particularly on the far right.There is also a generational element, particularly in southern Europe, whereunemployment rates among the under-25s have rocketed and many havebeen forced to emigrate to wealthier northern states to look for work.The crisis in Ukraine is likely to have some effect on how people vote,although of the larger countries that send the biggest number of Members ofthe European Parliament (MEPs) to Brussels, this will probably only be asignificant factor in Poland.

Who will win?Predicting the outcome of elections to a Parliament with 751 members and withvoters spread across 28 countries is difficult. A poll by Votewatch on April 23rd hadthe EPP on 217 seats, ahead of the PES on 208 and the ALDE on 63. This is similar toother recent polls, which tend to show the EPP remaining as the largest party, butsignificantly down from its level of support in the current Parliament, and with thePES slightly up on the last election.

In some of the bigger countries, notably the UK and France, the parties to the right

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of the EPP have strong momentum, and are likely to poll well. However, in othercountries, such as Spain and Germany, far-right groups are effectively non-existent,which means that the far right's strength in the next Parliament overall is likely to belimited. In Poland the Ukraine crisis appears to have boosted support for the rulingCivic Platform (PO) party, which belongs to the EPP. In Italy, Movimento 5 Stelle(M5S, the Five Star Movement) is likely to do well, potentially exceeding the 25%support it obtained in the February 2013 general election. However, although M5S ispopulist, anti-establishment and Eurosceptic, it is not hard-right. As a result, evenshould it send a significant number of MEPs to Brussels, they are unlikely to findmuch common ground with many other protest parties in the Parliament.

In the 2009 election 12 of the 15 largest member states saw turnouts below the EUaverage. This suggests that the outcome of the election will be decided largely by acore of motivated voters in the largest countries. Given the well-organised andextensive party machinery and discipline of the centre-right and centre-left in thesecountries, on balance this should favour the EPP and PES over the smaller parties.The basic picture appears to be that centrist and pro-European parties will retain anoverwhelming majority in the next Parliament.

Some worrying implications for domesticpoliticsAlthough the far right is not expected to gain enough seats in the new Parliament tohave a significant impact on the legislative agenda, the picture may be different insome individual member states. A strong result for groups such as the UKIndependence Party (UKIP) in the UK, the Front national (FN) in France andthe Party for Freedom (PVV) in the Netherlands would increase their prominence andcould generate strong momentum towards a good result in national elections. Agreater prominence for these parties would push the centre-right (and potentiallyalso centre-left) parties in these countries further to the right on issues such asimmigration.ItispossibletoarguethatatleastintheUKandFrancethishasalready been the case. A particularly strong showing for M5S in Italy could putfurther pressure on the government to push back against Commission fiscal targets.

Implications for the CommissionThere is still a chance that the member states will not take into account the result ofthe Parliament election in selecting the next head of the Commission. However, webelieve that it is highly likely that either the EPP candidate, Jean-Claude Juncker, orthe PES candidate, Martin Schulz, will be the next Commission head. Mr Schulz inparticular would be hard to ignore, should the PES triumph. As head of theEuropean Parliament he has shown himself to be a very capable operator in theBrussels corridors of power. Of the two, Mr Schulz would be more likely to shake up

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the status quo, in our view. He is known to favour greater federalism, and is notafraid of facing down governments in the larger member states, including Germany,his own country. Mr Juncker would represent more of a continuation of the currentprocess, with the larger member states continuing to have an important influence insteering policy. One particular change under Mr Schulz's leadership may be achange of tone from the Commission on austerity, something that it has until nowfairly rigidly enforced. Mr Schulz has already called for France's deficit target to berelaxed. This could mean tension between the Commission and some members of theCouncil, given the opposition to a relaxation of deficit targets expressed bycountries such as Germany and Finland.

Implications for the ParliamentOverall we expect moderate and pro-European parties to retain an overwhelmingmajority in the Parliament, which should ensure that Eurosceptic parties are not in aposition to significantly disrupt the legislative agenda. Should protest parties dobetter than they are currently projected to do this would create more seriousproblems for policymaking in Brussels. However, even should this play out, there isa good chance that these groups will simply use a good showing in the Parliamentelection to reinforce their message nationally, given the lack of visibility enjoyed byMEPs in most member states. The chances of the Eurosceptic parties forming astrong and united front to attempt to shape policy in Brussels are minimal, in ourview. Once they are installed in the new Parliament, they are likely to find that inmany cases what divides them is more important than what they have in common.

