Cyprus -- 2004 Article IV Consultation, Preliminary Conclusions of the IMF Mission

October 29, 2004

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
October 29, 2004

1. The Cypriot economy has seen substantial changes since the last IMF Article IV consultation in 2002. Chief among these changes is accession to the European Union, the full impact of which is only gradually making itself felt. In a sense, Cyprus ceased to be an island on May 1, 2004. Cypriot views are being heard in EU institutions and the economy of Cyprus is adapting to EU directives. While these changes pose significant challenges for the authorities and for the private sector, they also offer substantial opportunities to enhance economic growth in Cyprus, both quantitatively and qualitatively. The main theme of our consultation with the authorities on this occasion has thus been the challenge of adapting to life in the EU.

2. After a period of relatively weak growth, the Cypriot economy has begun to rebound in 2004. While sluggish European growth and geopolitical concerns in the Middle East contributed to subdued growth in 2002-03, particularly in the tourism sector, tourist arrivals and growth more broadly have gradually recovered in 2004. Owing in large part to stronger domestic demand, the economy is expected to grow by about 3½ percent in real terms this year, and could reach almost 4 percent in 2005. Real per capita income has continued to increase, now reaching above 80 percent of the average European Union 25 income level, adjusted for purchasing power. Unemployment remains low, in particular by European standards, and inflation has been kept at bay, despite some upward pressure exerted through increases in indirect taxes in 2003 and higher energy prices in 2004.

3. Substantial progress with structural reforms has been achieved in a number of areas, mainly as a result of efforts to conform with the acquis communautaire. In the context of the major tax reform of 2002-03, indirect taxation has been aligned more closely with EU standards and direct taxes have been lowered. The capital account has been liberalized without jeopardizing monetary and external stability, while financial sector legislation has been strengthened in line with EU directives. Harmonization of Cypriot policies with the requirements of the acquis has brought about substantial changes in sectors as disparate as public health and regulation of the insurance sector.

4. Despite these achievements, Cyprus still faces significant policy challenges, which could be exacerbated by the uncertain international environment. Fiscal slippages in recent years could, if they persist, place the objective of early adoption of the euro in question. Since 2001, the general government deficit has increased by 4 percentage points, reaching 6.4 percent of GDP in 2003. There are also lingering concerns regarding competitiveness of the Cypriot economy. Significant external risks remain, including continued instability in the Middle East, further hikes in oil prices, or a setback in the current European recovery. Because of its small size, external openness, and geographical location, Cyprus is particularly susceptible to such developments.

5. The policy agenda should thus focus on strengthening economic performance through sound macroeconomic policies, particularly fiscal consolidation, and by reducing vulnerability to external shocks through structural reforms. The mission welcomes the comprehensive agenda outlined in the authorities' Convergence Program, which is designed to achieve these objectives. In particular, the mission:

• agrees with the authorities on the need for a credible and well-specified fiscal adjustment, paving the way for joining ERM2, as well as a conservative medium-term fiscal framework so as to ensure a sizable reduction in the ratio of public debt to GDP;

• welcomes the authorities' firm commitment to maintain low and stable inflation, and to ensure high standards of financial sector supervision; and

• supports efforts to strengthen external competitiveness and ensure that export performance remains strong, especially in the tourism sector, through deeper structural reforms aimed at improving economic productivity, particularly efforts to increase labor market flexibility and strengthen product market competition in order to increase productivity.

6. In light of slippages in recent years, fiscal consolidation should be the authorities' central priority. Driven by expenditure overruns, the deficit rose to 6.4 percent of GDP last year, well above the Maastricht criterion of 3 percent, as marginally improved revenue performance associated with the 2002-03 tax reform was more than offset by overly generous compensatory spending linked to the higher VAT rates (particularly untargeted social benefits). While medium-term fiscal sustainability is not in question, the debt-to-GDP ratio has continued to diverge from the Maastricht threshold of 60 percent, rising above 70 percent in 2003. Demographic pressures over the medium term, in particular as regards projected pension and health care costs, underscore the importance of bringing down the debt ratio.

