Exchange rate policy in Cyprus has been historically geared towards maintaining macroeconomic stability through the linkage of the Cyprus pound with a currency anchor, be it a single currency or a basket of currencies. Given, among other factors, the smallness and openness of the economy, this was considered to be an appropriate exchange rate policy framework for Cyprus. As suggested by the island’s overall economic performance, the policy of using the exchange rate as a means of containing inflation has served the economy well, not only in terms of maintaining low inflation, but also in terms of contributing to the country’s development process through the solidification of a stable and supportive macroeconomic environment.

The currency anchor of the Cyprus pound has changed several times since independence. During the period 1960-1972, the pound was pegged to sterling. Following the collapse of the Bretton Woods system in 1972 this link was terminated and the pound was pegged to the US dollar for a short period of time. The Cypriot currency was subsequently linked to an import-weighted currency basket during the period 1973-1984 and to a trade-weighted currency basket during the period 1984-1992.

Cyprus’s aspirations to become a member of the European Union led to a reconsideration of the choice of currency basket in 1992. As a result, on 19 June 1992 the Cyprus pound was unilaterally pegged to the ecu, with a central rate of CY£1=€1,7086 and fluctuation margins of ±2,25%. From a static point of view, the ecu basket did not fully reflect Cyprus’s composition of commodity trade. Nonetheless the larger share of trade in services was with EU countries. Furthermore the choice of the ecu anchor was in part necessitated by the objective to tie the pound to a currency representing a group of countries whose primary goal was price and macroeconomic stability. Besides reinforcing economic ties with the EU, the choice of exchange rate policy was also driven by the desire to maintain price and macroeconomic stability in Cyprus as well as to safeguard the international competitiveness of the island’s economy.

Following the successful ecu-peg policy, the Cyprus pound was pegged to the euro on 1 January 1999, the first day of the introduction of the new European currency. The central parity rate was maintained at CY£1 =€1,7086. Initially, the fluctuation margins were also maintained at ±2,25%. On 1 January 2001, however, wider bands of ±15% were introduced in order to enable the Central Bank to absorb any shocks from potential destabilising capital movements and to deter speculative capital flows, in the context of capital account liberalisation. At the same time, the narrower bands of ±2,25% were temporarily maintained in order to anchor prices and expectations.

The introduction of the wider fluctuation margins coincided with the implementation of two important structural reforms in Cyprus. The first reform concerned the abolition of the statutory interest rate ceiling, which was accompanied by a relaxation of all restrictions on medium and long-term foreign borrowing by Cypriots. The second reform concerned the introduction of a new process for the determination of the daily bilateral rates of the Cyprus pound, namely the “fixing” process. Under this process, the Central Bank and the commercial banks meet once a day and through an auction process the parity of the Cyprus pound against the euro, the dollar and sterling is determined. The resulting rates are considered as important benchmarks for the domestic market. This process has replaced the administrative method of determining the daily value of the Cyprus pound that existed before.

Developments in 2001 led to the abolition of the narrower bands on 13 August 2001, so that only the ±15% margins are currently in place. In particular, following the abolition of restrictions on medium-term and long-term borrowing with maturities of over two years by residents on 1 January 2001, capital inflows rose significantly as private individuals and firms increased their borrowing in foreign currency, mostly euro, taking advantage of the interest rate differential between euro-denominated and pound–denominated loans. This exerted an upward pressure on the exchange rate, and it also exposed these borrowers to increased exchange rate risks.

The decision to abolish the narrower fluctuation margins was taken concurrently with decision to reduce interest rates by 50 basis points. These reductions were perceived as necessary due to the anticipated negative impact of the prolonged global economic slowdown on the Cyprus economy. The decline in interest rates also reduced the interest rate differential between euro-denominated and pound-denominated loans, which further slowed down foreign currency borrowing by residents.

As a consequence of the global economic slowdown following the 11 September attacks, interest rates were reduced further in September and November 2001 by 50 basis points in each case.

On 1 May 2004 Cyprus became a full member of the European Union. The compliance with the acquis communaitare, which included among other things the liberalisation of the capital account, was accomplished very smoothly. The political uncertainty which prevailed in Cyprus in April 2004 just before and after the Annan Plan referendum, together with the full capital account liberalisation upon accession, were the main reasons for the outbreak of rumours of a possible devaluation of the Cyprus pound. The Central Bank of Cyprus reacted to these rumours, which caused limited but persistent capital outflows, by comments by the Governor intended to send appropriate signals, as well as by increasing interest rates by 100 basis points. Following these measures, capital outflows returned to normal levels.

During the second half of 2004 the Cyprus economy showed signs of recovery, while the rate of inflation rose moderately due to a significant increase in the price of oil. In February 2005 the Monetary Policy Committee (MPC) decided to cut interest rates by 25 basis points following further fiscal consolidation.

On 2 May 2005 the Cyprus pound joined ERM II, at the pre-existing central parity of CY£1=€1,7086 (€1=CY£ 0,585274) and at the pre-existing fluctuation margins of ± 15%. The participation of the pound in ERM II confirmed its sustainability, therefore satisfying the appropriate prerequisite for interest rate convergence. Indeed, in two consecutive meetings of the Monetary Policy Committee in May and June 2005, interest rates were reduced by 50 basis points in each case.

On 10 July 2007 the EU Council of Finance Ministers approved Cyprus adoption of the euro as from 1 January 2008 and decided that the Cyprus pound exchange rate vis-a-vis the euro will be fixed at the central parity of €1=CY£ 0,585274. This decision was the result of Cyprus' commitment to a prudent exchange rate policy framework along with disiplined monetary and fiscal policies.

Hence, on January 1 2008 the Cyprus pound will be replaced by the euro as the legal tender money of Cyprus at the irrevocable fixed exchange rate €1=CY£ 0,585274.