May 27, 2014

European elections ratchet up domestic pressuresIt is not the so-called earthquake that was shocking, but the fact that somemainstream politicians profess to have been shocked by it. The results of theEuropean Parliament elections on May 22nd-25th confirmed that the turmoil ofrecent years has exacted a significant political price. This should not surprise us.Worryingly, it is likely to hamper policymaking across the EU at a time when thebloc'sinstitutionsareinflux.InsomecountriesGermanyandItalyparticularlyvotersappearcontentwithandsupportiveoftheirleaders.ButtheresultsincountriessuchasFrance,theUKandGreecehighlighttheSisypheantaskmadeworsebyyearsofcomplacencythatpolicymakersnowfaceinattemptingtosecurecontinentwideapprovalforcontinuingand,quitepossibly,furtherintegration.

It is important to put the election results in perspective. Despite the high-profilesuccess of various populist Eurosceptic forces, the European Parliament remainsunder the sway of the centre-left and centre-right parties (see chart below). Granted,these parties may struggle to respond in concert to the expansion of Euroscepticismin the parliament chamber from an irritant fringe to an emergent force. But theinsurgents hold neither the levers nor the balance of power.

Home thoughts, from abroadIn so far as the elections herald a potential crisis of political legitimacy, they do soprimarily at the national level. The EU's hybrid governance structures have manifoldproblems, but voters' only meaningful political relationships are with their domesticrepresentatives. If there is a breakdown of trust, we should expect this to be at thenational level. Just as during the euro zone crisis a national breakdown of individualgovernments' budget deficits was much more telling than an aggregate figure for thebloc, so the EU's democratic deficit is best understood not primarily as a deficiencyat the European level (although it is certainly that too) but as a failure of nationalpoliticians to respond to their voters' concerns.

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ThemostdramaticresultoftheelectionthevictoryoftheFrontnational(FN)inFranceshouldbeunderstoodinthisway,innationalterms.Itreflectsacrisisinthe French political system more than a crisis of Europe. The two mainstream partieshave lost touch with the electorate. In 2012 voters wanted to get rid of the formerpresidentNicolasSarkozy,buttheyendorsedFranoisHollandeonlyreluctantly.Mr Hollande's approval ratings almost immediately began to display a significantdegree of regret on voters' part and have worsened steadily. However, there is nocorresponding swing of the pendulum back towards Mr Sarkozy's Union pour unmouvement populaire (UMP). Instead, it is the far-right iconoclasts of the FN whohave surged.

A similar pattern can be seen in the UK. Many voters wished to punish the twoparties of the governing coalition, but without endorsing the centre-left oppositionLabour Party, which, like the UMP in France, was all too recently the incumbentbeing punished. This explains the surge of the UK Independence Party (UKIP).

In both France and the UK, populist insurgents profited from a failure of themainstream parties to connect with their electorates. In neither country did the twomain parties manage to articulate (and thereby ease) voters' inchoate sense ofdissatisfaction with the direction things have taken. Still less did they convincepeople that they could turn things around. This is also true in Greece, where SyrizaUnifying Social Front (Syriza) was a clear victor; in Spain, where unprecedentedfragmentation saw the combined vote of the two largest parties slump from 80% in2009 to less than 50%; and in Ireland, where the deputy prime minister resignedfollowing his party's electoral collapse.

Exaggerated reports of the mainstream's deathContrast this with the results in Germany and Italy, where voters opted decisivelynot only for mainstream parties but for mainstream parties of government. They didso for opposite reasons. In Germany, the electorate is broadly content with policyand with the political mainstream's responsiveness to voters' interests. In Italy, thelandslide enjoyed by Matteo Renzi's Partito Democratico (PD) showed thecontinuing power of mainstream politics when practised by a leader who is able toconnect with the electorate.

Italy might have been the perfect breeding ground for a populist surge in theseelections by Beppe Grillo's Movimento 5 Stelle, but Mr Renzi has dulled thatmovement's appeal by recognising what voters want and promising it to them: aradical departure from the sclerotic business-as-usual of Italian politics. In Franceand the UK, by contrast, no such clarity as to voters' preferences exists. Rather thansteer the national mood, the mainstream parties in these two countries haveappeared confused and buffeted by it. This has allowed a destabilising politicalvacuum to develop, opening an unusually large gap in the political market, which is

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being filled by charismatic leaders bearing simple political messages.