7. The mission supports the fiscal consolidation strategy laid out in the 2004 Convergence Program, and welcomes the authorities' firm commitment to its implementation. The adjustment targeted for this year is relatively modest, but attainable. Importantly, a much more substantial retrenchment—to a deficit of 2.9 percent of GDP—is projected for 2005. Further tightening is expected to take place over the medium term, bringing the general government deficit below 2 percent of GDP and the primary balance to a surplus of 3 percent by 2007. The measures laid out in the Convergence Program are well-balanced between revenues and expenditures, and include several politically difficult structural reforms. Importantly, while the Convergence Program is aimed at ensuring successful participation by Cyprus in ERM2 and ultimately the euro area, the mission feels that strong fiscal measures would be called for even if euro adoption were not in question.

8. Despite relatively favorable fiscal data for the first nine months of 2004, there is no room for complacency. Previous efforts to contain the fiscal deficit have been disappointing, meaning that the authorities' credibility is now on the line as never before. The full-year deficit target of 5.2 percent of GDP is within reach, but seasonal spending pressures late in the year must be resisted in order to achieve it. In this context, the mission particularly welcomes the government's decision not to submit supplementary budget requests of quantitative significance during 2004.

9. This year's welcome momentum toward fiscal consolidation should be maintained in 2005. The draft budget that is currently with parliament includes a number of sensible measures designed to contain the deficit. Several of these measures are politically difficult but extremely important—such as a significant increase in public sector retirement ages, moderation in public sector wage growth, and a hiring freeze for the government. It is worth emphasizing that some sacrifice is called for if Cyprus is to maintain macroeconomic stability and thus enjoy the full benefit of membership in the EU, including early adoption of the euro. Hence, the authorities should stand ready to take further measures if needed in order to achieve their fiscal adjustment targets. Sensible additional steps would include: more aggressive collection of tax arrears; widening the tax base to ensure full coverage of sectors currently subject to preferential treatment (such as commercial businesses owned by the church or the cooperative movement); further broadening and revision of fees for government services; better targeting of social benefits (to concentrate state assistance on poorer households at the expense of relatively wealthier Cypriots); and—if other options are not sufficient—a limited tax increase.

10. Looking ahead, credibility and policy formulation over the medium term will be buttressed by establishing an explicit multi-year fiscal framework. Such a framework—based on realistic economic assumptions, clear fiscal objectives, and the specific measures to achieve them—would provide the basis for choosing among competing spending priorities in a transparent and efficient manner. In this light, we urge the authorities to undertake a Fiscal Report on the Observance of Standards and Codes (ROSC) as soon as possible, to assess the Cypriot budgetary system against best international practices for fiscal transparency.

B. Monetary and exchange rate policy

11. Monetary policy has remained vigilant in the face of capital account liberalization and relaxed fiscal policy. The long process of liberalizing capital movements has now been completed successfully. Further, the authorities demonstrated their steadfast commitment to maintain macroeconomic stability by sharply raising official interest rates at end-April. The mission notes that this move met with broad support throughout the financial and business community, and it supports the authorities' continued cautious monetary policy approach at this juncture, particularly in light of the potential for inflationary pressures reflecting higher prices for oil from abroad and for real estate at home.

12. The authorities intend to join ERM2 as soon as possible, underscoring the need for fiscal adjustment and further structural reforms. Cyprus has long-standing and successful experience with an exchange rate framework similar to ERM2, so technically the move should be straightforward. Politically, moving into ERM2 will require expenditure restraint and the courage to tackle long-overdue structural reforms. In particular, the need to improve external competitiveness points to the need for greater labor market flexibility and product market competition. There are lingering concerns in the tourism sector that other Mediterranean destinations are threatening to eat into Cyprus's market share. Although the decline in tourism arrivals of the last few years can partially be attributed to geopolitical uncertainty as well as sluggish growth in the rest of Europe, the decline in tourism spending points to a need to address the underlying cost structure, including via a thorough reform of the approach to wage setting.

C. Financial market liberalization and external sustainability

13. The mission welcomes progress in strengthening financial sector legislation in line with EU directives. Nevertheless, further reforms are needed to strengthen the financial system and its ability to deal with the increased external exposure and competition following EU accession. For example, loan recovery cycles remain excessively long, contributing to nonperforming loan ratios that seem high by international standards. In this context, the mission welcomes the steps taken by the authorities to bring loan classification definitions in line with European best practices, and it supports the cautionary note sounded recently by the CBC as regards lending to the real estate sector. Nevertheless, while coordination and cooperation between the several financial sector supervisory authorities has been stepped up, more remains to be done in this area. Future reforms need to focus particularly on enhancing the supervision of Cooperative Credit and Savings Societies, strengthening their capital base, and generally encouraging consolidation in this sector. The mission looks forward to next year's update of the 2001 offshore sector assessment, upon completion of which we strongly recommend that the authorities seek to participate in the IMF's Financial Sector Assessment Program (FSAP).

