Iran war only exacerbates Cyprus’ underlying economic challenges

Even before the outbreak of the war on Iran the Cyprus government faced profound challenges including the need to protect the living conditions of lower income households, to undertake investments in energy infrastructure and conservation to safeguard against the adverse effects of shocks and climate change on the economy, and to support the provision of other basic infrastructure and productive investments required to sustain real economic development.

And now the external shock of the widening Iran war distinguished by its impact in boosting energy prices and disrupting aviation and shipping transportation is challenging further the resilience of the Cyprus economy.

Short-term resilience

As stated by many commentators including Finance Minister Makis Keravnos the impact of the war on Cyprus will depend crucially on its duration and particularly on how long the Strait of Hormuz is closed for the passing through of ships carrying fossil fuels, fertilisers and other essential products. Already in the first two weeks of the war crude oil prices have shown great volatility and by March 12 were over $100 per barrel, more than 35 per cent above the pre-war level. Initially, higher fuel prices will quickly feed into boosting transportation costs including those of jet fuel for aircraft and petroleum for motor vehicles. And thereafter prices of other products, like fertilisers and plastics, where oil is a key input, are likely to record large increases.

More generally, with energy resilience of Cyprus relatively low because of its heavy dependence of the country on imported crude oil, the country’s rate of inflation in Cyprus can be expected to show a sizable increase in the coming months. And the extent of the rise in prices will depend importantly on the duration of the Iran war and the measures taken by the government to moderate price increases.

Notwithstanding, any anti-inflation measures taken by the Cyprus government, such as increased subsidisation of the electricity costs of vulnerable households and businesses, many families and firms are likely to have diminished purchasing power in the face of significantly higher costs.

Notably, the Cyprus economy is heavily reliant on tourism and the closely related hospitality sector of accommodation and food services to generate production and incomes. And surely with the substantial curtailment of air services with Middle East locations and hubs and the psychological impact of Cyprus being a possible target for incoming drones and missiles from Iran, travel to Cyprus will be negatively affected. Already, many hotel reservations by foreign tourists for the coming months are being cancelled, and if the war continues on into April and/or Cyprus is the target of more attacks from Iran, the inflow of tourists will be reduced substantially.

In addition, planned business investments could be delayed, even cancelled, by the prospect of rising costs. And with rising prices restraining consumption a fall in domestic demand would combine with the decline in the external demand arising from declining tourist numbers to markedly reduce GDP growth and raise unemployment. Thus, there is the likelihood of the Cyprus economy experiencing a period of stagflation, especially if the Iran war continues for some months and involves military operations on and around the island. Indeed, proximity to the war zone guarantees vulnerability.

The statement of government spokesman Konstantinos Letymbiotis inferring that “key macroeconomic indicators supporting Cyprus’ resilience, including growth, budget surpluses, declining public debt, and a budget surplus” would make Cyprus more resilient is debatable. While relatively rapid GDP growth contributes to raising the savings of higher income persons enabling them to maintain their standard of living, many lowly paid employees in the private sector have hardly benefitted from recent GDP growth and will increasingly struggle to eke out decent living conditions in the face of rising prices.

And government leaders should realise that in so far as government surpluses take money and purchasing power out of the economy and stem partly from failing to spend effectively on necessary infrastructure projects, the resilience of the economy is weakened. And conversely, it can be contended that with surpluses enabling reserves to be built up and debt repaid and lowered, the government finances have become much less vulnerable to shocks, such as that emanating from the ongoing Iran war. However, the government will need to use its reserves, including nearly €7 billion in cash deposits at banks, effectively in the short-term, such as in subsidies and social spending to support vulnerable persons and businesses.

Longer-term resilience

In recent years the authorities have focused excessively on ensuring stability in the government finances, even fiscal austerity, so as to make the country resilient to the need for expensive debt financing in the wake of possible shocks to the economy. But over-emphasis on maintaining fiscal stability has been at the expense of achieving longer-term economic resilience and meeting basic infrastructure needs, which are inextricably linked, as high-quality, resilient infrastructure serves as the backbone for sustained economic growth and a cohesive society.

The government is failing in planning and effectively implementing projects that will provide businesses and households with reliable and affordable supplies of energy over the medium to longer-term, such as fuel and electricity inputs for transportation, business operations, and household needs. For many years the production and distribution of natural gas from offshore fields have been promised as the prime means for meeting the longer-term energy needs of Cyprus, with the construction of a terminal at the coastal location of Vasiliko for the receipt and distribution of liquid natural gas being central to the project. However, the implementation of this LNG project was halted in July 2024 owing to allegations of corruption in the award of the project to a Chinese consortium. And the costs of inaction in not completing this and other energy projects are being felt in the lack of energy resilience as well as in the large fines being levied on the taxpayer for the failure of Cyprus in meeting EU targets in reducing carbon emissions.

In addition, in the face of a rapidly expanding tourist population and drought conditions the government has failed to construct and adequately maintain the infrastructure necessary for ensuring adequate water supply for producers and households. Already, farmers in certain areas have been deprived of water for their produce in order to meet the needs of hotels and golf courses catering for tourists. 

Most importantly, from a longer-term perspective the government and banks are giving priority to extending building permits and loans, respectively, to developers to construct and renovate properties that are contributing to degrading the natural environment. And together with the government failing to penalise violators of environmental regulations and to significantly change the energy mix toward renewables, the resilience of Cyprus to the adverse effects of climate change is being increasingly and substantially diminished.

Concluding remarks

If the Iran war continues beyond March and prices of crude oil and other energy commodities remain elevated the government should moderate the pass-through of higher imported energy prices to certain domestic products, such as for electricity, fuel for transportation, and basic food and baby products, where additional costs will hit lower-income households and many pitifully-paid pensioners the hardest. Accordingly, in response, the government should use its abundant financial resources to raise the subsidisation of the electricity costs for vulnerable persons and businesses, lower further excises and VAT on the retail purchase of fuel for local transportation, and cap increases in the prices of essential food products and specific sanitary items.

Although tourism and closely related economic activities are being hurt by the consequences of the Iran war, businesses such as hotels have profited handsomely from the very large and sustained increase in tourist numbers over recent years and should have built up considerable reserves to meet contingencies. Thus, such businesses should not be provided with any financial assistance from the government.

If the costs of certain key inputs into the agricultural sector, like feed grains for livestock and fertilisers for crops, are raised substantially then there would be a good case for the government subsidising the pricing of such items so as to help alleviate the hardship of many farmers already suffering from drought conditions and diseases to their animals.

Most importantly, numerous countries including Cyprus have demonstrated a lack of energy resilience to cope with the higher prices of and the increasingly limited supplies of fossil fuels produced by the Iran war.

Indeed, Cyprus must prepare and seriously implement an energy plan to reduce the economy’s vulnerability to shocks in the availability of fossil fuels. The drive toward the increased output and storage of renewables must be accelerated by effectively implementing policies that significantly raise competition in this area of energy production. And in addition, serious efforts to raise energy supply at affordable prices must be supported by investments in essential infrastructure, such as in the upgrading of the electricity grid and its interconnection.

Equally, Cyprus must invest in the construction and high-quality maintenance of infrastructure and take measures to conserve water to ensure water resilience.

And in line with action to create energy and water resilience Cyprus should become serious in implementing measures to enhance resilience to the adverse effects of climate change by, among other things, taking into consideration damage to the natural environment in prolifically giving building permits and in enforcing environmental regulations.