We should expect to see more of the same in coming years. We are at the beginningof a long electoral cycle across Europe that is likely to be more revealing of voters'disenchantment and disaffection than was the last such cycle. The previous cyclesaw numerous incumbent governments ousted and replaced by their traditionalrivals. But in many instances, these traditional rivals have been unable to deliverchange on the scale that they explicitly or implicitly promised. So they too now findthemselves battling their electorates' disaffection. Meanwhile, many voters appearwilling to vote for "outsider" parties or candidates, who offer a more abrupt breakwith the status quo than do most mainstream opposition parties. Results in theNetherlands appear to have been an exception in this regard, with Geert Wilders'high-profile Party for Freedom (PVV) failing to match its pre-election expectations.

Parliamentary arithmetic now slightly morecomplicatedThe impact of these elections at the European level is likely to be much less dramaticthan it promises to be in a number of individual countries. Despite the surge insupport for populist parties, a majority of seats is still controlled by the maingroupingsofthecentrerightandcentreleft.Thetwobiggestgroupingsthecentre-right European People's Party (EPP) and the centre-left Progressive AllianceofSocialistsandDemocrats(S&D)enjoyarelativelyslimmajorityof53%,butthatfigure is boosted by a further 10% if the Alliance of Liberals and Democrats forEurope (ALDE) is included.

The likelihood of such cross-party consensus is strong in many areas. Rivalgroupings vote together in the European Parliament much more commonly than isusually the case in national parliaments. One reason for this is that political rivalriesbetween EU institutions are often sharper than those within them. But there will beareas in which centrist consensus will be more difficult to achieve and therefore inwhich the prospect of a Eurosceptic blocking will become more likely.

New free-trade deals are one possible such issue. In the context of heightenedeconomic uncertainty and many voters' feeling that globalisation may be to blame,concerns about the impact of major trade deals (notably a proposed agreement withthe US) could see a sufficient number of centre-left and centre-right parliamentariansrebel to make parliamentary approval difficult. Similarly, proposals to deepen theEU's single market for services are likely to generate a greater degree ofprotectionism across the parliament than might previously have been the case.

The culture of EU politicking is unlikely tochangeHowever, anyone expecting a fundamental shift in the way EU politics worksfollowing the elections is likely to be disappointed. This will become apparent withindays of the results' announcement, as attention shifts to the choice of a replacementforJosManuelBarrosoaspresidentoftheEuropeanCommission.TheLisbontreaty, which came into force in late 2009, subtly increases the European Parliament'spower in this area. The basic division of labour remains unchanged: the heads of EUmember state governments propose a candidate for the job, who the parliament mustthen approve or reject. The change introduced by Lisbon is that the heads ofgovernment must now take account of the parliamentary election results whenchoosing their candidate.

The main groupings in the parliament have, unsurprisingly, adopted a maximalistinterpretation of this new requirement. Prior to the election, each grouping selectedacandidatefortheCommissionpresidencyJeanClaudeJunckerfortheEPP,MartinSchulzfortheS&Dbeforebusilyspinningthelinethatinordertotakeaccount of the election results, the heads of government would have to nominatethe candidate of whichever grouping emerged victorious. They have threatened to

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vote down any other candidate proposed by the heads of government.

The heads of government, in response, have said that they are under no obligationto take their instructions from the parliament. They are correct on this point, bothformally and in terms of what the current political mood requires. Neither Mr Juncker(the former prime minister of Luxembourg) nor Mr Schulz (president of the EuropeanParliament) can be said to embody the rejectionist spirit of the election results. Thisis not to say that the heads of government will be any more adventurous when theycome forward with a candidate. On the contrary, the most likely outcome in the daysahead is a period of horse-trading both within and between EU institutions thatconfirms many voters' intuition that Europe's policymakers are deaf to their calls forreform.