14. While external debt sustainability is not at risk in Cyprus, the growing burden of net external liabilities is of some concern, reinforcing the need for fiscal consolidation. Current account deficits of 4-5 percent of GDP may be financable in light of the strong record of economic growth in Cyprus—now bolstered by EU membership, but an external debt stock of nearly half of GDP is moderately worrisome. As evidence of the country's international creditworthiness, a sovereign Eurobond issue of €500 million was successfully launched this summer, priced at only 23 basis points over the comparable German bund benchmark. Although lower cost external borrowing is welcome, it should not feed a temptation to relax fiscal adjustment efforts. It also suggests a need to deepen domestic debt markets.

D. Structural reform and the labor market

15. Cyprus has made major strides in meeting the requirements of the acquis communautaire, but further progress with structural reforms is necessary. In particular, more remains to be done to foster competition and promote efficiency, including in sectors like air transport, electricity, and telecommunications. Together with measures to promote competition more generally throughout the economy, it is now time to consider corporatization of the electricity authority and the telecommunications company, with an eye toward introducing a modern corporate governance structure in them. Over time, the authorities should consider privatizing these firms, unless a management and financial review confirms that the return on the state's equity investment exceeds the opportunity cost of alternative investments—including in better healthcare and education. Ultimately, except in the unlikely event that the government can manage productive enterprises more efficiently than the private sector, it should exit from areas of economic activity where commercial forces can operate adequately.

16. With near full employment conditions, labor markets have performed well, but there is still scope for policies to improve labor market flexibility. Labor shortages exist in some sectors, and the labor market is likely to tighten further as growth picks up. Flexibility would be promoted by:

• facilitating the use of part-time and fixed-term employment, thereby raising labor force participation, particularly for women;

• strengthening the link between educational training and the requirements of the labor market, to improve job matching;

• continuing a flexible policy vis-à-vis foreign workers; and

• expanding the number of crossing points for Turkish Cypriot workers from the northern part of the island—to the extent that this is possible.

17. Although the centralized wage bargaining system in Cyprus has traditionally fostered social dialogue and contributed to peaceful employer-union relations, it is now in need of reform. As currently constituted, the wage formation mechanism contributes to the persistence of inflationary shocks, thereby leading to a loss of Cypriot competitiveness on external markets. The automatic cost-of-living indexation of wages to past inflation (COLA) was an important security factor in times of macroeconomic instability. But Cyprus has long had low inflation, and the clear aim of entering the euro area should provide comfort to social partners that real wages will not be eroded by lax macroeconomic policies. In the event, the COLA system—especially when coupled with seniority-based rules governing salary increases in the public sector—builds in a structural upward drift in the real wage bill. For the past few years, therefore, the wage bargaining system has led to high nominal wage increases, as well as unit labor cost increases that are higher than in partner countries, implying a deterioration in the competitiveness of Cypriot goods and services on both domestic and external markets. Moreover, this system affords employers relatively little scope for providing performance-related compensation increases. The mission therefore recommends that a reform of the COLA system, and the wage-setting mechanism more generally, be undertaken with social partners interested in ensuring the long-run competitiveness and rapid growth of the Cypriot economy. For example, as a first step the COLA system could be redesigned to exclude changes in the VAT or energy prices.

18. Lastly, while Cypriot statistics are generally of good quality, improvements are possible in a few areas regarding the timeliness, consistency and definitions used by the authorities. The mission therefore urges the authorities to move promptly to subscribe to the IMF's Special Data Dissemination Standard (SDDS).

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19. The Cypriot economy has undergone a period of momentous change on its way to EU accession. In recent years, strong efforts have been undertaken to reduce structural impediments to competition and strengthen institutions, as required for EU membership. Nevertheless, significant challenges remain. The authorities should continue to strengthen the fiscal position, both in the short run (thereby improving prospects for early euro adoption) and over the medium term. They should also move expeditiously to adopt further reforms designed to improve competitiveness, foster competition, and enhance labor market flexibility. These steps will enable Cyprus to take full advantage of the opportunities offered by its membership in the European Union and, more broadly, in a rapidly globalizing world economy.

20. In concluding its visit, the mission wishes to thank the authorities very sincerely for their full cooperation and warm hospitality.

Nicosia, October 29, 2004





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