May 28, 2014

US vice-president's visit fails to break deadlockThe US vice-president, Joe Biden, visited Cyprus for 24 hours on May 22nd. Theevent naturally received much local media attention, not least because it was thefirst visit by a US vice-president since 1962. The official purpose of the visit was tostrengthen bilateral ties and consult on the latest regional developments, includingthose that have taken place in Ukraine. Mr Biden expressed US hopes that Cypruswill emerge as an important regional player in the gas sector in the easternMediterranean. This is unlikely to happen unless there is a resolution of thedecades-old division of the island, but Mr Biden's efforts to push forward thenegotiations that resumed in February 2014 appear to have been unsuccessful.

Mr Biden named Cyprus as a "strategic partner", saying that it could be "a growingforce for peace, prosperity and stability in the eastern Mediterranean" and a majorplayer in "transforming the eastern Mediterranean into a new global hub for naturalgas and markets". The flattery was deliberate. During the cold war Cyprus was amember of the non-aligned movement with leanings towards Russia and the rhetoricof the former ruling communist Progressive Party of the Working People (Akel) hastraditionally been hostile towards the US. Moreover, the Cypriot professionalservices sector and, increasingly, the tourism sector, are heavily dependent onRussian business. This has made the Cypriot government reluctant to supporttougher US and EU sanctions on Russia in response to developments in Ukraine.

The issues of eastern Mediterranean stability and the resolution of the Cyprusproblem are connected. Natural gas fields located offshore of Israel, Cyprus andpotentially Lebanon can be better exploited if there is co-operation among gassuppliers, on the one hand, and Turkey, on the other. Turkey can play an importantrole both as a large consumer and as a transit country to the EU. The need todiversify EU gas supplies from Russia has taken on new urgency since the Ukrainecrisis.

Regional role depends on a Cyprus settlementWhether or not Cyprus really does become a key regional player, however, dependson several factors, the most critical being whether Turkey, Israel and Cyprus can co-operate on the exploitation of natural gas fields. The private companies exploitingthe giant Israeli Leviathan field received ten bids in March to supply gas to Turkeyby pipeline. There are two potential obstacles to this plan being realised. First,although theoretically the Leviathan partners could come to a commercialarrangement with Turkish companies on gas sales, it may well be difficult in practicegiven the current poor state of Turkey-Israel relations and the political weight givento energy issues. Second, such a pipeline would have to traverse the exclusiveeconomic zone (EEZ) of Cyprus. Under the UN Convention on the Law of the Sea(UNCLOS) the course of the pipeline is subject to the consent of the Republic ofCyprus. It is difficult to see Cyprus giving consent in the absence of a solution ofthe Cyprus problem.

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Yet, it was in precisely in his efforts to push forward a resolution of the Cyprusproblem that Mr Biden was less successful. His attempts to secure an agreementwhereby technical experts would be allowed access to the fenced-off "ghost"district of Varosha, which is under Turkish military control, fell through. Access fortechnical experts was a fairly minor confidence-building measure compared withthose that have been discussed but never implemented in the past. However, GreekCypriots have long insisted on Varosha-related moves and have suggested that thetalks cannot really progress without them. Thus, the failure of even this measure tobe implemented supports The Economist Intelligence Unit's assessment that there isonly a 30% chance of solving the Cyprus problem.

Hopes of shared LNG terminal plan are fadingCypriot hopes that Cyprus and Israel could share a planned liquefied natural gas(LNG) plant on the southern coast of Cyprus are beginning to wane as the partnersin Leviathan and the other large field, Tamar, pursue other options. An agreementwas signed in January to supply the Palestinian Authority from Leviathan; anotherfollowed in February to supply Jordan from Tamar; in May a preliminary accord wassigned to supply gas to an unused LNG plant in Egypt, also from Tamar. All ofthese involved supply by pipeline. This, together with the tender for supplyingTurkey from Leviathan, threatens to leave Cyprus out of the picture. This isespecially the case now that the agreement between the Leviathan partners, whichare also involved in exploiting Cyprus' Block 12, and Woodside Petroleum, a majorplayer in land-based LNG facilities, broke down in May. When announcing the endof the agreement, Noble Energy, one of the Leviathan partners, made it clear that itsplans for Leviathan were to build a floating LNG facility, thus not the shared land-based facility that Cyprus had hoped for. The only likely co-operation in the shortterm is selling gas to Cyprus for domestic consumption until Cyprus can use its ownresources.

As Israeli exporters pursue other options, time is moving against Cyprus. It will onlyplay a leading part if Turkey is brought into the picture, which in turn depends on asettlement of the Cyprus problem. Without this, Mr Biden's hoped-for role forCyprus as an important regional player in the gas sector could simply pass thecountry by.

EconomyForecast updatesApril 17, 2014: Inflation

Euro zone inflation confirmed at 0.5% in March

EventInflation, as measured by the EU's harmonised index of consumer prices (HICP), wasconfirmed at 0.5% in March, according to a final estimate released by Eurostat onApril 15th.

AnalysisFood and energy prices have been the main factors driving the slowdown in eurozone inflation since July 2013. However, core inflation (which excludes these volatileitems) was revised down to 0.7% in March, reflecting underlying weakness in pricepressures owing to weak demand conditions in much of the euro zone. Prices fell inthe weakest economies, notably Greece (-1.5% year on year in March), Cyprus (-0.9%), and Portugal (-0.4%). Meanwhile, Spanish inflation turned negative for thefirst time since October 2009 (-0.2% from 0.1% in February).

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Euro zone inflation is now being driven almost exclusively by the "core" economies,with price rises in Germany (where inflation fell to 0.9% in March) accounting foralmost half of the aggregate (or 0.24 percentage points), up from a 28% contributiona year earlier. France's contribution more than doubled over the same period (now29%), despite a fall in the inflation rate for March to 0.7%. It is therefore worthnoting that energy prices weighed less on price growth in Germany in March, anddomestic demand is also strengthening, underpinned by rising house prices andstronger wage growth. By contrast, tight credit conditions are still constraining theperipheral economies and suppressing price growth.

Base effects from Easter price increases in 2013 helped to depress the annualcomparison of price indices in March 2014. The inflation rate will therefore besubject to a sharp, albeit temporary, correction higher in April. This gives theEuropean Central Bank (ECB) more time to contemplate unconventional policyaction before weak price growth returns in May. We are expecting oil prices tosoften in 2014, and the euro to remain relatively strong, increasing the influence ofexternal downside price pressures even while demand recovers across the bloc. Theforthcoming asset quality review (AQR) may also constrain lending. In view of this,the ECB president, Mario Draghi, is likely to face increasing pressure to followthrough on the pro-easing rhetoric heard at the April press conference.

Impact on the forecastAlthough the governing council has yet to reach consensus on what form thiswould take, we expect a loosening of the bank's policy within months; of theunconventional measures available to the ECB, we think it is most likely to purchasesecuritised business loans.

April 23, 2014: Economic growth

Flash PMIs show euro zone improving, but France disappoints

EventThe flash purchasing managers' index (PMI) for the euro zone in April 2014 stood at54, an improvement following the dip to 53.1 that was recorded in March. Germanysurprised on the upside with a reading of 56.3, but France slipped back to 50.5following a sharp improvement to 51.8 in March.

AnalysisThePMIdataforAprilpublishedbyMarkitandgenerallywellcorrelatedwithrealGDPgrowth(seechartbelow)providefurtherencouragingsignsthataggregate

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economic activity across the euro zone is picking up. Real GDP has been on agradual upward trend since the end of 2012, when the growth rate troughed for thesecond time during the crisis.

Although the aggregate picture is a welcome one, the renewed divergence in theperformances of the euro zone's two largest economies, Germany and France, is adisappointment. A sharp improvement in the French composite PMI in March (whenit jumped to 51.8 from 47.9 in February) had raised the prospect of more balancedgrowth across the region. However, the data for April, which record a slide back to50.5 in France, highlight the continuing lack of momentum behind the Frenchrecovery.

In Germany, by contrast, the flash composite PMI picked up to 56.3 in April, from54.3 in March. The Ukraine crisis was an important factor in a range of weak Germansurvey data in March; the PMI's rebound in April suggests that the impact of thecrisis on the economy may be smaller than was feared a month ago.

Looking at a breakdown of April's flash PMI data for the manufacturing andservices sectors, Germany posted strong readings of 54.2 and 55, respectively. InFrance, the corresponding figures were 51.6 and 53. Across the euro zone as awhole, the flash manufacturing PMI stood at 53.3, a three-month high. Although theservices PMI was lower, at 53.1, this was the strongest result in almost three years.

Impact on the forecastThe latest PMI data are in line with our forecast that the euro zone will register real

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GDP growth of 1.1% in 2014.

April 30, 2014: Inflation

Euro zone inflation remains far below target in April

EventThe headline rate of inflation, as measured by the EU harmonised index of consumerprices (HICP), rose to 0.7% in April 2014 from 0.5% in March, according to a flashestimate released by Eurostat on April 30th.

AnalysisAn increase in the rate of inflation in April was widely expected, but Eurostat's flashestimate again came in below market expectations. As the chart below indicates, theservices sector accounts for almost all of the total aggregate level of inflation acrossthe single currency area, with prices rising by 1.6% year on year. Inflation slowedagain to 0.7% year on year for food, alcohol and tobacco, bringing the sector'scontribution to the overall rate down to just 0.1 percentage points. This was offsetby a 1.2% fall in energy prices, reducing the overall inflation rate by 0.1 percentagepoints.

With the euro showing little sign of depreciating and with little prospect of animminentsharppickupinenergypricesunlessdevelopmentsrelatingtoUkrainebegintoescalatemorerapidly,whichisnotourbaselineforecastthedevelopmentof demand and credit conditions in the euro zone will be key determinants of theinflation rate in the months ahead. Lending is likely to be under pressure for much ofthis year as banks undergo the asset quality review by the European Central Bank(ECB), and although recent quarters have seen a tentative recovery of economicactivity across the bloc, as yet this is too fragile to underpin a significantimprovement in consumer sentiment and spending.

When announcing its next monetary policy decision, the ECB is likely to highlightthe fact that core inflation picked up to 1% in April from 0.7% in March, but itshould be noted that this increase just takes the rate back to its position inFebruary. It is much too early to say that upward pressure on prices is building. TheECB continues to assert that medium-term inflation expectations remain wellanchored to its target of below, but close to, 2%. However, its scope for pushing therate upwards is constrained by significant political and technical obstacles.

Impact on the forecastWe do not expect the latest inflation data to prompt a change of stance by the ECB

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when its governing council meets on May 8th. We continue to expect someloosening in the months ahead, but consensus does not yet exist in the ECB as tothe timing and nature of any policy change.

May 9, 2014: Monetary policy outlook

Draghi paves the way for a June rate cut

EventAt its monthly meeting on May 8th the governing council of the European CentralBank (ECB) left its key policy rates unchanged. However, the bank's president,Mario Draghi, stressed his "serious concern" about the external strength of the euroand raised expectations that policy would be eased in June by stating that thegoverning council is now "comfortable with acting next time".

AnalysisA loosening of monetary policy in June is in line with our forecast that the ECB willact to counter the stubbornly low inflationary pressures across the euro zone,underpinned by weak bank lending and an appreciating currency. We had expectedthe bank to turn first to non-conventional policy tools (such as private-sector assetpurchases or liquidity operations tied to bank lending volumes), but two factorshave prompted us to alter this part of our forecast.

First, Mr Draghi appears to have made little progress in overcoming the political andtechnical obstacles that he faces if the ECB is to use non-conventional tools.Second, the strength of the euro has compounded weak price pressures in the eurozone and steadily ratcheted up the pressure on Mr Draghi to deliver sooner ratherthan later on his repeated commitment to loosen policy if needed.

We now think that monetary loosening will take the form of a cut to policy rates, aneasier policy shift to deliver. This would take the bank's main refinancing rate to, orclose to, the nominal zero bound and its deposit rate into negative territory. Thisshould put downward pressure on the euro; indeed the currency weakened againstthe US dollar following Mr Draghi's press conference. However, it is unlikely todeliver a boost to the real economy of the scale that other central banks havesought with non-conventional interventions such as quantitative easing.

Impact on the forecastWe maintain our forecast that the ECB will loosen monetary policy at its meeting onJune 5th, but we now expect this to take the form of a cut of up to 25 basis points inboth the bank's key refinancing rate (currently 0.25%) and its deposit rate (currentlyzero). There is still a risk that Mr Draghi will fail to follow through on his words:earlier this year he appeared to strengthen the bank's easing bias but failed to followthrough with a change in policy. However, price and exchange-rate movementssince then have strengthened the case for action.

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May 16, 2014: Economic growth

Real GDP contracted by 0.7% quarter on quarter in Q1

EventReal GDP in Cyprus declined on a seasonally adjusted basis by 0.7% quarter onquarter in the first quarter of 2014. This compares with a 0.8% contraction in thefourth quarter of 2013. On a year-on-year unadjusted basis, real GDP fell by 4% inthe first quarter.

AnalysisThe year-on-year contraction recorded in Cyprus in the first quarter was by far thesteepest in the euro zone. Greece ranked a distant second on this measure, with afall in output of 1.1%. Nevertheless, there are signs that the long recession inCyprus, which began in mid-2011 and accelerated in the run-up to the banking crisisin March 2013, has started to bottom out.

First, January-March 2014 was the third consecutive quarter in which the pace ofquarterly GDP decline has moderated. Signs of the recession easing are supportedby other data, such as the Eurostat economic sentiment indicator, which has shownconsistent improvement since April 2013, the month in which Cyprus entered theeuro area bail-out programme. In April 2014 the indicator reached 97.3, close to the100 threshold that shows positive sentiment. Other signs are that the decline inretail sales has also been moderating and the pace of increase in unemployment hasbegun to ease.

The first quarter of 2013 largely preceded the banking crisis in the second half ofMarch 2013, when the banks closed for 12 days. As pre-crisis levels of activitymove more fully outside the 12-month horizon, it is quite likely that year-on-year realGDP rates of decline will continue to ease over the remaining quarters of the year.

Impact on the forecastGiven the slower than expected pace of of contraction in the first quarter, we will bereviewing our current forecast that real GDP will decline by 4.6% this year.

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May 22, 2014: Economic growth

Euro zone PMIs steady but concerns mount about France

EventThe flash composite purchasing managers' index (PMI) for the euro zone in May2014 stood at 53.9, down marginally from 54 in April. Germany was unchanged at56.1, but worries about France's faltering recovery were compounded by a fall from50.6 in April to 49.3 in May.

AnalysisThe latest PMI data from Markit highlight the unevenness of the euro zone's post-crisis recovery. The German economy started the year with robust quarter-on-quarter growth of 0.8%, and the PMI suggests that a solid expansion has continuedinto the second quarter. Of particular note is the fact that the German servicescomponent reached 56.4, a 35-month high and well above the no-change thresholdof 50. The contrast with France is stark. Having nudged into expansionary territoryin March and April, it slipped back into contraction in May, suggesting stronglythattheeconomy'slacklustreperformanceinthefirstquarterrealGDPwasunchangedquarteronquarterhaspersisted.

A number of the region-wide PMI components point to a strengthening of the eurozone recovery. Output and new orders recorded their fastest expansions since 2007,while job creation was at its highest since 2008. We remain cautious about makingdirect inferences from the PMIs to expected rates of real GDP growth. In recentmonths, survey-based indicators have tended to present a more optimistic picture ofeconomic conditions than has subsequently been borne out by hard data releases.The aggregate performance of the euro zone relies to a large extent on theperformance of its four largest economies: Germany, France, Italy and Spain. AtpresentbothFranceandItalyareflatwhichisaformidableobstacletothebloc'simmediate growth prospects.

Impact on the forecastThe latest data are in line with our expectations. We recently revised upwards ourforecast for German real GDP growth in 2014 from 1.6% to 2%. But French andSpanish growth will be significantly weaker, both at 0.9%, and we have reviseddown our Italy forecast from 0.5% to just 0.1%. The combination of theseprojections underpins our unchanged forecast that the euro zone will grow by 1.1%this year.

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June 3, 2014: Inflation

Euro zone inflation falls back to 0.5% in May

EventThe headline rate of inflation, as measured by the EU's harmonised index ofconsumer prices (HICP), fell back to 0.5% in May 2014 from 0.7% in April, accordingto a flash estimate released by Eurostat on June 3rd.

AnalysisThis was the eighth consecutive month in which the inflation rate has been below1%, a level which the president of the European Central Bank (ECB), Mario Draghi,has referred to as a "danger zone". Mr Draghi has already clearly signalled that thebank intends to ease its policy stance when it meets on June 5th. However, giventhe length of time it has taken him to build consensus behind this position on theECB's governing council, the latest data raise questions as to the ECB's capacity todeliver a sufficient policy response to disinflationary pressures that appearincreasingly broad-based and entrenched.

The ECB will be concerned by the fact that core inflation (which excludes energy,food

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